1) Why bother reading this?
Good question. You may choose not to. It is long. It’s off topic There’s nothing here that addresses specific advice on a specific investment. But, China is now the second largest economy in the world. I am of the opinion that it will be larger than the US economy in my lifetime. If you gain some insight into the way the Chinese think and function, maybe it will help you better understand world-scale macro-economics and thereby make you a better investor. Also, for better or worse, the US stock market often moves in tandem with the Chinese market. China is 12 hours ahead of New York, so when it closes it sets the tone for the NY open. If you find this essay too long and simply not worth spending your time, let me suggest that you read section 2 and then skip down to sections 9 & 10.
2) Who am I, and why do I think I can write about China?
I’m not an expert. I’m not an Asian academic. I’m not an economist. I’m not a Poly Sci major either. I don’t even consider myself an authority on China. And I only speak a limited bit of Mandarin. So, where do I get off providing observations, thoughts and analysis about China? Here are my qualifications.
I first travelled to China in 2007. I’ve been there almost every year since. I generally spend 2 – 3 months out of the year in China. While I’ve traveled in China quite a bit, admittedly, most of my time is spent in and around my wife’s hometown, Guilin. To that extent my views on the Chinese people and culture are primarily taken from my experiences in this particular city. China has about the same land mass as the US and roughly four times the population, although the Chinese population in far more concentrated in urban areas than in the US. But, just as making generalities about the US based on local experience can lead to faulty conclusions, the same goes for China.
I voraciously read about China, both its history and contemporary affairs. My wife is Chinese. I have some unique insights because I have been in many Chinese homes. I’ve talked to a lot of Chinese folks (in English, or with someone translating). The folks I talk to are mostly average, middle class folks with jobs and families. My wife has a niece and nephew, both speak English pretty well, so I also get some youth perspective. I’m a keen observer (I think I am anyway). I spent 30 years in IT, most of it as an analyst of some sort at a Fortune 50 aerospace firm – I’m comfortable with and good at analysis. I have an MBA, an undergraduate English degree, and a lot of technical credits. I’ve remodeled my mid-century modern Northwest home (including rewiring and replumbing). I’m a woodworker. I’m an amateur investor. I play guitar.
I don’t wish to sound arrogant, but at times I feel I know China much better than a lot of “experts” who get paid to write about China. It seems like a lot of “experts” write from afar; they seem to have never walked the streets, gone to the shops and markets, visited the countryside, mingled with the people or been in anyone’s home if indeed they’ve been in China at all. I do all those things every time I visit China. Keep this in mind as you read. You are getting my inexpert (and likely at times inaccurate) perspective.
My perspective is a mix of things published and broadcast about China with a very up-close and personal view. One more observation about the “experts,” IMO many of them know nothing of Chinese history. They often appear to apply “west think” to situations and circumstances in China. The Chinese culture is vastly different from the West. There is no heritage of democratic ideals in China. China has no Judeo-Christian heritage. There is little notion of individual rights, but, at the same time there’s deep respect for elders and people in positions of authority; children are cherished (these are Confucian ideals).
The vast majority of Chinese live in the present; by that I mean that few seem to know much of anything about their own history (I suppose that’s equally true for Americans). The effect of this is that the Chinese live by and accept certain cultural norms that are very foreign to Westerners. But most Westerners who have never lived in China won’t even recognize these norms. Instead, they will try to impose their own cultural norms on the Chinese. I’ve witnessed this phenomena first hand upon numerous occasions.
Oh yeah, one more thing. For very good reasons, Saul has asked us to keep this board apolitical. It is impossible to talk about China without venturing into some political discussion, but I will only discuss Chinese politics superficially as I understand them, and only as seems necessary. Please don’t respond to any partially positive comments about the Chinese government with outraged political arguments. That’s not what this article is about. It’s intended to help you understand China, the Chinese people, and their Chinese culture from my experiences and studies. I will refrain from discussing US politics.
3) Where to begin?
When I say “China” I am referring to the citizenry, the government, the business community, the infrastructure and even the physical land, water and air.
OK, I’ll get it out there right away: I am of the opinion that most of what the average American knows and believes to be true about China is wrong. Or, if not flat-out wrong, what they hold to be the “truth” is so biased, one-sided and incomplete that it provides a very distorted and inaccurate picture of China. I am of this opinion based on “news” reports about China, the comments blogs for stories written about China, and the comments about China made by politicians, journalists and pundits.
For example, think about the Chinese environment, what picture do you see in your mind’s eye? Is it one of choking, polluted air so terrible that it burns your throat when you breathe? Do you believe the soil is so loaded with toxins that there is no such thing as safe agricultural products? These things are true in some places at given times, but they are not true for the vast majority of China.
