The Great Uncoupling

There have been a number of intriguing developments in the last week that have potentially big implications for U.S.-China commercial, financial & trade relations.

Keen observers of China's banking scene may remember that a number of big western financial institutions, including Bank of America, Citigroup, UBS, Goldman Sachs, American Express and Royal Bank of Scotland have invested in various big Chinese banks a few years ago, primarily before those Chinese banks went public in western and/or the Hong Kong stock exchanges. At the time, these investments made plenty of sense for both sides. The western investors, of course, got to jump into -- even if a bit passively -- the Chinese banking markets. Those markets had been largely closed to their significant participation before China's accession to the WTO. After China became a member of the WTO, altho the banking market technically was partially opened, only a few foreign banks hopped over the border. Not that the Chinese government exactly made it particularly easy, but that's a story for another day. The one avenue where the gates swung wide open, altho the gatekeepers were still on duty, was equity investments in Chinese banks. With the prospects of the big four (Industrial & Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China) going public in the near future, the chance to jump in before the expected stampede for public shares was irresistible. For the Chinese side, there were big advantages. Looking forward to impending IPO's, the Chinese banks got a bit of legitimacy. If Bank of America buys shares in a bank, it must be a good investment. Or so the reasoning went at the time.
In addition, the then badly managed Chinese banks, in their rush towards legitimacy, could rightly claim that they had not only dumped a lot of their bad loans but they also were getting operational advice & counsel from their western brethren. In hindsight, we can all hope that they didn't learn too much.

Since those days in the not too distant past, the banking world has turned topsy-turvy. Those western pillars of the banking world turned out to have been infinitely more poorly managed than the big four Chinese banks. After the events of the last few months and the effective partial nationalization of many, if not all of those western banks, the scene has become truly surreal. Follow the logic. The big U.S. banks, with their significant ownership in major Chinese banks, are now largely owned by the U.S. Treasury. That means that the U.S. Government owns a chunk of the Big Four Chinese banks. Since the Big 4 are partially owned by the Chinese Governmentas well as the investing public, it means that the Chinese & U.S. Governments are, effectively, co-investors in the banking business. Mao Zedong & Ronald Reagan must both be squirming around in their graves, wondering what on earth could have happened.

But that's not the story. Now, in an effort to raise badly needed funds, Bank of America has sold off some of its Chinese bank stock for approx. $2.8 billion (for a profit of a bit more than $1.1 billion -- we're glad something has worked out for them, by the way). Analysts expect that B of A will be selling more stock (and they've got plenty left). In addition, other western banks are expected to begin to sell some of their Chinese bank holdings as well over the next few months as restrictions on stock sales expire.

So that's the first part of the story: Western banks begin divesting Chinese bank stocks.

The second and also intriguing development is this story, reported in the New York Times, among others:

China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home, a move that could have painful effects for American borrowers.

The declining Chinese appetite for United States debt, apparent in a series of hints from Chinese policy makers over the last two weeks, with official statistics due for release in the next few days, comes at an inconvenient time . . .

In the last five years, China has spent as much as one-seventh of its entire economic output buying foreign debt, mostly American. In September, it surpassed Japan as the largest overseas holder of Treasuries.

But now Beijing is seeking to pay for its own $600 billion stimulus — just as tax revenue is falling sharply as the Chinese economy slows. Regulators have ordered banks to lend more money to small and medium-size enterprises, many of which are struggling with lower exports, and to local governments to build new roads and other projects.

While this is not, in itself, striking news (it follows reports last year of China's national sovereign fund, The China Investment Corporation, coming under popular criticism in China after some of its less-than-stellar western investments began showing the strains of the times), it comes, as The Times notes, at a rather inconvenient time for the U.S. As mentioned previously in this blog and numerous other places, there's a lot of U.S. Treasury debt that must be rolled over soon and a big bill to be paid, financed by soon to be issued, crisp new Treasuries, for the first & second phases of the Big American Rescue Plan. That will mean that, in order to attract investors to the Treasury auctions, interest rates will need to be higher than they are now. Interest rates going up means Treasury prices go down. And the current Chinese holdings aren't immune to those market forces. It doesn't mean, of course, that Chinese bond buyers will entirely sit out upcoming U.S. Government bond auctions, but they can expect to demand higher returns. And we wouldn't be surprised if they bought less than they have in the past. And you can't blame them; you'd do the same thing.

