North Central China Real Estate Association

North Central China Real Estate Association
Jiefang East Road 161
Changzhi, Shanxi 046000
Membership@NCCREA.com

China's Shell Game

China's Shell Game

Jeff LoCastro, April 25, 2012

Founder & President, NCCREA

Much is made of the enormous debt that the US has accumulated and

the cataclysm that will occur if the current course is not reversed soon.

There is a place for debt, but only when the debt delivers actual

accountable returns and not simply opportunity returns. Opportunity

Returns are the opposite of Opportunity Costs which is the "cost" of any

activity measured in terms of the value of the next best alternative

forgone (that is not chosen). American debt was never measured in

terms of accountable returns it was always measured in terms of

opportunity returns, i.e. the perceived revenue generated by spending

money on one thing rather than another vs. not spending it at all. It's

somewhat Keynesian, but not exactly. Either way, it's not good. Much is

also made of the #1 foreign buyer of US backed securities: The People's

Republic of China and the fact that this foreign buyer carries zero

Central Government (federal level) debt. That is, the PRC government

pays for what it spends. Or does it?

Most things in China operate just below the surface. Anyone who is

doing business here full-time (not the business traveler) knows this all

too well. Things are never quite what they appear. That's not a value

judgment, but a statement of fact. China's debt is no exception. The

debt that China incurs is not central government debt, but local

government debt. And this is the way Beijing wants it. Local

governments borrow from Chinese banks (owned and operated by the

Beijing government) to provide economic subsidies and general growth

funds to maintain their current economic trajectory. And to do so they

are borrowing in massive amounts. In 2010 alone local debt reached

¥10.7 trillion. In 2011 another ¥2.15 trillion was added. In actuality, I

suggest that the debt is closer to ¥20 trillion and ¥4 trillion respectively

by applying my "2x Rule." The 2x Rule states that a statistic or number

that is being owned by the powers-that-be should be multiplied by 2

or divided by 2 (depending on which result is the positive or the

negative) in order to discern the true value. However, even without

applying the 2x Rule, in 2010 local governments (not enterprise) took up

an astonishing 80% of all bank lending. If the Central government is

owning that figure on it's face, the debt situation is clearly out of

control. Having local governments borrow to drive economic growth

instead of the Beijing government is akin to hiding expenses in a shell

company so that the parent appears profitable. The problem is that it's

the central government that still owns the debt and is responsible for

making it good when defaults occur. Although individually branded

banks are making all the loans, the banks are state owned enterprises

and are the Beijing government. This play is akin to X Company setting

up Y Company for the purpose of making loans to Z Company for the

express benefit of X Company. In most business quarters such an

arrangement would never pass the smell-test.

So, where's the money going? It is not a secret that China delivers

massive subsidies to its people and industries. It's everywhere and in

every city and most are invisibly obvious. For example, in Changzhi City

(pop. 3.5mm) in Shanxi Province if one walks down any one of the major

thoroughfares you will observe row after row of enormous 4, 5 and 6

story swap-meet-like "malls" each easily 400,000 to 750,000 square feet

(38,000 to 70,000 m2). Each floor in each building accommodates row

after row of vendors sitting in 8' x 8' cubicals each selling identical items

as the vendor in the next stall. On one floor alone one may routinely

find 50 - 100 vendors selling exactly the same hair clips, pants, shirts,

wallets and even toilets at exactly the same price as the guy in the next

booth. Imagine walking into a mall in the west where each store sells

exactly the same items at exactly the same price. But in China they

don't care.

These businesses are not about selling anything, its about the

government giving them free rent, a cot on the basement level to sleep,

money to buy their initial inventory and an hourly stipend. At the end

of day the "hair clip" vendors, for example, settle-up with each other, the

money is pooled and split and used for that evening's noodle bowl. Sure,

you can buy things in these malls, but these are false businesses meant

to simply keep people busy. The problem is that it provides only

Opportunity Returns and minimal value to the economy in terms of

Accountable Returns. Therefore, there is no practical way for local

governments to service the debt without more borrowing and more

deficit spending. Not withstanding the massive subsidies provided to

build the tens of thousands of new apartment/condo units each year

(166,000 new units in Changzhi City alone in 2011), this scenario is

played out scores of times in hundreds of cities throughout China. It's

the local governments that have the burden of borrowing to create and

maintain perhaps millions of these false enterprises and is encumbered

with the task of sustaining growth with no realistic method of

repayment. It's one of the biggest shell games in the world.

What does this all mean? It means that Chinese Government continues

to keep its debt off the books. It means that the Chinese Government

can, therefore, maintain the moral high-ground in discussions over the

international debt crisis. It means a real threat of stagflation in China.

It means that, although China is a terrific growth market (and one in

which I have staked a personal claim), the entrepreneur must enter it

with eyes wide open and understand what is going on just below the

surface.

Contact the author at: Jeff@NCCREA.com or Jeff@CaliforniaSecured.com

Copyright 2011 North Central China Real Estate Association. All rights reserved. All content, web site design, text, graphics, the selection and arrangement thereof are Copyright 2010-2011 by North Central China Real Estate Association. Any use of this website, including reproduction, modification, distribution or republication in any form, without the prior written consent of North Central China Real Estate Association is strictly prohibited.

North Central China Real Estate Association
Jiefang East Road 161
Changzhi, Shanxi 046000
Membership@NCCREA.com