There are times when the air in Beijing, Xi’an, Shanghai and other large cities is very bad, but so was the air in the LA basin and NYC in the 60s and 70s. So was the air in London for at least a hundred years. And there are some horribly polluted rivers in China, but in 1969 a fire on the Cuyahoga River nearly set Cleveland, Ohio ablaze and motivated President Richard M. Nixon (R) to create the EPA.
China is years behind us, but we were once in the same place. It’s true that the vegetables grown down-wind from the lead smelter in Tianjin are toxic, and many children there have lead poisoning. Unfortunately, despite the outrage, the Tianjin lead smelter is still in operation. The problem is that it is essentially the only major employer in town and it is an SOE (State Owned Enterprise). I’ll briefly discuss SOEs later. In January of this year the plant was finally forced to operate under strict anti-pollution regulations. Hopefully, it will eventually be shut down. But before we feel too superior, let’s remember that in the US we have Flint, MI where the tap water is still unsafe to drink.
4) If most of what you know is wrong, what’s the truth?
For starters, Americans and Chinese are a lot more alike than dissimilar. For sure, there are differences, and some of them are quite profound, but for the most part you would probably be surprised by how much we have in common with the Chinese. My experience has been that the Chinese do not envy America; rather they admire and aspire to acquire their perception of the good things that constitute the American lifestyle. And to a significant extent the rapidly expanding middle class has succeeded in doing so.
A while ago I contemplated starting a business in China with a Singaporean man. He, like me, has a Chinese wife, but unlike me, he is fluent in Mandarin and already had a few small businesses in China. There seemed to be a synergy between his contacts and knowledge of conducting business in China and my American contacts. I won’t dwell on it; I’ll just say it didn’t work out. But in the course of one of our many conversations he said something to the effect of “don’t be deceived by the population of over a billion people, maybe a quarter at most have a disposable income.” My thought was, “A quarter? That’s not too different than the population of the US.”
That was in 2007 on my first trip. Ten years later I’m confident the percentage is much greater. China’s middle class is rapidly expanding. When I first traveled to China in 2007, only the big cities had traffic jams. Now, you can’t even drive in the countryside without traffic and parking problems. And you would probably be stunned at the number of Mercedes, BMWs, Audis, Peugeots and even the occasional Lamborghini, Ferrari, Rolls and other high-end vehicles. Recently, I saw a Tesla. Auto ownership is a rather new for the Chinese and therefore so are the cars. I don’t recall seeing any cars over ten years old (but some of the trucks appear to be left over from the revolution). I won’t digress into the driving habits of the Chinese, but it can be hair-raising. As far as I can tell, the only traffic convention consistently adhered to is stopping for red lights. But, for example, driving in the “wrong” direction on a limited access divided highway is not a problem.
Americans have been accused of obsessing over superficial beauty. They have nothing on the Chinese. Beauty is not even considered superficial in China, it has inherent value. About 30% of the main floor of the main department store in Guilin is devoted to skincare and beauty products. I’ve read that Asia is the world’s largest market for skincare and beauty products. Nearly everyone (but especially the youth) pays a lot of attention to how they dress and accessorize. An Apple phone is a must have item. Starbucks is a place to be seen. Even torn jeans (purchased new from a boutique) are modeled after what has been popularized from American movies, TV shows and celebrity/lifestyle magazines. Western branded products are very popular: Nike, Adidas, New Balance, Levis, North Face, Columbia, etc. (I just saw my first Skechers store in a new mall not long ago).
I have never seen a second-hand store in China (à la Goodwill). I asked my wife about this; she said no one would wear anything that had been discarded by someone else. The Chinese like to buy new things. This has implications for the auto and real estate markets. I don’t know the impact yet. When my mother-in-law died, all her clothes were burned; they could not even be given to a charity (there’s more to this than second hand clothes, I’ll touch on it later).
In general, middle class Chinese homes are kept immaculately clean, and beautifully furnished and appointed. I’ve yet to enter a home with carpets; they are considered impossible to keep clean. All residential flooring is wood, laminate, tile or stone. Even area rugs are uncommon, and everyone takes their shoes off at the door. A great deal of attention is paid to harmonious design, and fengshui. However, while there are a few, single-family homes are a rarity in the cities. Virtually everyone rents an apartment or owns a condo. However, single-family brick and cement homes are the norm in the countryside. Wood construction is rare (might even be illegal, I don’t know) as it poses a fire hazard. The concept of home ownership is somewhat ambiguous, more on this later.
I will interject just a few more comments about the Chinese people before moving on. My experience has been that the Chinese people are hospitable to a fault, friendly and helpful. Maybe it’s because I was born and raised in the Chicago area, but I’ve never been in a Chinese neighborhood where I felt threatened. That’s not to say there’s no crime, but the incidence of violent crime is very low. You might have your wallet or phone stolen if you’re not careful, but it would be extraordinarily rare for someone to stick a gun (or a knife) in your face and demand your belongings. The police are unarmed.