Let the Great Uncoupling Begin!

Savings Imbalances & the Washington Follies

As I've mention before, these are interesting times we are living through & there is no end to the fascinating tidbits one can find in the press. One of the more valuable series, presumably ongoing, is the New York Times series titled The Reckoning about the economic tumble of the last year or so. And one of my favorites (and more revealing) in the series was a piece that ran the day after Christmas titled Dollar Shift: Chinese Pockets Filled as Americans' Emptied. While I agree with the basic premise -- that Americans, both our government and our households, have been living "high on the hog" through over reliance on debt -- is correct, there are some interesting insights that are left unmentioned. First of all, economists have recognized this problem for years and some, like Morgan Stanley's Stephen Roach, have been been persistent in eloquently & tirelessly telling everyone within earshot that this phenomena would come to a disaster sooner or later. What the Times' article points out is that our erstwhile Secretaries of Treasury in recent years, altho aware of the imbalance, didn't do much effective about it. The prevailing view seems to have been to blame the Chinese and to press the Chinese government to somehow get the Chinese people to increase their spending & decrease their savings. The average Chinese consumer can certainly afford to save less -- the aggregate savings rate in China is generally higher than 30% and sometimes up to 50% of income -- but the Chinese government has little it can do to prod the masses to buy more. For one thing, the vast majority of Chinese people remain poor. Consumption in the cities by the emerging Chinese middle class is a combination of healthy (lots of new cars & a vastly larger private housing market than only a few years ago) and frugal. A visit to those glossy new shopping malls leaves one with the impression that Chinese love to window shop but hate to part with their cash. Or, when they do, its at the shopping areas where you can buy things at sharply lower prices than at the big name shops. Think Prada & Gucci vs. the little clothing stalls on the west side of Beijing; the former are uncrowded and unrushed, while prowling the latter is a contact sport like a rugby scrum. Other big Chinese cities are no different.

One of the proposals out of Washington's policymakers has been for the Chinese government to improve health care funding along with retirement pensions because that's, they think, why the Chinese peple save so much; to save for a rainy day. The irony of suggestions like that from the U.S., where health care funding is famously inadequate and where the U.S.'s Social Security retirement system just barely missed being largely handed over to the thieves of Wall Street, is hard to miss. In any case, it wouldn't have worked. Chinese do not save so much solely out fear that they will end up poor and sick or poor and retired. The entire world-view of traditionally minded Chinese is, apparently, beyond the comprehension of Treasury Dept. policy wonks. Chinese do not generally get into debt to others because they know what so many Americans are only now discovering: getting in debt to the levels common in America means giving up control of your life to someone else; it is inherently risky.

In China, where success is a recent commodity much less taken for granted and failure & poverty are often multi-generational companions, people are much more conservative and tend to see themselves as part of a family continuum of ancestors, extended family and yet-to-be-born descendants. Having family money safely put away is honorable, while getting in debt is both shameful in itself and risks multi-generational ruination. In some parts of America, sefishness and immediate gratification are all-too-common (along with a tendency to blame others for one's failures). The average Chinese, in contrast, is nothing if not self reliant. These are, of course, generalizations. There are many self-reliant Americans who are not mired in a debtor culture just as there are plenty of Chinese who live way beyond their means and are addicted to conspicuous consumption. Nevertheless, the generalizations are useful and are clearly reflected in the aggregate economic data of consumer behavior.

