Wine Country Conference April 5, 2013

James Chanos Kynikos Associates

China: The Edifice Complex

2

The China Way

• What we have learned

– Guanxi is a way of life

– Caveat emptor in acquisitions

– Beware reverse merger listings

– “Audited” numbers?

• What goes on in China Inc.

– Gaming receivables

– Questionable “Other Income”

– Property on the side

– Copper and steel financing

• Foreign technology partnerships

– “Absorb and digest”

– “Re-innovate”

– Undercut partners

Source: shutterstock

3

“The Number” Is Paramount

• GDP drives economic activity, not

vice versa

• Countervailing priorities

– Set centrally and locally

– Stability for Central Government

– Vehicle of ambition for local officials

• Regional-to-national GDP gap

continues to grow

– Gap of RMB 5.8T in 2012 vs.

RMB 2.6T in 2009

– “Size of Guangdong’s economy”1

• Capacity overinvestment (2008-2012

CAGR)

– Cement 12%

– Steel 10%

– Autos 18%

“GDP: Killing the Hen to Get the Egg”

Source: China Media Project Source: “GDP gap in China the size of Guangdong economy”, South

China Morning Post, February 5, 2013

4

The Law Of Diminishing Returns

• Unprecedented fixed asset

investment boom

• Gross fixed capital formation

as a percent of GDP in

China has increased from

previously high levels over

the past decade

• Law of diminishing returns

• Asset depreciation liabilities

Source: National Bureau of Statistics of China

Gross Fixed Capital Formation/China GDP

5

The ‘Shā Chén Bào’ Of Money is Wealth Destruction

• Large-scale capital projects grow

sillier by the day

– New South China Mall – world’s

largest and loneliest

– New Ordos – empty city in Inner

Mongolia

– Sky City One – world’s tallest building

to be built in only 90 days

• Massive infrastructure spending

continues

– 1,188 new shopping malls by 2015

– Airports: 14 opened in 2012 and 12

to be constructed in 2013

– Subways: 28 cities get approval to

build or expand subways

• Feasibility is secondary thought

– Overstate revenue and understate

maintenance costs

– Is economic depreciation being

factored in?

Source: Global Times

Hard To Keep Up

6

• Bank lending remains high – 2012 saw a YoY increase in new bank

lending by 10% to RMB 8.2T

– 2013 new lending forecasted to grow yet again

• Banks poorly capitalized for potential

losses

• Rapid growth in shadow banking

spurring total social financing

– Greater portion of social financing being

done outside banking system

– Increasing difficulty of controlling

liquidity within the system

• Chinese culture of credit

– The myth: China has no history of

credit-fueled booms and busts

– Reality: History proves otherwise

– Over 40% of banks loans went sour

post-1990s boom

Source: PBOC

Pervasive Growth Of Credit Driving Boom

7

Wealth Management Products are the Democratization of Credit

• The triumvirate of shadow banking

– Local Government Financing

Vehicles

– Trust Products

– Wealth Management Products

• Wealth Management Products

– 66% growth rate in 2012

– Substitute for deposits on or hiding

assets off balance sheet

– Dubious investments

– Investors expect both yield and

protection

• First cracks appearing

– Huaxia Bank

– CITIC Trust: Recent questions on

viability of three trusts

• Warning from bank regulators

Source: CBRC, BoA Merrill Lynch, Barclays, Kynikos Associates

estimates

8

Urbanization: Last Refuge of the Bulls

• Goal of 80-85% urbanization

rate – Bulls look to 600 million people

migrating

– Will be lower based on 250 million floating population and some farmers

– Cities change boundaries and definition

• Leads consumption economy – Urban dwellers consume more

– Increased demand for social services

• Is urbanization national? – New theory migration will be

towards the Eastern coast inside the high speed rail network

– Go West policy in doubt

Source: China Daily

9

Property is the Lynchpin

• China’s current urban real estate

boom

– 2012 Total Real Estate Under

Construction approximately

10.6B sqm vs. 5.7B sqm in 2009

– 2012 Total Real Estate per capita:

14.9 sqm

– 2012 Total Real Estate sqm per US$

1M GDP dollars : 1,283 sqm/US$1M

• Oversupply is an overlooked issue

• Property management fees are rarely paid

• Lack of affordability remains an issue

• No one can identify the buyers

• Commercial real estate is the future issue

Source: CRI English

10

Residential Real Estate Affordability?

• Major Chinese cities versus

NYC and London

• Generational investment:

Parental savings funding

purchase of real estate by next

generation

• Speculative fever provides

breeding ground for corruption

• Mass market buyers priced out

Residential Affordability Comparison

Source: Soufun (China), National Bureau of Statistics of China, US

Census Bureau, The City of New York, The Land Registry (UK),

Greater London Authority (UK). China real estate values as of

December 2012, NYC 07-11 Average, Greater London Nov 2012

Beijing28.1 yrs.