I have a habit of taking long directionless walks. I’ll just wander for hours. A few years ago I found myself in what I surmised to be a very poor residential neighborhood in Shanghai. People would stop and stare at me, not that I was a target, but simply because no round-eyed Westerner had ever been in that section of town. There was disbelief and consternation about my presence, but nothing I could detect as hostile or threatening. I could provide several more examples, but I don’t want to drag this out. The point is that for the most part, the Chinese are friendly and peaceful.
5) About the differences
My wife and I go out for dinner with others frequently. The food is Chinese. There is an enormous variety of dishes and the cuisine varies by region. Personally, I like a lot of the food, but it is dissimilar from Western food. My wife’s friends are all amazed by the fact that I use kuaize (chopsticks) with ease. Primary cooking methods are frying, steaming and boiling. Ovens are a rarity in home kitchens and even many restaurant kitchens, so baked and broiled food is uncommon. Primary seasonings in this province (Guangxi) are soy sauce, dark vinegar, salt, garlic, all manner of peppers, ginger, cilantro, sugar and anise. I’m not going to write a treatise on food; suffice it to say that authentic Chinese food is quite different from Western food no matter what region you’re in.
People do not order individually. A group meal will typically consist of a soup, a chicken and a duck (or maybe goose) dish, maybe three or four different meat dishes (mostly pork, maybe one beef dish, or even dog, ick), fish, shrimp and a shellfish, two or three vegetable dishes, some steamed, savory or sweet filled breads, rice and fruit. It’s a lot of food even for a dozen people. The food is brought from the kitchen as it’s prepared and placed on a central lazy susan. Other than the soup (which is always brought first) there is no specific order in which food is presented. Everyone takes what they want from the selections. Smaller fowl and fish dishes are served whole; the innards removed but heads, feet, bones, et al are included. People place food from the center in their bowl. Each person’s plate is used to collect bones and other inedible bits that are spit out. Tea, hot water and sometimes fruit juice are the primary beverages. I was at a lunch with 11 people and one bottle of red wine was consumed. I probably drank half of it.
But, Western fast food is becoming ever more popular. Micky D, KFC, Pizza Hut and Starbucks are ubiquitous and popular, I think to the detriment of the Chinese. When I first traveled to China in 2007 these brands were not to be seen everywhere and there were not many Chinese who were overweight. As these brands have grown in popularity, so have waistlines, particularly among the youth.
Smoking is very popular, and there are few restrictions on where one may smoke. I was once in an elevator in a Xi’an hotel, there was a “No Smoking” sign by the floor selection keypad printed in about a dozen languages. A man standing in front of me facing the sign lit up a cigarette without hesitation. My wife says “10 men, 9 smoking.” The official statistic is 40% of the population, so my wife’s estimate is not far off if you consider the population about equally split by gender. Smoking is almost exclusively a male activity; it is very unusual to see a woman who smokes.
Another couple of very important differences between Chinese and Americans; the Chinese are very superstitious and the Chinese love to gamble. This directly impinges on investment strategy. First, a couple of examples of superstitions; for perspective, before she retired, my wife was a medical professional. She ran the transfusion department in the main hospital in Guilin (metro population, about a million). She was a professor and taught classes about transfusion in the medical college associated with the hospital at which she worked. In other words, she is an educated woman. I had a camellia tree with white flowers in the front yard. She made me dig it up. White flowers are symbols of death and bring extremely bad luck.
Qing Ming is the Chinese holiday for visiting the graves of the dearly departed. It occurs in early April. A year before last our flight left China before this day and my wife wanted to visit her mother’s grave marker before we went back to the US. The only problem is that except for Qing Ming, there is no regular bus service to the cemetery. No taxi driver will take you there. It’s as if death might be contagious. When my mother-in-law died, we (family and friends) got to the funeral via a rented bus driven by a friend of the family. The bus driver took a different route home than the one he took to the cemetery in order to confuse spirits that may have tried to follow us. I mentioned earlier that my mother-in-law’s clothes were burned rather than donated. The primary reason is that no one would willingly wear the clothes of a recently deceased person. It would be considered a cruelty to donate them, thereby allowing someone to unwittingly put them on their body.
But there are not only bad omens. There are others that bring good luck. The number 8 is considered very fortuitous. It was no accident that the Beijing Olympics opened on August 8, 2008 at 8:00PM. If a bat’s nest is found in your home, you can be nearly certain that a monetary windfall is soon on it’s a way to you, the same applies if bird poop should fall on your head. Meeting up with a snake is an omen that you are soon to meet with an influential person who will provide you with some benefit. And the list goes on. Obviously, encountering a good luck omen will give you leg up at the mahjong table, or the stock market.
6)The political factors
I do not have a deep understanding of Chinese politics, so I won’t dwell on this, but a few words about the political system are necessary to understand Chinese economics.
To get started, I’ll begin with a few facts. The Chinese government is neither communistic nor a dictatorship. First of all, communism is an economic theory based on the concept of: From each according to his ability, to each according to his need. Marx really didn’t spell out the details about how to organize the governing body in order to implement this concept.