The second insight is the often repeated description of the U.S.'s current Treasury Secretary as someone who is an expert on China. While he appears to have been in China many times in his tenure with Goldman Sachs, he has not been able to accomplish very much in China as Treasury Secretary. While I don't know him at all, I can only speculate that his self-described 70+ trips to China had been directed at senior Chinese from both the government & private sector. His down-time in Beijing, Shanghai and elsewhere was probably with his own employees and with the Chinese government officials, Chinese bankers, and Chinese entrepreneurs that American investment bankers and business leaders visiting China usually seek out. While there's nothing wrong with that at all, it doesn't make you an expert on China. It gives you only a highly choreographed glimpse of a tiny slice of a vast and vastly complex place. Add to that the tendency of Chinese to frequently tell foreigners only what they think those foreigners expect to hear. Stir both up in a pot with the typical Wall Street bankers' "Masters of the Universe" arrogance and you end up with the kind of delusional policy presumptions that have boxed the U.S. in. The one consolation is that the Chinese have as little room to maneuver as the U.S. does.

Where the Smart Money is Going: And Why Yours Shouldn't

We live in interesting times, to say the least. During the economic collapse of the last four months, if you're not too squeamish to watch, there have been some fascinating things going on. First of all, as virtually everyone with a brain can see, the stock markets in the U.S. have dropped, losing close to a third of their value. I'm not going to rehash all the details on that; you can read all about it here, as well as many other places. Suffice it to say that stock markets around the world, whether in the developing world or in the developed world, have been on a roller coaster of instability that we haven't seen since the 1930's. If you want to put your money there (presuming Bernie Madoff hasn't made off with your nest egg), be my guest. Just don't come back to me in two or three years and complain. I'll just say, "I told you so!"

So what are your alternatives? A friend of mine asked me this exact question a few days ago. I told him what I thought and I haven't changed my mind, but I've been thinking about it ever since. One of the rather interesting things that's been happening recently is that, for government bonds -- and, in particular, for U.S. Treasuries, traditionally the safest bets in the capital markets -- yields have dried up. Basically, if you want to lend money to the U.S. Government, its an "even up" deal. In exchange for the chance to put your cash in Uncle Sam's pocket, he's promising to give it back whenever that bond or T-Bill matures. Interest? Fugetaboutit! Your return, for the duration, is being able to sleep at night. The risk is low and everybody knows it. So the U.S. Treasury has no shortage of willing lenders. This is nothing new, by the way. Whenever the markets for stocks & other marketable financial instruments gets rocky, investors stream out of those markets in something called a "flight to quality", namely U.S. treasury obligations. And that's where the Smart Money is going now. They're not getting much for their bonds & bills, though. Here are the yields as of close of business at 2008 Year End:

Treasury Bills, Notes and Bonds

Most recent issues
Maturity	% yield	Change
At close 12/31/2008
3-month	0.112%	0.00
6-month	0.249%	0.00
2-year	0.75%	0.00
5-year	1.55%	0.00
10-year	2.22%	0.00
30-year	2.68%	0.00

So that's what the Smart Money Pros are getting as a return on their investments. If that 2.68% yield on a hypothetical 30 year Treasury looks good to you, have at it. I'm sure, come the market's opening after the holiday, yields will still be there. With the bailouts of the banks & auto companies, and the big stimulus package being designed by Obama's troops, there'll be no shortage of treasuries around. Everyone can get as much as they'd like. Here's the problem, though: Excluding any correction for inflation (or, as the case may be, for deflation), 2.68% seems pretty measly to me. Especially given the risk. And, yes, treasuries have risk. Not credit risk (i.e., the possibility of default); I trust that the U.S. Government will still be in business when this whole thing is over -- altho other governments may not. Treasuries are, though, vulnerable to market risk. Their price fluctuates. As interest rates go up and down, the prices of Treasuries go up and down. Or, more exactly, they go down and up. If interest rates in general go down, bonds go up. And if interest rates go up, bonds go down. U.S. Treasuries obligations (Bills, Bonds, & Notes, technically speaking) are not at all immune to this. They go up and down, too. So, class . . . think about our current situation a bit. Treasury rates are unlikely to go down. There's no place to go. They are just about as low as they could possibly go. They could stay the same. But, as I hinted up above, in my own, always humble, opinion, even 2.68% is hardly worth the trouble. At these levels (especially considering the transaction costs of buying & selling modest amounts of bonds) there's basically no yield here to speak of. You might as well hold cash (more later on this brilliant plan). But there's another alternative: Interest rates could go up. Of course, they won't do that very soon. But, eventually, they will certainly go up. And, when interest rates go up, all those safe-as-can-be Treasuries will drop like a rock. The short term ones -- less than a year will drop like pebbles. The medium term ones (as in 2, 3 or 5 years) will drop like rocks. And the longer term ones will drop like big ol' boulders. The longer the maturity, the bigger the fall will be. It's a financial law, folks. There's no escape from the mathematical certainty of this basic principle

