China's Debt Crisis

China may be forced to continue to increase its debt position. Their cash flow future looks grim.

China’s debt is largely held by corporations. The problem is a fair number of their small and large companies are poorly managed. Their inefficient equipment and systems results in high-cost, money-losing operating companies. This results in deficit cash flows which severely limits the capital available for the repayment of debt.

China is reportedly attempting to have lenders restructure weak loans into equity. The majority of the lenders are banks. Banks will be converting their loans into equity in a number of financially distressed companies which may negatively affect a bank’s financial condition.

Will the current tariff challenge affect corporate revenue and further increase operating losses?

As a consequence China may need to increase its debt to support companies incapable of repayment or restructuring.

Debt Articles:

Forbes

South China Morning Post

China Power

Bloomberg

Tariff Articles:

Bloomberg

Politico

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Is China’s decline permanent?

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News reports are replete with China’s struggles and decline. China’s past success is frequently labeled a “Bubble” with the question – Is it bursting?

Yes, China is in decline. But not just due to negative Global economic struggles. China has entrenched problems that are contributing to its decline. Are these problems intractable?

Following are significant but an incomplete list of its problems:

● Manufacturing processes and systems are at the same capability level as were in-place in the USA in the 1970s. Relatively inefficient production operations coupled with the sizable increase in hourly factory labor wages are reducing profit margins and free cash flow. A large percentage of Chinese company owners and managers do not have knowledge of the more productive methods of operating.

● The absence of trucking and freight forwarding capabilities to support expansion into lower labor cost Western China. In addition, it is difficult and costly to get quality managers to move to these remote areas.

● China needs to maintain its historic growth rates to ensure that capital is available to clean up its environmental problems. In addition, high employment levels must be available to mitigate the current increases in social protests and riots.

There are several other negatives for China. Click on these links to see further details:

Where is China Heading?

China’s Achilles’ heel– Obstacles to Low Cost

Will China duplicate Japan’s decline from its 1980s success level?

Not exactly the same as Japan since China’s leaders have a history of responding and changing its formulas. But some of its entrenched problems will not be easily solved and China’s pendulum will swing to the negative side of the ledger.

UPDATES: 

August 23rd New York Times article, Manufacturing in China Slows, reporting on a worsening economy.

Business Week’s November 15 article, “Xi takesChina's helm with many tough challenges”, further documents the serious problems facing China’s new leader. 

Criticism of GE’s CEO, Jeffrey Immelt

A March Money Watch article on Jeffrey Immelt, titled 'GE Has Been An Investor Disaster Under Jeff Immelt', is strongly critical of his relatively high level of compensation as it relates to GE’s depressed stock price. Mr. Immelt is General Electric Company’s Chief Executive Officer.

An example of the criticism:

"By any measure of shareholder value, GE has been a disaster under Jeffrey Immelt. Investors haven't made a nickel since he took the helm as chairman nine years ago. In fact, they've lost tens of billions of dollars."

There is certainly room to criticize Mr. Immelt’s salary, bonus, common stock grants and retirement plan while GE’s stock price and profit performance are in the doldrums. However the article does not analyze the condition of GE’s operating businesses. Have its divisions deteriorated? Are there market share losses? Are its operating units registering Operating Losses? Or is its poor profit performance related solely to the 2007-2010 financial and economic crisis?

During this crisis most blue-chip, well-run companies have experienced sales and operating profit declines of 20% - 30% with large declines in the price of their common stock. Although slightly improved recently, many prices are still sluggish and down.

This even includes my Alma Mater, Emerson Electric Co., one of the best managed companies in this country. Emerson has registered sales and operating profit declines of 20%-30%. But their operating divisions have continued to perform well.

Chief Executive Officers are responsible for the operating performance of the businesses they manage – this is their primary role. Granted their tenure is also dependent on the stock price. If the performance of GE’s operating businesses has deteriorated, then Mr. Immelt should be criticized and replaced as CEO.