What kind of government is it? I’m not sure there’s a name for it. So I’ll describe it as I understand it. The government (both central and local) is run by a one party system. The fact that the party is called the communist party is an artifact of the revolution that ended on October 1, 1949 (October 1, is the Chinese equivalent of July 4 in the US). The Chinese Communist Party (CCP), under the leadership of Mao Zedong came to power, having defeated the Republican national Government, the Kuomintang under the leadership of Chiang Kai-Shek who retreated to Formosa (Taiwan). Mao harbored an unrealized dream for China to become a communist country. When Mao died in 1976 the dream had frayed and faded considerably.
Mao’s grip on power after the revolution rapidly increased to the point of being absolute and uncontested (harkening back to the fairly recently bygone days of dynastic emperors). Mao was a self-educated son of a peasant farmer from the southern province of Yunnan. Mao spoke a local Yunnan language. He never learned Mandarin. While Mandarin is the national language taught in school, there are more than 50 languages in China (asking if one can speak Chinese is like asking if one can speak European). Most people who live in an area where Mandarin is not the native language speak at least two languages: Mandarin and the local language. However, all mainland Chinese languages use the same writing system, so Mao’s Red Book could be read and understood by all (who could read).
Many of Mao’s ideas about governance and leadership came from his studies of the dynastic emperors of the past. The system and organization of government in China exists today pretty much as it was designed by Mao and reformed under Deng Xiaoping who came to power in 1978, two years after Mao died.
Leadership in China is not subject to the “checks and balances” of the US system, which as we’ve seen can degenerate into partisan bickering and obstructionism. In practice, the top leadership role is split into two positions. The Premier, head of internal affairs (currently Li Keqiang) and the primary representative of China to the rest of the world, the General Secretary of CCP (currently Xi Jinping), there is also the title of Chairman of the Military Commission and yet a fourth title, President of the People’s Republic of China. Xi, was given three of the four titles upon his innaugeration. This is unusual as the Chairman of the Military is usually withheld for a couple of years or more.
How does someone ascend to these positions? The answer to that question is not completely clear. There is a process that has been published which is a series of votes by an hierarchy within the party. The group which gets to vote is ever decreasing in size and increasing in power, but it is obviously not so simple. Nevertheless, holding positions of increasing responsibility within the party is an important pre-requisite. Should this interest you, Wikipedia has an impressive write up about Xi’s rise to power. But let’s be clear, there’s a succession process that is not dictated by birth or theology. Just as we have in the West, there are conservative and progressive voices. The leader is selected via a process of compromise and finally consensus.
Top leadership is restricted to two 5-year terms. Other positions are constrained by compulsory retirement age. Nevertheless, all former, living leaders exercise a considerable amount of influence, especially over the selection of a new leader. At least, that’s the way I understand it.
7) Deng XiaoPing and Market Reforms
After the revolution ended in 1949, the state confiscated most things of value, including all the land. Personal ownership was inconsistent with communism. The confiscation of land was intended to be a reform ushered in after the revolution. Prior to 1949, all the land was in the hands of a relatively small number of powerful landowners.
In my opinion, Mao was a great revolutionary war leader. But that did not translate to governance; he had many failings as a political leader. In many ways, life under Mao’s leadership got worse than it was before the revolution. Some of the ideas that he tried were naïve and turned into disasters. For example, literally millions of people starved to death during the Great Leap Forward (1958 – 1961). Nevertheless, Mao ruled with increasing and ultimately absolute, unquestioned authority from 1949 until his death in 1976.
Wealth inequality and rampant corruption was largely what caused the revolution in the first place. In fact, these same factors were the driving force that ended dynasties. But, these factors did not end with the revolution. Hardship persisted until 1978, about two years after Mao’s death when Deng Xiaoping rose to power. Of course, things did not change overnight with Deng’s ascendency.
Deng, famous for his declaration, “I don’t care if it’s a white cat or a black cat, if it catches the mouse, it’s a good cat,” ushered in a number of reforms. The cats were references to communism (white cat) and some other economic arrangement (not specifically capitalism, but market based reforms enabling private ownership and the ability to retain a significant portion of the fruits of one’s labors were important components).
I said ushered in as if Deng made a declaration and everyone got in line. Lining up for anything in China is a rarity. Market based economic reforms faced enormous resistance from a lot of people at every strata of society for a host of reasons. While Mao had been revered, Deng was openly despised. His first name “Xiaoping” also means “small bottle.” It was common for people to order short bottles of beer in the taverns and then shatter the bottle on the floor (after the beer was consumed, naturally). Deng ordered that the police take no action against these open expressions of dissatisfaction.