So, what I told my friend was to put extra cash into, well . . . cash. No commissions, no market risk, no credit risk (or, at least, no more -- or less -- credit risk than Treasuries). Kinda simple, actually. In fact, maybe not just U.S. dollars. There are also Euros, the Chinese Renminbi, Japanese Yen . . . A caution, tho: currency markets are also not without risk. Don't say I didn't warn you!

Upcoming Stories

Watch for these upcoming stories in Beijing Eye:

• Why the Chinese savings rate is so high & why the U.S. (and China itself) probably can't do anything about it.
• Education in China: What's right, what's wrong & what needs to change.
  

A Day in Beijing

From The Archives:

A Day in Beijing

We were walking in the center of Beijing, along the northern end of Tiananmen Square. My son Josh's first time to Beijing, my third or fourth visit. He was visiting from New York and I was living in Hong Kong. We were in Beijing for a January week, being tourists, visiting friends.

We walked along the sidewalk between the square and the front gate of the Gu Gong, the Forbidden City. Chang’An Avenue, the Avenue of Eternal Tranquility stretched out to the west towards the Fragrant Hills. It was still in the days before massive urban reconstruction began to turn half the city into a replica of Los Angeles, with bland tasteless buildings built on top of historic rubble.

As bicycles streamed by, then still the most common transportation tool, we walked along the crimson walls that separated the city rush and flow from the Zhongshan Park gardens on the inside. The park was originally built in 1420 as the Altar of Land & Grain and in 1928 renamed for Sun Yat-sen (Sun Zhongshan in mandarin), the founder of the 1911 revolution. Inside the park is the Zhongshan Concert Hall, now renovated and modern, but then a down-at-the-heels theatre little better than the bandstand it had started out as. We didn't know this at all. We were wandering west down the street, soaking in the sites, watching the people flow past us in both directions, like schools of fish gracefully keeping their distance. We had no discernable destination. When we got there, where ever it was, we'd know. It was a grey day, from threatening snow or pollution or both.

We had been walking for more than an hour and looking for a break. We turned north, and walked up the quiet street that divides the Forbidden City and its public parks and museums and Zhongnanhai, the "Central and South Seas", the really forbidden home base for China's central government. Maybe Deng Xiaoping was inside. The further north we walked, the more little shops we saw. As we walked, a bicyclist rider slowed along the curb in front of us. Strapped to the back of his bike was a canvas backpack, faded through long use into a colorless tan. It was open on the top and the cover flapped loosely to the side. Out of the top of the pack we saw the black ends of ten to fifteen scrolls, either calligraphy or traditional Chinese paintings. The rider, a middle-aged Chinese man with a sensitive face and a full head of hair, seemed just as frayed as his backpack.

He pulled his bike over the curb, angling across the wide sidewalk, on a trajectory that would quickly intercept us.

“Hello”, he said in accented English.

We mumbled a response, ambivalent about the encounter. On the one hand, we wanted to make contact with people. On the other, we’d become bruised by the constant efforts by Beijingers to separate us from our money.

“Where are you from?”

Again we responded. He introduced himself as “Wang Laoshi”, Teacher Wang, and said he was a calligraphy teacher from a nearby school. The scrolls in his pack were both his and his students. He was taking them to an exhibit.

“Where are you going?” he asked.