CHINA - Its Past, Present, Future

The following is an op-ed article written by Tony Gleason of Neuberger Berman. In this interesting work, Mr. Gleason studies essential history, reviews present issues, and predicts future trends, regarding business within China. It is very helpful for those of us, who have operational dealings and investments in China. Extremely worthwhile reading:

China Wakes, the World Shakes
by Neuberger Berman’s Tony Gleason - November 17, 2009

As we have all witnessed, the economic system that drove much of world trade buckled in the financial crisis of 2008. It appears that the U.S. will no longer be the insatiable source of demand for the world’s manufacturing countries. Our credit has unfortunately hit its limit with our creditors, namely China and Japan. From an investment point of view, understanding the new financial, economic and political system that is evolving from the 2008 crisis will be a key to making and preserving capital in the decades ahead. China, as I will explain, is re-emerging on the world stage and will likely play the leading role in this evolution. Within this piece I offer my perspective on China today and how I believe it will influence the investment landscape.

I’ve had the extraordinary good fortune of traveling frequently to China. Each time, I’m startled by the progress the country has made since my previous visit. The most recent trips are no exception.

Cities visited in the past few months include:

• Tier one cities: Beijing, Shanghai, Guangzhou, Hong Kong
• Second tier cities: Nanjing, Hangzhou and Chongqing
• Small, but important cities: Li Jiang and Macau
  

Along the way I met with over 60 companies, various government officials and many interesting people. Since the crisis began almost a year ago it’s become abundantly clear that the Chinese government recognizes they can no longer grow the country’s economy based on exports to the United States and Europe. Recognizing that economic growth is necessary for harmony and its own ability to stay in power, Beijing has shifted gears quite dramatically and so far has managed its way through one of the most significant financial crises in a century. Many will argue with how it got there, but China is on track to leave 2009 growing at a better-than-8% rate. While China has many goals, in our view, the three with the greatest implications for the investment business are to:

1. Increase domestic consumption;
2. Accelerate infrastructure; and
3. Diversify away from the U.S. dollar.
   

In the investment business, getting the big picture right is key; we believe the ability to appreciate what is going on in China—and act on it— will have a significant impact on investment results. For some perspective on where China is headed, it pays to look back a few years. Therefore I’d like to provide you with some history intertwined with my observations on this most fascinating country...

2nd Follow-up to the Analysis of the Financial Crisis

Mr. Komal Sri-Kumar analyzed the Financial Crisis on October 31. It is his fourth webcast since October 3. Mr. Sri-Kumar is TCW Group’s Chief Global Strategist.

It is a meaningful, worthwhile analysis.

A summary of Mr. Sri-Kumar's views and forecasts:

1. The 4th quarter of 2008 will be the worst quarter with a 4% drop in GDP.

2. Is relatively optimistic in expecting the USA recession to end in the middle of 2009 because: “…the economy and stock market went down very fast…for the same reason the upturn will be equally rapid”.

The significant decline in consumer sentiment suggests a deep consumer recession. Does not see a depression risk. Expects unemployment to hit 8% or higher.

3. Federal Reserve should not have cut the interest rate by 50 basis points. It gave little stimulus to the economy. It was not the reason for the stock market increase. The stock market surged because the TED risk spreads have come down. The principal negative issue is the “liquidity trap” in that lenders are not willing to lend.

He suggests that direct to consumer stimulus is more important than interest rate reductions.

Does not see an inflation risk – including copper and oil. But he advises that the Federal Reserve will need to increase the interest rate in six months to avoid inflation.

Federal Reserve has ignored older people who largely rely on interest income for living expenses. An important factor to the economy.

4. As this webcast was prior to the Presidential election, he commented on both candidates and said the new President will not have much flexibility. Senator McCain cannot reduce taxes because of the sizeable budget deficit. President-elect Obama will not be able to increase taxes – particularly dividend and capital gains tax rates – because of the negative impact on economic growth.

5. Forecasts a $1 trillion budget deficit in 2009 which at 7% of GDP he views as manageable.

6. Continues to be bullish on equities. Is negative on Europe’s prospects. Expects equities to yield 9%-10% over the next 3 to 5 years. Forecasted 3% GDP growth and 2% inflation. Considers leverage dead.

7. Surge in the dollar has ended.

8. “What worries him most?” Policy maker errors. Not the economy. Not consumers. In September 2007 he predicted a recession. Federal Reserve and Treasury policy makers ignored the signs. “…will need to depend too much on policy makers”.

Click on this link for access Mr. Sri-Kumar’s October 31, 2008 webcast, approximate duration 60 minutes, expires January 31, 2009:

On October 15, 2008 a panel of economists at New York University gave a decidedly bleaker analysis of the financial crisis compared to the analyses Mr. Sri-Kumar has given.