Deng anticipated that things might not go smoothly. Unlike the communists of 1949, he did not attempt to change everything, everywhere simultaneously. Deng was a pragmatist and a brilliant politician. First of all, Deng realized that the Chinese were entering unchartered waters; not exactly true, if you look at the history of international trade and commerce, you will find that the Chinese actually invented the process (read about The Silk Road for context), let’s say the maps had been lost over time.
Under Deng’s direction, four “special economic zones” (SEZs) were established in 1980 in separate cities. The idea was for these cities to act like incubators. Deng realized that even though his ideas were not entirely new, and were reasonably successful in other countries, China had its own culture. Things would have to be tailored to the Chinese culture.
I won’t belabor this history too much further. As mentioned earlier, things did not go smoothly. There was internal resistance from government officials who lost positions of influence and power (and bribes, er, I mean gifts). There was resistance from the common people who lost a lot of socialized services. Merchants who had sold what was provided by the state at fixed prices and retained no profits had to develop supply chains and learn about competition. There were a lot of winners and losers.
But overall, the general standard of life improved enough for Deng to seize the successes as reason to push forward. And he did so rapidly. He felt it important to move quickly lest the forces of resistance mount and frustrate the effort entirely. Also, Deng was an old man; he wanted to get as much accomplished as possible as quickly as possible. Additionally, there was chaos in the government after Mao’s death as there was no succession plan. Deng wanted to retire rather than die in office. It was vitally important to him that China establish and follow an orderly succession process.
In seven or eight years, there were enough SEZs that there was no turning back. Deng had created the modern Chinese economic miracle. Deng also tried to introduce additional reforms, such as a code of law and a justice system. That set of reforms did not progress so far or as well as the economic reforms. To this day, the justice system in China remains primitive at best. At the age of 85, Deng retired in 1989. He lived long enough to see the success of his efforts. He passed away in 1997.
In my opinion, Deng Xiaoping was one of the greatest statesmen to have ever lived anywhere at any time. He completely transformed China’s economic-political system without it devolving into violent conflict.
8) Modern China
Starting with the revolution’s end in 1949, the literacy rate in China has gone from something in the single digits to well over 90% today. Since about 1980 to about 2000, over 500 million people in China have been lifted out of abject poverty. At no time and no place in history has this occurred before or since. China has seaports and airports that are among the most modern in the world. China has more ultra high-speed rail than any other country, and they are aggressively expanding connected city-pairs. The highways and bridges in China are modern and near flawless – no potholes or other defects. China takes climate change seriously (as does the rest of the world except the US and Syria); they are rapidly expanding wind and solar installations. They have shut down hundreds of coalmines. I could go on, but I hope you’re getting the picture. China is a modern, vibrant place. Yes, there’s still poverty, pollution and myriad other problems. But you can talk to almost anyone over 30 and they will affirm that China is a better place to live in now than it was when they were young. I personally have observed big changes in the ten years since my first visit in 2007.
Much earlier in this essay I said I’d address State Owned Enterprises (SOEs). After the revolution, nobody owned anything. That, of course included the means of production. The state took over/created factories and other businesses in order for people to have jobs and to produce the goods and services that people needed to live. SOEs did everything from mining and extraction, raw materials production, engineering and manufacturing, civil engineering, construction, even farming took place on state collectives. I think (not sure) that even retailing was provided primarily by SOEs. SOEs are still a major part of the economic system in China. Because they are government owned they have a favored position, but they are often inefficient and corrupt for the same reason. Xi has a plan to shutter over 200 SOEs, but millions of jobs are at stake.
The Chinese tax system is far simpler than the US tax code. There are 11 tax categories in China (I won’t list them). Personal income (one of the 11) is taxed on a progressive scale of 3% - 45%. The top bracket cuts in at 80,001 RMB (a bit over 12,000 USD). Foreign income is taxed and there is a deduction for foreign taxes paid. There’s also a standard deduction that is also progressive and income is calculated differently than in the US. For example, the hospital where my wife worked would occasionally hand out coupons that could be used like cash, but only at certain stores. This was not income. One year the hospital paid for a week’s Thai vacation for everyone in my wife’s unit. This also was not included as income. In general, benefits and bonuses (unless cash) are not included as income.
Passive income (rents, royalties, dividends, capital gains – there’s no distinction between short and long term – etc.) are taxed at 20%. Businesses have to pay a VAT. There’s also a progressive income tax for business which ranges from 5% - 35%. There are additional tax categories. There are also local taxes which may include income, licenses, permits and so forth. The simplicity of the Chinese tax code makes it very difficult to avoid/evade taxes in China. There simply aren’t a lot of loopholes and deductions to exploit. The penalties for failure to pay the appropriate tax are severe including heavy monetary penalties and prison time. Most people (including the very wealthy) and businesses in China pay the taxes they owe. Most locations have no real estate or sales tax.
9) Ownership in China
Seems like an absurd heading. But by 1990 ownership was a relatively new concept in China. In some ways it still is. But let’s back up just a minute; a couple of observations about modern China since Deng Xiaoping’s reforms.
