Big Dragon, No Fire?

[HenryTo]

Very interesting article on the Chinese economy - anything goes when everyone is having a grand old time, especially property developers. Look, even the U.S. does not have an effective control over real estate lending - how can the Chinese have effective control even with dictorial powers?
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Big Dragon, No Fire?
China's Might Masks
Falling Profitability

By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
June 27, 2005

HONG KONG -- From offshore, with Chinese attempts to acquire ever-bigger corporate targets making daily headlines, Asia's largest dragon looks suddenly both wealthy and powerful. That view became more entrenched last week when Chinese oil company Cnooc Ltd. offered to acquire U.S. energy company Unocal Corp. for $18.5 billion.

Seen from within, China doesn't look quite as invincible. An increasing number of economists in China believe such acquisitions are needed not so much to flex China's muscle but to help defend against a looming problem: declining profitability. Indeed, it is precisely the lack of profitability and other economic distortions at home that are contributing to China's quest for opportunities abroad.

"China is running out of profits," says Jim Walker, chief economist of Credit Lyonnais Securities Asia in Hong Kong. He blames the pincerlike effect of rising input prices and wages as well as a reluctance to raise output prices for fear of losing market share and customers.

At the same time, gradually tightening monetary policy is beginning to cool the frenzied overinvestment and chilling local demand. It means that for the first time ever, Chinese executives will have to pay attention to the cost of capital and the return on capital.

A survey from CLSA found that nearly half of China's companies reported rising input prices in April -- but only 18% planned to increase output prices at all. By the end of last year, 14 out of 23 categories of companies listed on domestic Chinese exchanges reported falling profits. Meanwhile, manufacturing capacity continues to expand: By the end of the year, China will have the capacity to churn out six million cars for a market that is half that size.

In addition, property accounts for an expanding portion of economic activity across China, according to Mr. Walker. Harbin, a city in northeast China, seems as unlikely a candidate to spawn a property bubble as a Rust Belt city. Yet ask locals to name the richest people in town, and the list will always start with property developers.

As with Asian cities in the mid-1990s, before the region's financial crisis, capital in China has been nearly free, thanks to state-controlled banks whose mission was to lend easily. Even foreign companies drawn to China by incentives were attracted by cheap capital as much as low labor costs.

"There is liquidity in so many hands," says Johannes Schoeter, head of Victoria Capital, an investment boutique in Hong Kong. "And there is more liquidity than there should be in the hands of property developers and state-owned enterprises."

Fueling the building craze is a banking system that still lacks effective credit controls. There are restrictions, for example, on the size of a loan based on the value of any given property. By artificially inflating the value of the property, developers end up putting none of their own money in and use the first loan as collateral for a second one from a different bank. The banks are happy to lend because one way to bring down their ratios of bad loans is to increase the size of the total loan book.

Such a boom is far less logical in the hinterland cities such as Harbin that lack the rising wealth to support such projects. Such cities are feeding fears that China is awash in too much cash and that the boom will turn into a bust, with adverse consequences for many parts of the world, which have come to depend on Chinese demand. Both Korea and Japan sell more to China than they do to the U.S. (although, of course, some of what they sell to China ends up exported elsewhere, particularly across the Pacific). The new buildings stand empty for want of buyers.

Market and administrative forces are combining to bring an end to the liquid conditions of the past several years. In its annual report, China's central bank, the People's Bank of China, warned of the dangers of excessive fixed investment and low-quality economic expansion.

How exactly the government finesses its economic management has implications for the rest of the world. If it doesn't apply enough of a brake, the overinvestment continues. If too harsh, domestic demand will dry up further and even more of China's productive energies will have to be taken up by a world that is already having trouble absorbing its output.

Write to Henny Sender at henny.sender@wsj.com

[pete richardson]

Henry --

Do not forget the "stir fry" economy.

Banks deposit rates capped at 2.25%...Private financiers gather would-be
deposits by offering much higher returns, with the favorite target being
the real estate market.

Tremendous speculation going on outside of the banking system.

East coast producers losing low wage workers back to the West, paying
up hansomely for fuels...Only tax subsidies remain undisturbed.

China now letting more Chinese export capital...This will let many HNW powerbrokers move their money out.

Will Hu have moved most of his dough to Swiss banks at the top?

Best,

Peter