Click on this link for a summary and access to NYU’s October 15 webcast:

Follow-up to Analysis of the Financial Crisis

Two weeks ago, I posted about Mr. Komal Sri-Kumar’s near calming treatise of the financial crisis provided on October 3rd. He is TCW Group’s Chief Global Strategist.

Mr. Sri-Kumar expects a 6 to 9 month Recession, with the stock market starting it's recovery in April 2009. He is rather bullish on equities, and does not believe we are heading into a Depression. Bearish on oil and bullish on the dollar: Oil $75, Euro $1.25, Gold $700.

However, last week I attended New York University’s financial crisis seminar. This Panel’s views and forecasts were decidedly bleaker than Mr. Sri-Kumar’s.

NYU Panelists:

• Dennis Berman, Deputy Bureau Chief, Wall Street Journal’s Money & Investing
• Mark Patterson, Chairman, MatlinPatterson Global Advisors LLC
• Nouriel Roubini, Professor of Economics, NYU Stern School of Business
• Lawrence White, Deputy Chairman & Professor of Economics, NYU Stern School of Business
• Moderator: Thomas Cooley, Dean, NYU Stern School of Business

The NYU Panel’s views:

1. Predicted that the worse is yet ahead.

2. The recession would last 18 to 24 months. The question is whether the recession will be V, U or L shaped. While the word “depression” was not used, the Panel described the economic recession as one of the worst since the Great Depression years.

3. Equities will decline further from current levels and will not have a meaningful recovery for perhaps two years.

4. Housing prices expected to decline further. Housing prices will not recover quickly and will reduce the net worth of consumers to such an extent that it will affect spending.

5. Expect consumer loan defaults and hedge fund failures to add to the financial crisis.

6. The bond default rate is currently at 3%. Its historical average is 4%. The Panel expects it to rise to 10% or higher with the possibility it could reach 25%. The covenant light and toggle loans will delay defaults and bankruptcies.

7. China’s funding the USA trade deficit will become problematic and may require higher interest rates and perhaps a political “quid pro quo” such as Taiwan.

Mr. Sri-Kumar and the NYU Panel are in agreement that:

1.The Financial Rescue Plan was not developed and implemented effectively. The solutions have come late to a problem that was obvious in 2007. The handling of the Crisis by officials world-wide undermined their credibility and the predictability of the Crisis which has exasperated it.

2. “Inter-bank lending” is a key variable.

Click here to access the NYU Panel’s webcast link. Seminar held October 15, 2008. Duration: 97 minutes.

Click on this link for a summary and to access Mr. Sri-Kumar’ October 3, 2008 teleconference call.

Analysis of the Financial Crisis

Mr. Komal Sri-Kumar, TCW Group’s Chief Global Strategist, gives a thorough, almost calming, treatise of the financial crisis in his October 3rd teleconference call.

It is worthy of review.

A summary of Mr. Sri-Kumar's content and conclusions:

Believes the two major reasons crisis came about:
1. Low interest rates in force for a longer time than necessary which encouraged borrowing regardless of qualifications or the ability to repay the loan.
2. Ineffective regulation.

Not heading into a depression. Disinflation is major threat, not inflation.

His expectations include being bearish on oil and bullish on the dollar: oil $75, Euro $1.25, Gold $700. USA recession starts 4th quarter 2008, 1st quarter 2009 and ends March April 2009 with the stock market starting its recovery. Recession will be worldwide. Bullish on USA equities. The $700 billion rescue plan may result in a profit for the Federal government.

Europe will continue to decline and will decline much steeper than other areas. Particularly affected will be the United Kingdom since 20% of its economy relies on the financial sector versus the USA’s 5%.

China’s GDP growth will be reduced perhaps to 7%-8% in 2009 compared to 2008's expected 11% with the complication that China has stopped trying to curb inflation and is striving for growth.

His presentation explores: When will this crisis end? Are foreign investments safer than investing in the United States? What areas of the world offer attractive investment opportunities now? The origins of the ongoing financial crisis. An explanation of what the rescue plan is intended to achieve.

The recording of Mr. Sri- Kumar's Conference Call is available for free to the public domain.

For the Digital Playback call:
Primary Playback Number: (888) 843-8996
International Playback Number: (630) 652-3044
Passcode: 22866500
Call available: October 3, 2008 - November 3, 2008
Broadcast on October 3, 2008 – duration 45 minutes.

Click here to get a copy of the PDF of his presentation.
(* It is not necessary to register on the web site to listen to the conference call, just call the 888#).