I mentioned earlier that after the revolution the government confiscated all of the land. In fact, the land fell under two primary forms of “ownership,” for lack of a better word. First, the government maintained all mineral rights so people only got surface use rights. In the countryside the famers were grouped into collectives during the 50s. The collectives had a leadership council most often made up of village elders. The council made decisions about how the land was parceled out to the farmers, what remained was collectively owned rather than parceled out to an individual “stewards” (e.g., bodies of water, land that could not be farmed, etc.), no individual actually owned the land they lived on and farmed, it was collectively owned and managed by the council. As the elders aged and died or retired, their positions were handed down to the eldest son. While the revolution was mostly good for women in terms of equal rights and opportunities in business, government and the military, it was not so much in the rural areas.
Land in the cities remained under central government direct ownership; however, it was administered by the local political bodies. Existing housing was issued to people by the city. New construction was also undertaken by the local officials. People were provided homes, but nobody owned the home they lived in, it was all government held. So what happened when a window was broken, or the roof leaked, or the building needed paint, or any one of hundreds of repair/maintenance problems arose? Usually nothing. Would you be motivated to spend your money to repair a government owned property? Well, that’s how the Chinese pretty much felt about it as well. People would complain of course, but the light bulbs did not get replaced. I imagine it was better managed in some places than others, but the Chinese did not take any pride in ownership of their homes, for the simple reason that they did not own their homes.
And then there was the nasty fact of corruption as well. In the rural collectives the decisions were made by a small group of people who had all the authority and no accountability. As cities expanded and encroached on adjoining rural communities, the ruling councils were charged with the responsibility of collecting compensation from the city governments and distributing to the displaced farmers. But that didn’t always go as planned (this is still true today). And in the cities, there were departments in charge of maintenance and repair budgets, but in fact a lot of maintenance and repair was neglected. In other words, humans being humans are not always guided by principles.
Old habits die hard. It is my first hand observation that the Chinese are loath to spend money on home maintenance even though they now have an ownership interest. For that matter, even necessary repairs are often left unattended. The people have learned to ignore these problems as not being part of their personal responsibilities. In addition, there is absolutely no DIY predisposition among the Chinese people. Labor is cheap, why DIY when you can hire someone to do it at a reasonable cost? My wife won’t even change a burnt out light bulb, it’s not her job.
In addition, as I mentioned earlier, the vast majority of city dwellers live in condos. Virtually none of them come with external storage space. Who’s going to buy anything more than a screwdriver and hammer for home use? I own a table saw, two band saws, a drill press, two horizontal sanders (4” belt and 16” drum), a 13” planer, a 20 gal compressor, a pressure washer, an airless paint sprayer and a large variety of hand and power tools. Absolutely no one I know in China has any place to keep all this stuff. You would think it does not require a high degree of observational skill to see this. Yet, early in 2006, one of the worst CEOs in American business (IMO), Bob Nardelli opened a Home Depot store in several Chinese cities. Under a cloud, Nardelli ended his tenure at Home Depot later that year (with a $210M golden parachute). Home Depot closed all their Chinese locations at a total loss soon thereafter. This is a classic example of failure via stupidity born of blindly imposing one’s own cultural norms on a very different culture.
10) Investment in China
First off, let me emphasize that I will be discussing middle-class individual investors; I have little knowledge of Chinese institutional investing or the investment strategies of the very wealthy in China.
So, what do the Chinese do with their money? You may have read about the very high savings rate in China. In my opinion (I don’t have hard research) there are two primary reasons for this: one is the dearth of investment opportunities, the other is distrust of intangible assets. These two things combined provide little incentive to do anything with extra money other than save it. Why do the Chinese save so much rather than spend it? Primarily to pay for health care as they age.
But, investment does take place. Real estate is the prime vehicle for investment in China. But it comes with a number of inherent risks. Let me explain.
My wife bought a home before we were married. It’s a nice, modern condo in the southeastern city of Guilin. She financed it under a 7-year contract, which struck me as extraordinarily short term for such a large purchase. As I inquired more about it, I found that the Chinese government (which confiscated all the property in the country shortly after October 1949 as mentioned earlier) never really relinquished their ownership of the property upon which the condo development was built (there’s some 50 odd buildings total). My wife actually holds a 70-year lease. I asked, “70 years from when?” The date the developer took out building permits? The date she closed (mind you, that would give everyone in the building a different lease period)? Exactly when is the “start” date? No answer, it’s ambiguous. If she sells the home, is a new 70-year lease initiated to the buyer? What happens when the lease expires? Assuming there’s residual value in the property, who gets it? Can the lease be renewed? No answer for any of these questions, it’s ambiguous. And there’s a ton of other unanswered questions. I should clarify, there might be answers to most of the questions, but even if there are, the answers are not common knowledge. I imagine many real estate purchasers don’t even know they have a lease rather than a deed.
