Chinese Bubble? What Bubble?

China is a conundrum. It makes no sense. And people accept that as normal. It is a country that has collided with capitalism and is now trying to manipulate it. It is country with a government that is adept at sleight of hand. What remains to be seen is whether China is pulling off an economic miracle or just the wool over the world's collective eyes.

The last time I visited Beijing, there were few cars, few cabs and few high rises. There was nothing to buy, and what was for sale was only available at the Government run "Friendship Stores." That was just ten years ago. I came home with a few trinkets and a couple of discoveries about how business was done in China. The most eye-opening experience was a visit to a steel mill in Chengdu, capital of the Sichuan province. The business was a sham and an easy one to avoid.

That was then. Last week I spent several days in Beijing and Shanghai, hosting a Supper Club Venture Capital meeting. Many things have changed in ten yearsand some have not.

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Beijing is now a bustling metropolis with skyscrapers sprouting up everywhere. The city is surrounded by ring roads (beltways) and traffic is abysmal. Ten years ago, if you lived within the first ring road, you were considered wealthy. Now, if you live within the third ring road, you are considered up and coming.

A new national bird

The first thing that strikes you about Beijing is how much construction is going on. China's national bird must be the crane. Then you are struck by how many empty buildings are up and gleaming in the sunshine, and how many more are within months of opening their doors. Then you notice how many new cars are on the street. Not just Chinese Chery's or Korean Hyundais or even the most popular Volkswagen Santana's. No, there are hundreds of expensive BMWs, Mercedes Benzs' and even a smattering of brand new Buicks.

Whilst admiring this newfound font of capitalism, I was struck by how dirty the city was. Not trash mind you, but dust. Trash is a valuable commodity here with old women snatching just emptied plastic water bottles from your hand and others poking into empty garbage cans with flashlights looking for any scrap of tin, paper or plastic. What you will notice about Bejing and Shanghai for that matter is that the litter cans are free of litter. The dust is the byproduct of the massive construction going on to prepare Beijing for the Olympics in 2008. I counted more than 50 yellow cranes from my hotel room window. Driving around town there were hundreds more.

Beijing is now a vibrant city, open all hours and bustling with commerce. Except that the commerce that we witnessed was not in the boardrooms, but in the back alleys. There is so much to buy in this city that you could spend a week shopping at the Pearl Market and not visit every stall. And, pricesyou WILL never shop at WalMart again.

Here you can buy shirts for $2, leather jackets for $20, watches for 30 cents, prescription eye glasses for $20, tools for less than $1, and a meal for a family for less than $3. I purchased 10 embroidered "Great Wall" baseball caps for $6. There is no way that the US or any other Western Country can compete with China prices. I left the US with one suitcase. I came back with three bags full of "stuff", and spent less than $200..including the new bags!

The Great Wall-Mart

I visited the Great Wall on my second day. The weather was gorgeous, about 72 degrees and sunny. The Great Wall extends for more than 3,700 miles across northern and central portions of China. Built to keep invaders out, many sections of this immense structure are still standing. About an hour outside Beijing, there is a whole section that has been preserved and is open for tourists. Bring lots of water, and wear VERY comfy shoes. By the time you get up to the fourth tower, you will be huffing and puffing the climb on the "hard" slope is very steep, built purposely to make it difficult for any enemy to sustain an attack.

The last time I visited this "once-in-a-lifetime" sight, the roads were falling apart, there were no vendors and traffic was non-existent. Now there is a six lane super highway, tons of vendors pawing fake Rolexes and traffic is a problem. But, the wall is truly one of the seven "new" wonders of the world.

The Great Wall is also the most spectacular outdoor market in the world. Vendors and hawkers are everywhere, peddling China dolls, Great Wall t-shirts and engravings, all manner of knick knacks, toys, clothing and just about everything you pay ten to thirty times more at your neighborhood WalMart or Dollar store.

It is a haggler's delight. The strangest thing I encountered all over China was that you can buy everything at YOUR PRICE. That's right, the vendors will come down as low as you are willing to go without feeling like you just ripped off a starving family. If you ask the price of something like a Great Wall cap, they will start you off at 40 Yuan about $5. What a bargain you think the same quality baseball cap in the States would set you back at least $10. By the time I was finished, I bought the hat for sixty cents. I could have gone lower, but I was getting embarrassed haggling over 12 cents more. Of course, the vendors know that some tourists will jump at the higher price thinking it is a bargain and will make it up in volume. Still, a block further the vendors were starting the bidding at $1 for everyone. The question that begs to be answered is how can they afford to produce so much for so little? Doubtless labor costs are low, but there is more to this story. Do yourself a favor, when you visit China, never shop at Friendship stores and bargain for everything, even at department stores. Whatever they start with offer no more than a tenth and start from there. Do not let them ask you to start the pricing- make them do it firstand know full well that whatever price you settle on, it will be cheaper next door. Oh, yes before I forget to mention this price tags mean absolutely nothing here.