We told him we were looking for a place to rest, maybe have some tea. Actually, coffee would have been better but, in those days, coffee was hard to find. None of Beijing’s now ubiquitous Starbuck’s existed.

“I know a place very close; you can have tea. And noodles. I’ll show you.” Wang hadn’t asked for money, at least not yet. I kept my hands in my pockets. As we walked up the road, he told us that calligraphy was a very time-honored art in China. Writing hanzi, characters, was both literary and artistic. Every educated Chinese was taught calligraphy, he said. I thought of how different it is in the west and how bad my handwriting looked. I’d almost failed penmanship in second grade. If I were Chinese, I’d be considered a complete idiot. We nodded and smiled.

“It is different from the past. Before we used traditional characters. The same for a thousand years. Now, we don’t. China is a very poor country. No money. So Chairman Mao decided Chinese people should use simplified characters – use much less ink and paper, save money.”

I’d never heard this theory before. I mean, I knew what he said was true: that outside the PRC, in Taiwan, Hong Kong, Singapore, and even New York’s Chinatown – the characters were the traditional, more complex ones. They had more brush strokes and were harder to write & read. I’d always thought that the PRC had switched to simplified characters because they were easier to learn. If they were easier to learn, more people would master them. If more people mastered them, literacy rates would go up and China would look better to the world. I kept my mouth shut, but determined not yet to discard my own view; maybe I was wrong, but Wang’s theory sounded a bit, well, . . . goofy. What was this guy up to? He hadn’t offered to be our tour guide, translator, money-changer, girl-friend-finder, or any of the myriad other scams and money-related schemes we’d been battered with.

We arrived at the faded green door of a tea shop, tucked up against the west wall of the park. To the right of the door was a window, but little could be seen of the inside.

“May I join you?” he asked.

“Sure. Why not”

We went inside and, in the dim light, took seats at a small “four-top” on the right, a few meters in from the window by the door. The whole place looked like it was last renovated during the reign of the Empress Dowager, a hundred years ago.



We ordered tea and noodles.

“Would you like to see a scroll?”

“Yes, of course!” I’d hoped, but hadn’t wanted to ask. I’d been afraid maybe he would think it was too intrusive.

He shuffled through the scrolls in his pack, finally selecting one and pulled it out of the pack. He put the pack back on the floor.

“Do you know Li Bai?” he asked.

“No.” We hadn’t met many people in Beijing besides our hand-full of friends.

“He is China’s most famous poet, from the Tang Dynasty.” No wonder we hadn’t met him.

The tea came, followed by steaming and enticing fragrant bowls of noodles. We slurped the little cups, careful not to burn our tongues.

Wang untied the scroll, stood up, and unrolled it. As it cascaded down, I could see that it was beautiful. But to my ignorant eyes, it was also a mystery. That I couldn’t read it was irrelevant; the mystery just added to its beauty.

“What does it say?”

Wang rolled the scroll back into itself and put it on his chair. He backed away from the table and stood with the window to his right. We watched him, fascinated. He held out both hands, palms down and swept them from one side to the other, parallel to the floor.

“Jing Ye Si”, he said. “From my bed . . .” He leaned towards the window and lifted his hands, palms facing each other but still apart, towards the sky outside the window.

“ . . . bright moon shine.” His hands, palms still facing each other, pointed to the floor near the table. “Chuang qian ming yue guang . . . Think snow on ground.” His hands swept back in a smooth arc.

His hands came together as if in prayer. He raised them towards the ceiling and lifted his face.

“Yi shi di shang shuang . . . ; Raise head see bright moon.”

His chin dropped to his chest, his hands at his sides.

“Di tou si gu xiang . . . lower head, think of home.”

I was overwhelmed. I wanted to clap; a standing ovation wouldn’t have been inappropriate, In the dim light, Wang smiled. He sat down, slurped some tea – by now a bit cooler. He began to eat his noodles.

By now, after Wang’s performance, I wanted that scroll. I would remember the grace and depth of feeling and the magical moment every time I looked at it at home, I was sure. But how to buy it? Wang had offered nothing for sale. I felt awkward and culturally illiterate. What was proper? How could I buy this thing without insulting the moment, without taking its magic and making it a crass commercial encounter?