Nevertheless, the Chinese pour a lot of their wealth into real estate. Real estate is tangible. If you own a condo, you can visit it and touch the walls. Also, real estate can be held cost free. There are no real estate taxes (in most of China, I read that Shanghai is thinking about it). In that all the structures are made from cement, few people bother with insurance.
By and large, these investments are purchased new and allowed to sit vacant. Generally speaking, they are not turned into rental properties. Why aren’t they made into income properties? Start with what you actually get when you buy a new condo. In China you buy an empty cement box. Power, phone and cable are brought to a main panel, but no internal wiring is provided as part of the construction (wiring paths have to be jack hammered into the walls and ceiling, post-purchase). Plumbing will be roughed in. The basic floor plan is established (internal walls are not easily moved, they too are cement). Obviously, there are no furnishings, appliances, flooring, lighting, HVAC – nothing, the new owner is responsible for all of that. Making a new home a place you can live in is a major expense. So an investment property will most often sit vacant with the hope that it appreciates faster than the 70-year lease wastes its value.
The Chinese government legalized private ownership of gold in 2004. Since that time, gold has also become an important “investment” in China. Usually held in the form of objet d’art or jewelry rather than bullion or coin (but these too may be purchased). The Chinese are proud of their material achievement; making one’s wealth conspicuous to one’s friends and family is part of the enjoyment of wealth accumulation. Earlier in this writing I alluded to the unusually large number of high-end autos one sees in China, this is motivated at least in part by the desire to show off one’s wealth. It’s also commonplace in China for people to have very expensive slabbed and polished beautiful stones and/or natural crystals on display in their homes and offices. These items are purchased not only for their beauty, but also with the notion that they will increase in value faster than inflation will erode it.
I’ll only briefly discuss digital currencies in that they have become popular in China. I don’t have deep understanding of how they are being used, so you are getting my impression rather than a well researched account. It is my understanding that Bitcoin and other digital currencies are used primarily for two purposes: 1) as a means of evading Chinese government currency controls. China has strict laws that regulate how much money can be taken out of the country. Not that these laws truly inhibit it, The Chinese have come up with numerous creative ways to get around these laws, and 2) the other use for Bitcoin, et al is to conceal ill-gotten gains. The Bank of China recently closed down all the Bitcoin exchanges in China. I have no idea if this will be as a major impediment or merely an inconvenience.
So, how about securities? Now we’re getting to the investment vehicle most discussed on this board. Stocks and bonds are intangible, so there’s an immediate impediment to investment in these vehicles. Securities are nothing more than a promise. In the West we place a high degree of confidence in this promise due to regulatory enforcement, standardized accounting and historical precedent. Even with these good controls we’ve had the near total dissolution of the Savings and Loan industry (i.e., The Keating 5 scandal), Enron, Worldcom, Arthur Anderson, Bear Sterns, Lehman Brothers just to name a few major publicly traded companies that collapsed under a scandal. The Chinese securities market is far less regulated than in the West.
Here’s a quote from the Global Times, (an official English language publication of the Chinese central government). The article praises the SSE (Chinese SEC) for taking action against Zhuhai Boyuan, the first company ever to be delisted as of 5/11/2016. The delisting was allegedly the result of the company having …misused capital, forged commercial bills and inflated deposits and shareholder equity… Analysts blame a lax regulatory system for creating a brisk market in listed shell companies that could be acquired via reverse takeovers, and also for inflating average price-to-earnings ratios in China, despite widespread public concerns that insider trading, dishonest accounting practices and market manipulation were endemic among listed Chinese companies.
You may think this is an example of responsible journalism, but it is very much more. Though the article praises the SSE for delisting a company, it also notes that there had been no prior delisting of any publicly traded Chinese company even though the cited faults were “endemic.” This is a rare example of an information organ of the Chinese government openly criticizing the lax enforcement of the regulatory responsibilities of another arm of the Chinese government. Articles of this nature almost never go to print, especially for foreign consumption.
Yet, the Chinese do put money in the stock market. Mainland China has three stock exchanges: Shanghai, Shenzhen and Hong Kong (I’ll exclude Hong Kong from this discussion as it is treated differently than the other two). The Shanghai and Shenzhen markets are the primary exchanges available to Chinese citizens (non-citizens have been excluded from direct investments in these markets. They are scheduled to be partially, cautiously opened in 2018 to foreign investors via some index funds and ETFs sponsored by participating foreign brokerage houses).
I mentioned earlier that the Chinese love to gamble. Casinos are illegal in China (save for Macao, where the casinos cater to tourists and aren’t really available to the vast majority of the Chinese). But the stock market is available. And a gamble rather than an investment is how every Chinese person I know views the purchase of securities. The Chinese I’ve spoken with about the market tell me no one puts their life savings in securities of any sort (stocks, bonds, annuities, even life insurance policies). They simply don’t trust that the promise made will be a promise kept, and the legal recourse for a broken promise of this nature is pretty much “How stupid and gullible can you be?”