Shanghai20.9 yrs.

Chongqing14.5 yrs. Wuhan

12.9 yrs.London10.8 yrs.

NYC10.0 yrs.

0

5

10

15

20

25

30

Years to pay off Apartment (Apartment price / Household Income)

11

Rising Wages: No Longer the Workshop of the World

• Chinese wages are up

– Private sector manufacturing

pay up 20% in 2011 and 16% in

2010

– Minimum wages continue to rise

13% through 2015

• Margins are thin, profits down

– SOE profits down 11.4% first

nine months 2012

– SOEs under local governments

profit decline 20.4%

• Regular protests for back wages

• Chinese unit costs to the US not

as cheap as they were

• Factories offshoring from China

Source: The Epoch Times

“Evil Factory! Return My Annual Bonus”

Source: “Chinese SOE Profits down 11.4% in the first nine months”,

Gov.cn

12

Wealth Gap: Straining the Harmonious Society

• Popular resentment growing

• Gini coefficient is “out of the lamp”

– Not released for ten years

– January 2013 official release:

0.474 in 2012 with peak 0.491 in

2008

– Academic study estimates 0.61 for

20101

• The New Government plan

– Raise low incomes and “adjust

over high incomes”2

– Details vague with watered down

proposals and loopholes

• Corruption crackdown?

– New regime vows to crack down

on corruption

– Recent restriction to property

ownership information

Source: China Daily Sources: 1) “More Findings from the China Household Finance Survey”,

Li Gan, Texas A&M University, January 2013

2) “China approves income distribution strategy”, Reuters, February 5,

2013

13

Property Graft Is An Issue

• Dirty money hides in property

– Exposed officials have multiple

properties

– Not concerned with liquidity or

mobility

• “Home Purchase Restrictions are

only for the ones not smart”

• Fake Hukous can be bought for

RMB 30,000 to RMB 50,000

• Foreign passports advantageous

• High profile catches

– Newspapers carry rogues galleries

of corrupt officials

– “Grandpa of Property” -

Guangdong Policeman with 192

properties

– “House Sister”- 41 properties

Source: China Daily Source: “Hukou forgery scandals highlight police corruption”, Xinhua,

January 24, 2013

Official sacked over property scandal

14

Faith in Government: Are People More Satisfied Today?

• Leadership change was not

seamless

• Frustration with self interest – New anti-corruption policy

– Netizens are the Fourth Estate

• Quality of life – Pollution blots out the sun

– Food and baby milk scandals

– Cancer villages

• Demonstrations are a way of life – 2010: mass incidents estimated

between 180,000 to 230,0001

– Environmental protests

– Selected local strikes

• More spent on internal security

than the military2

• Will there be real reform?

Source: China Media Project

"This is us [China] today!”

Sources: 1) “Social Unrest in China”, Europe China Research and Advice

Network, 2012

2) “China's defense budget outweighed by internal security”, Want China

Times, March 11, 2013

15

Shifting the Focus from the Real Problems

• Cold war tactics in Senkaku/Diaoyu dispute

• Staged demonstrations

• Pressuring neighbors

– New Chinese official map includes disputed islands

– Hainan Province announces policy to board and search vessels

• Reaction to foreign press

– Newspaper hacking

– Reporting equipment stolen from

hotels

– Visas revoked

• Attempts at intimidation

Source: Global Times

16

Chinese Proverb: “When the Tree Falls, the Monkeys Scatter”

• Unprecedented fortunes

amassed by leaders’ families

• Buying foreign property and

citizenship

• Getting the money out

– $2.7T cumulative outflows

from 2001 through 2010

– 2010 estimate of $420B

almost 3x 2001 estimate

• “Playing” in Macau

– VIP Baccarat is the channel

– Estimated in 2012 at $18B

Source: China Media Project Source: Global Financial Integrity “Illicit Financial Flows from Developing

Countries: 2001 – 2010”

Tunneling Out of China

Don’t Take our Word for it

• “GDP figures are ‘man-made’ and therefore unreliable, Li said.”

• “To some extent, this is fundamentally a Ponzi scheme.”

• “The bubble must be controlled, or both the real estate market and domestic economy will be jeopardized”

• "The government has already been considered untrustworthy, let alone businesses…"

Xiao Gang, Chairman Bank of China “Regulating shadow banking”

China Daily, October 10, 2012

17

Li Keqiang, 1st Vice Premier China US Embassy Cable March 15, 2007

Wikileaks – December 4, 2010

Wang Shi, Chairman China Vanke “Vanke boss sees bubble in spike”

Standard , January 29, 2013

Chinese Netizen “Chinese companies trusted in China, says US

report; Nope,Say netizens”

Want China Times, February 6, 2013

18

Thank You to

the Wine Country Conference and

the Les Turner ALS Foundation

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