International | Nov 10 2006
“Every crowd has a silver lining.” – Phineas Taylor Barnum.
It didn’t take long for mutual funds to scramble aboard the bandwagon. Allianz, Deutsche, Franklin Templeton, Goldman Sachs, HSBC, JP Morgan Fleming, Nikko, Old Mutual.. Just some of the fund management groups that have launched dedicated BRIC funds in the three years since Dominic Wilson and Roopa Purushothaman of Goldman Sachs
The numbers are certainly staggering. James Kynge, former China Bureau Chief for the Financial Times, has just written about them¹. In China alone, 400 million people have been lifted above the poverty line of $1 a day since reforms began in 1978. The average annual growth rate has been 9.4% over that period, the highest of any large economy anywhere. Private telephone use has grown from virtually nil to a population of 350 million people with mobile phones. More than 100 million Chinese now access the Internet, albeit with a degree of censorship that their peers in the west would resist. In each year since 2004, China has built enough power plants to supply all the electricity needs of a large European economy like Italy or Spain. China has 200 million ‘middle school’ students. Every day 22,000 girls get married; 44,000 babies are born. Every day Chinese eat 1.6 million pigs and 24 million chickens. The State has to care for 20 million children in kindergarten and 12 million people aged 80. (As Kynge also points out, demographics are not necessarily on China’s side. By 2040, around one third of the population – some 400 million people – will be over the age of 60. China may get old before it ever gets rich.)
Nevertheless, the impact on commodities markets is likely to be longer-lasting than those currently determined to view this sector through bubble-shaped spectacles believe. As James Kynge points out, the journey of urbanisation in China has barely begun. And even then, the progress made to date has been extraordinary. In 1949, the year of the revolution, there were only five Chinese cities with populations over a million. As at 2000, the last year for which data were available, there were forty.
“There are roughly 400 million people living in (China’s) towns and cities at the moment, but in 2050 that number is expected to have risen by between 600 and 700 million to reach a total of one billion.. Even at that level, China may be only slightly more than 70 per cent urbanised, compared to prevailing rates of around 90 per cent for the UK and the US, just over 80 per cent for France and Germany, and 77 per cent for Japan. The investment required to settle so many people in an urban environment is impossible to calculate with any accuracy, but
The staggering scale of all things Chinese is by no means a guarantee of wealth for successful foreign businesses. Piracy on a colossal scale means value destruction across a vast range of manufactured goods. Even legitimate Chinese businesses operate on margins that are either wafer-thin or negative. This is largely because the banking system barely works. With no functioning bankruptcy law, the liquidation of insolvent companies is hugely difficult (Japan’s “lost
published their now seminal ‘Dreaming with BRICs: The path to 2050′ piece on the likely long term growth of Brazil, Russia, India and China. The seemingly inevitable economic rise of these four countries has now become accepted wisdom in investment markets. it is clear that worldwide demand for steel, aluminium, copper, nickel, iron ore, oil, gas, coal and many other basic metals and resources may remain strong for as long as urbanisation unfolds at a rapid clip.” (Emphasis ours.)
decade” of the 90’s points to the results: thousands of zombie companies draining the lifeblood of the economy). As Kynge points out, in an efficient (western) market, oversupply normally results in output contraction. In China, the reverse is often true. Faced with shrinking margins and operating losses, Galanz, the world’s largest marker of microwave ovens, decided to expand into air conditioners; Midea, one of the world’s largest air conditioner manufacturers, decided to move into microwaves. This despite the fact “that nationwide demand for air conditioners lagged supply by 10 million units that year..” Haier, a consumer electronics company, is also in insurance, pharmaceuticals, personal computers, mobile phones, and noodle restaurants.
Corruption is also a huge problem. Kynge concludes his study of modern China with the story of 10,000 or so private investors who had 6,000 small oil wells confiscated – without compensation – by the authorities in 15 counties in Shaanxi. They still await redress. Nor is the Chinese public sitting idly by. Even assuming the figures are correct, the Ministry of Public Security in 1994 recorded 10,000 incidents of social protest involving 730,000 participants. By 2004, those figures had risen to 74,000 and 3.7 million. Perhaps the State’s single biggest problem is ensuring the smooth transition of hundreds of millions of agricultural workers into the cities – and ensuring that jobs are there for them when they get there. Ominously, Kynge suggests that “the sharp increase in localised protests shows that material enrichment alone does not guarantee greater public contentment.”