Retail stocks are purchased in small numbers usually based on momentum, omens and guesswork without financial analysis. Why perform analysis on untrustworthy financial statements? Even when auditors and outside accountants perform the work, there are few accounting standards and fewer still with any kind of regulatory enforcement.
Just one simple example, how is inventory defined in China? However the executive in charge wants to define it. Obsolete inventory can be kept on the books as an asset indefinitely. Of course that will impair turn rate, but that may well be preferable to declaring a substantial inventory loss. Extend this example to virtually every item on the balance sheet, P&L and income statement (should those documents even be made public). And this is not even viewed as dishonest, rather it’s seen as managerial discretion. Layer on top of these “honest” executive decisions the very real and ever-present tendency to simply make material misstatements as noted in the Global Times article. Why bother with analysis? The Chinese I know view the stock market pretty much like a public roulette wheel – for valid reasons.
In 2016, Transparency International (transparency.org) ranked 176 countries with respect to fraud. China was ranked 79 (tied with Belarus, Brazil and India). For perspective, USA ranked at 18 and Somalia was at the bottom at 176.
Another thing I suggest that you should also take into consideration prior to investing in a Chinese company is the fact that for the most part Chinese companies are run by the founder and close associates or their immediate families. “So what,” you might ask, “Isn’t this also true for a lot of American and European companies?” Of course it is, but there is a significant cultural difference regarding the meaning of business ownership in China and the West. In the West, stock ownership represents a fractional ownership in the company. Recognition of this ownership is generally taken for granted, but it’s also enforceable via legal fiduciary obligations. In China, stockholders are not seen as partial owners in the company. They are outsiders.
Before Ali Baba went public, Jack Ma published one of his famous lists of how to succeed in business (for those who don’t know, Jack Ma is the founder of Ali Baba and he’s semi-famous for his lists). The first thing on this list (which has pretty much disappeared) was attention to the customer. He sensibly noted that without customers, there is no business. There were about 12 things on the list, I don’t recall exactly, but I do remember that the very bottom of the list is where he placed investors because “they have constant demands of the business, yet they abandon it like a sinking ship at the first sign of trouble.” I won’t argue about the veracity of the statement, but it’s indicative of the Chinese executive’s view of investors. Jack and other captains of Chinese industry have learned to keep this opinion to themselves rather than express it, but this opinion is typical managerial thinking in China. As an investor in a Chinese company you are not viewed as an owner, you are an outside lender (at best). The real owners (the inside circle) will always do what they believe is in their own best interest. If that’s contrary to your best interest, so be it, or abandon ship.
Another thing to consider about Chinese investments; you as a foreigner (and curiously, even as a Chinese citizen) can’t directly invest in some of the biggest Chinese companies like Ali Baba, Baidu, Tencent and something like 100 other Chinese firms. “Nonsense,” you might say, “I can buy shares in Ali Baba, Baidu, Tencent and a host of other Chinese companies right now traded on American exchanges.”
Well, actually, no you can’t. You just own a piece of paper, not a part of a company. You buy ADRs in a holding company (usually incorporated in a tax shelter like the Caymans) that represents ownership in these companies through an arcane and peculiar corporate structure called a VIE “variable interest entity.” I won’t dwell on it (as I don’t understand it all that well anyway); you can look it up if you’re interested (http://www.investopedia.com/terms/v/variable-interest-entity…).
The thing to keep in mind is that the legal underpinnings of this structure are very squishy. Many analysts feel they could be declared illegal and collapse. Yes, “many analysts” is a cop out. I don’t have names and links. To be honest, I read that elsewhere in a not very widely recognized financial blog. You’re welcome to research it further and correct me if I’m wrong. But, in the context in which I read it, there did not appear to be an ulterior motive. It rang true with me.
What happens to your investment if VIEs collapse? Damned if I know, but it’s worrisome enough for me to keep my investments out of anything represented by a VIE. In addition, companies that utilize this corporate structure are prohibited from listing on any Chinese exchange, so Chinese citizens do not have access to invest in their most stellar companies.
It’s not my position to advise on which companies you should or should not invest in. At most I can tell you about my investment decisions and why I’ve made them. This is what Saul does and I think it is an appropriate way to run an investment blog.
What I can tell you is that while I truly enjoy spending time in China and find the people gracious and friendly, I have no investments in any Chinese companies (though I did hold some Chinese investments when I first visited China). I can also tell you I won’t even look at or attempt to financially analyze a Chinese company. IMO, there are just too many outstanding investment opportunities elsewhere to expose myself to the risks of investing in Chinese firms.
only just now “finished” it. There’s a number of the reasons it took so long which I won’t go into, but one of them is that I had to revise it every time I restarted. Most of the background is historical, so it didn’t change, but some of the more timely information would change between the time it was first written and the next time I restarted writing.