One country - two sets of books

After having a few days of pondering the puzzle of China, visiting with companies and catching the local real estate scene our group sat down to discuss what it was that did not make sense about the commerce that we were seeing. I will give you the backdrop as a series of the examples we encountered.

First, the taxis don't make much sense. The Chinese currency, the Yuan is pegged to the US Dollar 8.2 to 1 (this should change soon by about 3% to 5%, bring the Yuan to 7.8 or 8 to $1.) The Chinese face the same pressures of rising fuel prices as Americans. Right now, a gallon of gas in China cost $2.20. Now, try and figure this one out: a cab ride that last 30 minutes will cost about $2.50. When I got back home, the cab ride from the airport, about 30 minutes from my house cost $48 including tip there is not tipping in China for cab-drivers. How is it possible for a cabbie in China to drive you for 30 minutes, using up at least of a gallon of gas there is no such thing a economical driving here yet, it's pedal to the metal at all times pay for wear and tear, his time and insurance if available for $2.50. It makes no sense.

Next, we visited a retiree living in one of the old neighborhoods in Beijing. These old neighborhoods in the middle of the city are called Hutongs. They are set up in quadrangles with several families living in each quad. This pensioner, a former worker in the archaeology department for the government was making $25 a month in government pension ten years ago when he retired. At the time, his home was worth about $20,000. In China, the government owns ALL of the land. The homeowner/Office owner owns the building and leases the land.

Today the pensioner is getting $250 per month and his home is conservatively worth $300,000. His home is about 1,000 square feet which houses about three families. They have no bathroom and must share a communal bathroom in the neighborhood. Heat is provided by burning coal. The same house in the US would be condemned. I spoke with him about his standard of living which he says has increased measurably. No doubt having a pension increase from $25 to $250 in tend years is quite a jump in living standards. The funny thing is that inflation in Chinaaccording to the government has been increasing at single digit rates for the past decade.

Third, we looked at a bunch of companies. Most of them were leveraged to the hilt with more debt than equity. Most were government spin-offs that were now private and publicly trading in the US OTC market. When asked about how they were able to pay their debts loans owed to the State Owned banks they replied almost in unison that the loans were a low interest rates and renewable in perpetuity, and that the banks really did not force them (expect them??) to pay them back until they became profitable. One way around this, one executive intimated, was to keep tow sets of books, one perpetually showing low profits or a loss. I asked point blank if this "government subsidy" was commonplace and the answer was a resounding yes! The comment that was most telling was when one company officer, a US trained MBA blurted out " this wouldn't work in the US." I guess not, unless you were Worldcom or Enron!

The conclusion that I reached was that China is NOT a transparent country, the government is subsidizing every level of the economy from pensioner to taxi driver to major corporation, and that there will be a day of financial reckoning when many businesses go bust because the government will not bail them out by injecting more capital into already debt-ridden banks. And, you CANNOT trust ANY statistic that the government publishes.

Ponzi would be prouChinese banks aka the government are saddled with hundreds of billions of dollars in non performing loans. That is if you use their published numbers which are shaky at best. Yet, they continue to lend businesses whose owners are making money, not from product they sell, but from how much they can siphon out of the company knowing they are not being held accountable. As I see it, it goes something like this. You get a loan that you don't have to payback. You produce goods that you then sell below market to generate cash flow. You then show a loss from operations since you spent more to make the product than you are selling it for. You pocket some of the cash flow since the debt service is non-existent. You use your newfound profits to put deposits on new office space and apartments that you are planning to flip since in China you don't have to pay for the space until it is completed, and by then if prices have collapsed, you just walk away. And since few Chinese pay taxes in this "voluntary system", most of your earnings" are also tax free. So why does the government put up with this?

There are two reasons that I can come up with. First, corruption in the Chinese government is about as common as smog in Beijing. The skids are being greased at every level. Capital is being provided for these companies via share sales in the global markets to keep the party going after the loans run out. Basically this is how business is being done.(Now this may not be the case for every Chinese company, but elements of this type of chicanery cannot be isolated incidents or the number of bad loans would be much lower.)

