> Legend Strategic Commentary

Jasper Becker October 2011

John Boehner is wrong

The hysterical denunciations of the Senate's Currency Bill on both sides of the Pacific are misplaced. This is not a repeat of the 1930 Smoot-Hawley tariff law but an opportunity to press the reset button on America's relationship with China, something which everyone knows is long overdue.

America's elite should start by acknowledging what went wrong back in 1999. President Clinton and his negotiating team led by Charlene Barshevsky negotiated both a badly flawed trade agreement and the terms of China's membership of the World Trade Organisation. It set off an explosion in bilateral trade but in China's favour. The trade deficit grew from 84 billion to 278 billion USD between 2001-2010 costing by some estimates, a total of 2.8 million US jobs. No one, let alone the Chinese had predicted this would happen but by now and the deficit is so large it threatens to destabilize the international trade system.

The agreement was flawed from the outset because it allows China to unilaterally decide on the terms of trade. China was left free to control two important things: fix the value of the Renminbi against the Dollar, and to introduce international labour standards and other regulatory burdens only when and if it chooses to.

You can't have free trade without market driven exchange rates. When President Nixon abandoned the gold standard in 1972, the world entered an era of free floating exchanges rate. So when a country has continuous trade surpluses, its currency should move against its chief trading partners. With a currency peg this does not happen.

During the Cold War, it was vital that the United States made its allies in Asia, Japan, South Korea, Taiwan, Thailand, Hong Kong - grow strong and prosperous in order to keep them out of the Communist bloc. After the fall of Vietnam this became even more important. Thus they were encouraged to peg their currencies to the Dollar. The US was also prepared to sacrifice certain domestic industries like apparel making, even to the extent of subsidising overseas manufacturers with low cost US cotton. It tolerated countries like Japan or South Korea illegally blocking the import of American goods like cars or beef.

The strategy was a great success. American won the Cold War. In China, the Communist Party hung on to power but had to abandon the communist economic system. However by 1999 when Clinton was negotiating the trade deal with China, he seemed to forget that it no longer served any strategic purpose to extend these same privileges to China. At the time, China was doing very poorly. By the late 1990s, the state-owned enterprises had let go tens of millions of workers and most were bankrupt.

Clinton chose to treat China as a potential democracy and ally and was convinced that he was bolstering the inescapable forces of change. He famously lectured President Jiang Zemin, telling him that he was on the wrong side of history. Jiang in turn kept hinting he would soon introduce political reforms and begin negotiating directly with the Dalai Lama.

Unfortunately, none of these things happened. It must be obvious by now that we can discard this illusion. China is not an American ally nor is it ever likely to become one. On the contrary Beijing sees Washington as its enemy because Beijing fears that it is determined to replace the Communist Party with a democratically elected government.

Yet curiously, Beijing also acts on the assumption that it has a right to be coddled like Japan was during the cold war. It assumes that Americans are somehow obliged to help China.

This may be because earlier presidents flattered Chinese leaders because Henry Kissinger, told them they badly needed China's support to defeat the Soviet Union. Even at the time, this was a dubious assertion and we now know that China played no significant role in the downfall of the USSR. Both American and China must now change their expectations of each other.

A second miscalculation has been made by certain American industrial leaders. They thought they could outsmart their dangerously efficient Japanese competitors by relocating manufacturing in China. It is true that Chinese peasant labour has proved cheaper and more flexible than Japanese robots.

Many American manufacturers like Apple or GM have done well, creating millions of jobs in China, but the strategy has proved disastrous for America as a whole. You only have to compare the wealth and prosperity of Stuttgart (home of German auto manufacturing) with that of Detroit. The Germans have expensive labour but they export masses of cars to China and run a healthy trade surplus. GM may be doing well in China but America still exports virtually no cars to China or Japan or anywhere else.

Look at what that means. The median house price in Detroit is now just 7,500 USD but in Stuttgart it is 330,000 USD. Even in Wuhu, a city in impoverished Anhui Province and home of the Chery car maker, a 150 square metre property costs 165,000 USD.

China has a natural advantage over other countries thanks to its vast and almost limitless pool of peasant labour. These are employed under terms which are different from other Chinese and indeed workers almost anywhere else in the world. They are not, for example, allowed to form unions, let alone independent unions. Of course, this means they are very cheap and very easy to hire and fire.

Labour is only of many areas where a lack of regulation gives China a huge commercial advantage over its competitors. As western countries burden themselves with ever more complex and diverse regulations about employment or carbon consumption or whatever, China will keep this advantage even as its own standards rise.

In practice, it is always going to be very difficult for other countries to effectively interfere in China's affairs either by inspecting Chinese factories or by barring imports on the grounds that they do not meet certain standards. Of course, it can be done from time to time but it causes huge rows far out of proportion to the gains. It is never going to be enough to address the fundamental trade imbalance.

