Prosperity can be an illusion. While there has been consistent (and mostly breathless) commentary on the massive wealth in China’s market, fundamental indicators like property and the recent financial fraud expose in the 2018 documentary, The China Hustle, show that despite the property boom, burgeoning numbers of public listed Chinese firms and the rabid consumption of luxury goods; things could be coming to a head when reality hits.
With official releases pegging China’s third-quarter GDP growth at 6.5%, the “world’s factory” is hitting its slowest pace in nine years and if the luxury goods industry continues to depend on the market for revenue growth, it would a recipe for disaster.
“There are no good guys in this story, including me.” – Dan David, co-founder of GeoInvesting
Business of Luxury: The Illusion of Chinese Wealth, Chinese Luxury Goods Consumption and the China Hustle
In the cold open of 2018 documentary, The China Hustle, Dan David, co-founder of GeoInvesting, a company which has made millions performing due diligence research and then shorting fraudulent public listed Chinese firms is first to admit, “There are no good guys in this story, including me.”
Taking place primarily after the 2008 financial crisis when U.S. markets crashed in 2008, it was an international scam perpetrated by third-tier investment banks until 2012. For 4 years, some $14 billion was scammed from American investors including retirement funds and pensions. “Reverse mergers” engineered by these banks allowed Chinese firms to piggy-back operationally defunct but still legally active listed American companies and raise funds through share issues on Wall Street with little to no oversight.
The chance to participate in “China’s growth story” or the Chinese Gold rush provides the heedy allure and illusory assurance in a market that is all but well-regulated. But things came to light, when a group of investors, including David’s GeoInvesting noticed that the profits of these Chinese companies were overstated to the Securities Exchange Commission or SEC, subsequent investigations showed that the Chinese government had little interest in pursuing these fradulent companies nor was there any will in the Senate halls of Washington to hold these errant companies to task.
With secretly captured video of factories and firms depicting little production or logistics activity, these Chinese “massive conglomerates” were exposed and while a group of investors had profited from short-selling these firms, the damage was done.
Why Does China “Hustle”?
In a 2005 academic paper published in the Law & Society Review, Volume 39, Number 3, Professor Xin He (currently with Faculty of Law, The University of Hong Kong, 2018), a legal expert on China explored why entrepreneurs in Beijing do not fully comply with legal statutes and regulations. He discovered that widespread noncompliance was the rule rather than an exception when compared to other developing countries of equivalent progress and it boiled down to institutional and cultural hindrances – holdbacks from Chinese transition from previous institutional environments had entrenched certain attitudes in the population resulting in corruption, rent-seeking and various levels of patron-client relations – the much publicised guan xi 关系- the Western equal being: “You scratch my back, I scratch yours”.
Comparative studies in post-Communist countries indicate that legal compliance by the people is largely due to incentives and sanctions (Feige 1997). In the pursuit of financial prosperity, the
authorities and the law are not worthy of respect, and is therefore not in their practical self interest to obey them. Ironically, the situation is exacerbated by a balanced if odd semi-legal option which is reinforced and sustained institutionally by local businesses, law enforcement officers, and local authorities because their interests are inextricably intertwined with it, inevitably by officials’ own albeit conflicting business interests and the aforementioned “guan xi”. The whole situation constitutes a general equilibrium through which various interests are balanced and as The China Hustle documentary explores, it was not in the interest of Chinese authorities to pursue these fradulent firms because the “illegality” in this instance was perpetrated on foreign soil.
“If this one company was fraudulent… what does it say about the rest of the market?” – China’s Infrastructure Builds for No One – Ghost Cities
China’s economic prosperity and affluence is often exemplified in the massive building boom or in the wanton consumption of luxury goods. However, in 2016, The Washington Post presented a slight hiccup in China’s miraculous, double digit GDP growth story: China had been pouring billions to build a new city called Lanzhou New Area within the Gansu Province located on China’s Silk Road Economic Belt. The city was meant to be its crown jewel or “diamond” but thus far, it’s been nothing but carbon and sand, complete with garish monuments of pseudo-wealth: replicas of the Parthenon and the Sphinx. Speaking to Washington Post, Rodney Jones, founder of Wigram Capital Advisors in Beijing shared concerns of a double whammy waiting to befall the government managed capitalist economy.
“You’ve had massive credit growth and investment in projects that don’t generate an economic return. Now you’re facing two shocks — you’ve got to stop credit growing and deal with the bad loans, and you’ve also got to see how the economy expands once this credit boom is over.” – Rodney Jones, founder of Wigram Capital Advisors in Beijing
The Foundation for Economic Education is more damning in its criticism of the China’s wealth and the projects like the Lanzhou New Area meant to serve as a new Silk Road free-trade zone and logistics hub with industrial parks dedicated to manufacturing and petrochemicals: Construction of these so-called ghost cities is likely financed by artificial credit expansion. In other words, people aren’t necessarily saving to buy a home in the future; the government is simply printing money. As a result, when the houses are finished, people haven’t saved enough to buy them all. This kind of construction doesn’t contribute to prosperity; it is the illusion of prosperity.