The second reason, and just as troubling, is that the government cannot control the new capitalism that has been unleashed across the country. People are seeking a better lot in life and finding it through commerce. With 1.3 billion people, it could be an ugly scene. So, the government is filling the trough of liquidity, basically subsidizing the entire urban population, to avoid an uprising. Money is flowing, goods are being sold, buildings are being built and all within an artificial cost structure.

Shanghai SurprisWhile Beijing has a relatively short history of modern capitalism, Shanghai has a long relationship with money. Known to some as the Pearl of the Orient and others as the Whore of the Orient, Shanghai is truly one of the worlds great metropolis'when you can see it.

When you CAN see the city, you see modernity surrounding you. Subways, massive freeways that fly through the city center, suspended 40 feet above ground, a Maglev train to the new airport that I clocked at 430 kilometers per hour, and a port second to none. In my estimation, Shanghai, home to over 13 million people has more skyscrapers than Manhattan. It is also more polluted, more gridlocked and just as much fun.

I thought Beijing had the best markets, Shanghai has better ones. Here you can find all manner of goods and services that are available in the world's largest and most cosmopolitan cities. Five Star hotels abound, modern theater, huge malls with every imagineable offering from Europe and the US, a McDonalds around every corner. If it wasn't for the smells and strange rooflines, you could very well be in any modern capital. (Speaking of McDonalds, the Economist magazine has long put out a Big Mac Index as a measure for valuing whether a currency is over or undervalued. I have been using this index as a guide for more than a decade and it has proven quite accurate. My Big Mac meal in Shanghai set me back $2.19 about half what it would cost in the US. This is a good indication along with the 15 cents I paid for a snickers bar and the 30 cents I paid for 16oz Pepsi, that the Yuan could appreciate quite a bit from current levels).

Of course, the lower strata of the population does not see it this way. As in any big city there is a lot of poverty in Shanghai. And, it is in your face everywhere. Parents with invalid children begging for pennies, people walking around picking every trash can clean of its putrid treasures you name it and you will see it in Shanghai.

Shanghai is also the culinary capital of China. With everything from USDA Prime steakhouses to authentic local restaurants, you can take your pick from pigeon (with head) to a strip steak flown in from Iowa. Some of us, myself included, were unable to get past the third course of our 12 course meal. Quitting after the sauted duck's feet, we made off of for more "western" digs. As one of the members of our group S.P. put it: "not another bowl of snot soup." After a few days the local cuisine was overwhelming for a few of us. But, no one got sick, and no one lost any weight. And the majority of the group, especially T.A. could not get enough of the local fare.

Pudong was nothing more than agricultural land a few years ago. Today this part of China, sitting across the Pu river from Shanghai is the newest monument to modern architecture. Huge skyscrapers lit up by neon and lasers light up the night sky. This is the "new" China and there is a lot of building going on. Within a few years, Pudong will be the new skyline in Shanghai no small feat.

Shanghai is almost not China. There is very little overt sign of government control of this commercial mecca. It bustles like Manhattan, entertains like LA and offers Miami like temperatures and beaches. It is China's version of Laissez Faire economic. Anything goes here and the aura of the old money made by the first large opium houses abounds. On the streets you are as likely to see a Bentley as a rickshaw. Shops range from opulent malls to back alleys where one can still score knock-off Gucci and Louis Vuitton purses (about $10 a pop if you bargain hard enough.) This selling of pirated and knock-off goods is enduring China's version of a crack-down. Instead of selling openly in the markets, you are led down a series of back-alleys to small rooms with all the goods on display. China will pacify the west on the surface but underneath, it is business as usual.

Spending a few days in Shanghai almost made me a believer in the China miracle. It was a real city, with real history and real money. But, it was just one city in a sea of billions of people, many who have yet to experience a working toilet in the 21st century. China has four such cash cows: Hong Kong, Shanghai, Macau and soon they will suck Taiwan into the fold. None of them are too happy with being associated with a government that still tries hard to control every facet of life. It is not working and I think China will go the way of the USSR a weird sort of capitalism with no looking back.

China is a conundrum. It defies economic principles with low inflation, high growth, and huge money supply, and a socialist government all in onesomeone is lying somewhere. My advice on investing in China is this:

1) Trade Chinese stocks and look for emerging market like crashes as buying opportunities2) To really profit from China, fly over with a few suitcases and spend as much as you can buying goods at artificially low price

The only thing that you should not do is to ignore China. It is THE giant of Asia and there is no country even close. India may be an established democracy, but it is does not hold a candle to the development in China. That being said, India may prove to be the opportunity that China was ten years ago. For now, China is a juggernaut that looks to be growing to the moon.and as we know from past experience, that may not be a good sign in the short term.

Karim Rahemtulla of The Oxford Club