The only flexible and smooth way of adjusting trade imbalances is through fluid exchange rates. It worked during the 1930s when countries abandoned fixed exchange rates which were impracticable. France flourished after 1926 when the Franc stabilized at 25 to the Dollar. Britain did well when it went off the gold standard in 1931. Greece will benefit too when it escapes from the straitjacket of the Euro.

Abandoning the USD/Renminbi currency peg will be better for both sides too. The infamous 1930 Smoot-Hawley tariff law suddenly raised duties in imported goods by 50 percent in a bid create domestic jobs. The object of this sort of bill is not to raise tariffs or curb international world trade but spearhead a campaign to end the RMB/dollar peg. To do so will improve the functioning of the world trade system and allow China to import more goods, which it says it wants to and help Washington create more jobs at home. The experience of the 1930s showed that in the end flexible exchange rates were much important to a nation's prosperity than raising or lowering tariffs.

Jasper Becker June 2011

'Don't blame us': a threat or a warning from Martin Wheatley?

How many of the 400 or so private Chinese companies listed in America, Hong Kong and elsewhere in the last few years will turn out to be deliberate frauds?

No one knows. Yet. It could be just a few bad apples or as many as a third. Some experts believe a large slice of these companies have been exporting pork pies (that is reporting fictional profits). Investors could stand to lose $10 billion, $30 billion or even $50 billion.

Investors, underwriters, lawyers, auditors and regulators have all put their faith in the credibility of Chinese documentation. Yet the trail of falsified bank statements, fraudulent tax returns, bogus invoices, phony bank letters and imaginary audited accounts that have emerged so far brings to mind well-honed clichés about submerged icebergs and Titanics.

People have showered billions of dollars at Chinese investors without bothering going to see for themselves if fantasy forests truly exist or there really are advertising screens on buses. They haven’t asked basic questions about a company’s output, its assets and productivity.

The panic is now spreading. China listed IPOs in America have shown a 24 per cent loss since 2009, the worst performing sector in the US IPO market. Bloomberg’s Chinese Reverse Merger Index is down 40% this year.       

The next question is: who is going to cop the blame?

Martin Wheatley, the outgoing head of the Hong Kong Securities and Futures Exchange, says it is not the regulators’ fault. Investors have been failing to ask the proper questions on fundamentals, he says primly.

Considering that China-related stocks account for 70% of the trading volume on the Hong Kong Exchange and Hong Kong is trying very hard to encourage Chinese companies to move their listings from America to Hong Kong, this is a bit rich.

Hong Kong has even agreed to a mainland Chinese demand to authorize Chinese auditors to look at the books of those listing overseas. These are presumably the same Chinese auditors which the American Securities and Exchange Commission is blaming for the debacle on American exchanges. The Public Company Accounting Oversight Board been rejecting the applications of Chinese auditors even if they are based in Hong Kong.

China says it is vital to national security that only mainland Chinese should be allowed to review the accounts of such strategically sensitive businesses as bottled water or watch companies.

In America the heat is being turned on the big four auditors. The House Financial Services Committee wants action. Heads must roll. The auditors are now worried that one or more of them will have to pay the ultimate price for signing off on bogus accounts.  Starr International is suing Deloitte for the failed investment in China MediaExpress (it puts advertising screens on buses) and it is also under fire for auditing the accounts of Longtop Financial Technologies. Deloitte is blaming the Chinese banks for providing falsified accounts. Ernest & Young is under attack in Canada over the fraud at SinoForest.

Wheatley thinks it is the underwriters who should be liable for the accuracy and completeness of the listing prospectuses. It is an interesting idea whose time may have come. Hong Kong investment banks have been fighting this since 2005. Meanwhile they have profited from the world’s biggest IPO market: 57.7 US$ billion raised from 87 listings, with fee revenues running to over 6 US$ billions across the region. They can afford to pay.

Lawyers and auditors share in the due diligence work but it is the investment banks who really study the company. The Securities and Futures Exchange said an inspection of 17 sponsors found a range of deficiencies including inadequate due diligence. Among those criticised as JPMorgan, UBS, HSBC, RBS and Deutsche.  In America, Goldman Sachs and Deutsche Bank are taking fire for underwriting Longtops’ offer.

Hong Kong prides itself on having a superior system to the Americans but even in Hong Kong investors are now running scared. So far this year 55 companies across the region have scrapped mooted IPOs worth as much as $8.4 billion. The fear has even spread across the border to Shenzhen where Chinese car parts maker Nanning Baling Technology Co. cancelled its IPO after a formal launch.

Wheatley compared the craze for Chinese companies to the dot.com (or ‘dot con’) boom and bust of the late 1990s when any kind of unproven Internet stock was bought at inflated prices.

Yet the comparison is not entirely apt. China really is booming and there are a lot of companies out there which are making real genuine profits. It just takes some proper due diligence and journalistic research at the beginning to make sure it’s the right companies which are being brought to the market. Too many investors waste their time looking at the figures in a country where even the official statistics are always inflated instead of using their common sense.


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