“China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.” – Sally Chen and Joong Shik Kang, International Monetary Fund
“If something can’t go on forever, it will stop,” common knowledge succinctly summed up by Herbert Stein, Chairman of the US council of economic advisers under Richard Nixon and Gerald Ford is damning commentary that an economy cannot be infinitely fueled by debt. Thus, the eventual implosion of the China’s enormous domestic debts will resonate not just in China but on the many economies whose trade depends on it. We don’t know how the debt surge will end but we do know that it began in the early 2000s when Chinese gross debt was at an average 170 to 180% of GDP, it was higher than most emerging economies but not that much higher. In 2008, the global financial crisis resulting from the meltdown of the Western financial system led to the Communist Party, propping up their economy (the source of their legitimacy and power) to a tune of 12.5% of GDP in an attempt to offset the fall in demand. As with all centralised economies, the Party determined that a permanent offset was required and they let loose – Share of gross investment in GDP rocked from a high 41% of GDP in 2008 to 48% in 2010. While the huge investment boom was a steroid injection which maintained growth at close to 10%, the damage was done – China was hooked on huge, potentially unsustainable debt. But in economics as in physics, what goes up, must come down and far from raising China’s underlying growth rate, a slowdown soon ensued. The Chinese government was facing a double whammy of more debt and slower growth. According to the Financial Times, China’s gross debt exploded from 171% in 2008 to 299% of GDP in the first quarter of 2018. Then again, the solution was painful and if it lost public confidence in the Chinese Communist Party (CCP), the outcome was inconceivable: Complacency, a lack of leadership and protectionism had distracted it from the necessary rebalancing of its economy. The recently published paper by IMF analysts Sally Chen and Joong Shik Kang opined, “China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.”
It is some comfort, however little, that the CCP is powerful and has an effectively controlled central bank and a tight leash on the banking system as well as ownership of vast domestic and foreign assets. If it was politically necessary to protect the financial system from collapse, it could. But if debt were to rise above 400% of GDP, all this might not be sufficient. Furthermore, no mortal entity is all-powerful, particularly when there are external actors to contend with.
Icing on the Cake: Trade Wars with Trump’s United States
Following US tariffs on washing machine and solar cell imports, China imposed preliminary antidumping tariffs in April, levying taxes of 178.6% on sorghum, a crop used to make alcohol and biofuels, while President Trump’ countered with tariffs on imported steel and aluminum from all nations, including China. Each move was countered by an ever-escalating series of mutually destructive trade wars until late April when China began offering concessions. As of August 2018, talks have failed and China announced a list of $60 billion worth of U.S. imports it planned to apply tariffs on should the Trump administration follow through with higher tariffs on $200 billion of Chinese goods, and as of 18th September 2018, these look like where we are headed. (via Bloomberg)
When it comes to Trade Wars, an exporting economy is largely and arguably in greater threat while domestic consumption can serve as a bulwark of sorts but even with increasing domestic consumption, its exports still outweigh local demand – in 2017, it sold $506 billion in exports to the United States while the United States sold just $130 billion to the Chinese. What can be argued is that in the United States, the market might not be happy to find their purchasing power reduced overnight when it comes to China made goods.
According to the IMF, China’s already slowing economy could drop by as much as 0.5% once the tariffs are enforced. It goes without saying that continued escalation of the trade war could truly retard China’s GDP growth. That said, a slower economy would be the least of China’s woes, with close to 400% debt-to-GDP, there’s a bubble waiting for the right catalyst to explode.
Chinese Luxury Goods Consumption
While a lot has been discussed about the Chinese grey market – that is to say parallel imports which impact chinese luxury goods consumption – this is largely a problem confined to the luxury brand’s domestic presence. Luxury goods taxes typically mean that the same Louis Vuitton or Prada tote would typically cost more in China than it would in France leading to the raise of daigou or 海外代购 overseas personal shoppers. Legally speaking, Chinese law levies duties on goods purchased abroad amounting to more than $700 but this is not strictly enforced, leading to the rise of daigou agents, even then, with increasing foreign travel, 32% of Chinese luxury goods consumption is actually done overseas. During October Golden Week, stricter inspections for luxury goods purchases saw overseas consumption plummet, leading shares in Hong Kong listed luxury goods companies fall anywhere from 10% to 25%. Recognising commercial concerns, the government has been reactive, easing import taxes on foreign luxury goods over the last 18 months, allowing brands to better align pricing in China with global recommended retail prices, nevertheless, there’s still a 10% premium which for the more price sensitive, is still a good amount to save, not to mention further discounts for 15% refundable service tax premium for tourists. In answer to the daigou problem and the potential trade war, President Xi Jinping has implemented plans to transition China’s economy away from manufacturing and exports while shoring up domestic consumption.
According to Boston Consulting Group, Chinese consumers accounted for 32% of global luxury spend, accounting for US$121 billion. If the luxury industry was to continue depending on Chinese consumers for growth, China’s debt problem is a cause for concern. While changes in consumption patterns may take months to reflect the changes, the impact on equity investors is already felt with luxury stocks down 11% by mid-October, destroying US$150 billion of luxury market value, worsened by the looming, all out trade war between two global giants. It needs to be said war between two titans means everyone else is affected. It used to be “when the US sneezes, the world catches a cold”, today, with Chinese influence in every major market thanks to the silk road initiative, when China sneezes, the world catches pneumonia.