“Can I see some the other scrolls?”

A few more came out of the pack, all beautiful, all meaningful only as foils for the first one. No more poetic dances followed. Wang quietly shared calligraphy, noodles and tea. He seemed unrushed, attentive. When the noodles were finished, the scrolls neatly tied and put back in the pack, Wang stood.

“I must go now.”

We offered to pay for the small meal. He gently refused and took a few rumpled bills out of his pocket and put them on the table. He turned and took a few steps towards the door. He stopped and turned around, facing us again.

“I would like to give you a scroll,” he said. “For friendship.” He searched through the pack again, pulling one of them out. We couldn’t tell which one it was. They all looked the same – round coils of paper and silk, with black knobs on either end and wisps of silk string tightly holding the coil in place.

“It is Li Bai’s.” he said. I was speechless.

“But you cannot give us that one!” I wanted to say. But not wanting to, either.

“You must let us pay for it. Really!”

“No, no. I cannot.” He put it on the chair. He said nothing for a moment.

“But it is not mine. It is my student’s. Maybe you can give him something for the materials: the paper, the ink, the scroll . . .”

“Of course!” We wanted to be fair, of course. But we had no idea how much this could be.

“How much?”

“It is up to you. You can give him what you think it is worth.”

The scroll seemed priceless to me. A thousand renminbi would be too little. What could I say that would not be insulting? How much could the ink, paper, silk, and the wooden dowel be? And that was too little! Li Bai was a great poet! It was as if he, himself, had written this scroll!

“Two hundred and fifty.” I said.

“Haode”. Okay.

I counted out the money, stood up and gave it to Wang. I sat back down. He took it, carefully folded it and put the bills into his pack. Keeping it safe for his student, I thought.

Wang said goodbye, turned and left the tea house. Josh & I paid the bill, stood up and followed him onto the street. He had disappeared, nowhere to be seen.

A few snowflakes floated in the grey January air.

“I think we were just played.” Josh said. “I think maybe he planned that all out, just to sell us a scroll.”

“You think?”

“Yeah.”

I thought about what Josh said, as we walked back towards Chang’An Avenue.

“But he’s really a master,” I answered. “It was worth it every penny.”

We looked for a cab.

We never saw Wang again, but never forgot his remarkable performance. And, in the years since, I’ve sought out Li Bai many times.

Creative Bankers

I happened on this column by Thomas Friedman in the New York Times, titled "Time to Reboot America". I was struck by a number of things. First of all, Friedman's point, that the U.S. is essentially in the same shape as GM and that the country needs a fresh start and, furthermore , that the next 3 months or so present an historic opportunity, albeit an expensive one, to start anew, is spot on.

This is something that many American expats can see with a clarity that seems to get muddier the more time one spends in the U.S. these days.

Then a few other thoughts popped up. I saw an article here in China where a chinese banker was intent on defending the value of the many "innovations" the capital markets have been witness to in the last ten years. Quickly on the heels of that was a memory, long dormant but still clear, of the late great Peter Drucker telling me that the field of finance, as he put it, was not a place that encouraged creativity. What he was referring to wasn't management creativity, nor was it the creativity financial pros bring to solving organizational financial problems. He was talking about the kind of financial engineering that became the hallmark of the modern Wall Street; the kind of "creativity" that used smoke & mirrors to create financial instruments so far removed from anything of underlying real value that they had worth only in that someone thought they could be bought or sold, sort of like the mythical emperor's new clothes (which, of course, never really existed). At the time Drucker made that comment, to call a banker creative would have been an insult. People wanted their bankers conservative, even stodgy. That's an attitude that, today, seems rather refreshing.

How ironic it would be if the Chinese, in their efforts to bring innovation to the modern Chinese world, buy that myth from Wall Street: that financial creativity (of the third kind) is the kind of innovation that China needs. Its not. As the U.S. has learned, to its horror.

Christmas Eve, 2008

Seasons' Greetings To Everyone!