Tim Clissold² has also written eloquently of the challenge facing China’s leaders:
“..huge wealth imbalances between the coast and the inland provinces, which have sent a hundred and fifty million itinerant workers swirling towards the sea. That’s the equivalent of the entire US workforce tramping the streets of the coastal factory towns in search of a job. Corruption in the middle ranks of the Chinese government means that the central government has to make the most extreme efforts in order to transmit sensible national policies down to the local level and tackle the root causes of recurring unrest – forty million people took part in demonstrations in China last year, almost all of which were against corruption in one form or another, mostly involving land.. In the financial sector, integration of the Chinese banks with the global financial markets brings with it the most extreme dangers because of the astronomical sums of money that have started to flow through creaking systems in China. On top of all this, there are comprehensive foreign policy challenges as China tries to access resources it needs to grow and deal with the great sparking point over the Taiwan Straits.. every so often, at regular intervals in its long history, China has suffered complete system collapse and the whole of its political economy and civil society has dissolved into chaos..”
Thus the problems facing China. Victor Mallet, writing in the Financial Times (“Why the boilerman’s visit fills companies with dread”, 19.10.2006) alluded to the
“horrors of the ‘Inspector Raj’, the bureaucratic system that subjects Indian companies to as many as 67 inspections a year by a succession of officials concerned with labour, tax, the environment and, of course, the steam boiler as regulated by the Indian Boilers Act of 1923..”
Jim Rogers, probably the most vocal and most visible commodities bull, spoke last week at the Next Generation of Commodity Investment conference in London. While an unabashed supporter of commodities markets, Rogers is evidently no fan of India:
“I just don’t think it’s going to work. The Indian government has reaffirmed that its priority is not the financial markets but the masses.. India doesn’t like capitalists or foreign retailers.. It’s a mess.”
Perhaps India’s biggest problem on the road to wealth is the lack of a road itself, while China puts billions of dollars into upgrading its domestic infrastructure.
The other two BRIC components, Brazil and Russia, have at least been blessed with natural resources. But as the initial Goldman study concedes, real GDP growth in Brazil has been in sharp decline since the debt crisis of the 1980s. Throughout the 1990s, the average Brazilian inflation rate was 548%. Over the last 10 years, Brazilian real GDP growth amounted to 2.9%. This is hardly the characteristic of an economic tiger, and Brazil, as Wilson and Purushothaman point out, is also much less open to trade than its BRIC peers, with investment and savings rates significantly lower, and public and foreign debt significantly higher. To warrant membership of the growth club, Brazil requires further substantial structural reforms, almost certainly easier articulated than delivered.
Which leaves Russia. Notwithstanding its evident oil and gas wealth, and the fact that Russian equities are among the least expensive in the emerging market universe, corporate governance, the role of oligarchs and in particular fragile respect for minority shareholders remain key business risks for investors. As a subsidiary issue, any dramatic decline in the oil price – not, admittedly, an outcome we envisage over the longer term – turns the fundamentals for Brazil and Russia completely around. And even a firmer oil price is no panacea: dependency on resources tends to smother innovation and a diversified economy.
All of which is not meant to napalm the Goldman thesis. Indeed, Wilson and Purushothaman concede that each of the BRICs faces “significant challenges in keeping development on track”. Rather, it simply feels appropriate to greet the tidal wave of “one-way money” into the BRIC story with some contrarian scepticism. The rising tide will not float all boats within the BRIC harbour – particularly given the risks surrounding corporate governance, a focus on bottom-up stock-picking over beta surfing will surely pay dividends. The original winners of the 1849 California Gold Rush are widely presumed to have been the sellers of picks and shovels rather than the hordes of individual prospectors. By the time of the dotcom boom, ‘picks and shovels’ winners amounted (albeit briefly) to infrastructure providers like Cisco, Sun Micro and Oracle. While there is evidently more than just an easily marketable label to the BRIC story, the ‘picks and shovels’ winners for the longer term may remain those external companies fuelling the growth. For us, that includes the energy and natural resources sectors and corporate Japan. The BRIC story is still valid, but some of the mechanisms for playing it will warrant heightened scrutiny. The key, wrote David Williams, Asia Pacific partner in Draper Fisher Jurvetson, back in 2000,
“lies in the identification of long-term trends and the courage to pass over what appears to be easy money speculating on the theme of the moment.”
Tim Price
Union Bancaire Privée, London
6th November 2006.
¹’China Shakes The World – The Rise of a Hungry Nation’ (Weidenfeld & Nicolson, 2006).
²’Mr. China’ (Constable & Robinson, 2006).
Your feedback is always welcome; please email: tpr@ubp.ch ; Tel: 020 7369 1366
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(FN Arena wishes to thank Tim Price for his kind permission to re-publish his column on our service)
