Forget Greece and Italy

Greece and Italy have been stealing economic headlines these days.

The media has been so focused on Greece and its pint-sized economy, that they have completely missed what should really be headlining world economic news…the slowdown of the world’s second-largest economy.

China’s government-induced GDP growth and red-hot housing market have both stalled.  Ironically, the government itself caused the slowdown, as it introduced prudent anti-bubble measures throughout the year.  Such measures were an unfortunate necessity: without them, inflation was turning rampant.  But now the slowdown may turn out to be just as devastating.  And, it seems that the largest companies in the world are well aware of what is coming.

Last week, Goldman Sachs sold $1.1 billion worth of its shares in Industrial and Commercial Bank of China (1398.HK).  This week, Bank of America announced it was selling the remainder of its shares in China Construction Bank (0939.HK) – $6.6 billion worth.

Today, the International Monetary Fund announced that Chinese banks could suffer “huge losses” on the very extreme case that credit shock, currency shock, and yield curve shocks were to occur together.  Interestingly, this “slim and rare occurrence” appears to already be starting.

The IMF's Jonathan Fiechter stated rather bluntly stated (as far as economist-speak goes) that "while the existing structure fosters high savings and high levels of liquidity, it also creates the risk of capital misallocation and formation of bubbles, especially in real estate." In other words, the current government’s financial policies force people to invest in real estate (since buying other asset classes in China is considered too risky), and, banks are lending too much to capital projects with no economic future (again based on government direction).

One could say that the Chinese economy is a centrally-controlled “our government knows better” economic marvel mess.

It is my advice - stated on several occasions previously - that you follow the lead of Morgan Stanley, Goldman Sachs, and Bank of America; that is, sell all but your very best Chinese holdings.

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See also:

China faces grim foreign trade outlook

China's property cost curbs to remain despite home price drop

China’s CCB Plays Down BofA Share Sale Impact

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Chinese Con Companies – A Warning

REVERSE MERGER RULES TO TIGHTEN

Back in June, The Frost Report wrote about the sorry state of Chinese companies listed on North American exchanges.  Namely, that many such companies are rife with fraud (The Sick Man of Asia).  This week, both Canadian and American securities regulators began exacting their revenge.

The best way to understand this story is from the perspective of a Chinese con-artist/short-term entrepreneur, whom the new rules are designed to thwart.  And so, both the initial problem and the solutions are presented here in letter form:

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Dear North American Securities Regulators,

A few years ago, I had it made.  Through reverse mergers (buying out American companies listed on stock exchanges), I had a quick and easy way to become rich - fast!

Merely by listing on a North American exchange, putting together an impressive website, and manufacturing some nice accounting numbers, it was easy to get investors excited.  Most of them thought that because my company was listed on a North American exchange, it must be legitimate - the idiots!  Ha ha.  It was easy money.

Then the problems started. 

Savvy North American investors started questioning things - like my receipts and accounts that don't match, the ridiculously spectacular sales numbers, and the head office that doesn't exist (I didn't think anyone would go to Central China to check)!  And, I certainly didn't think anyone would check my resume to see that I actually did graduate from business school.  In China, buying a degree is no big deal: everyone does it - it only costs a few bucks for a degree from Harvard.

So now, it's all going to hell.

This week in the US, the Securities and Exchange Commission (SEC) announced stricter requirements for foreign companies that become listed on American stock exchanges through reverse mergers (buying out listed American companies).  Under the new rules, foreign companies like mine will be traded on the “over-the-counter” (highly risky, restricted) market for a full year before being allowed to trade on a larger exchange.  How am I supposed to make my fortune?  I need to have investors trust me immediately.  I need to take my cash and buy an overpriced house in Vancouver or Sydney right away, before I get arrested.  One year is too long.

Then I heard that in Canada, the Ontario Securities Commission (OSC) accused Zungui Haixi Corp and two of its executives of failing to cooperate with their special investigation.  The company’s auditor, Ernst & Young LLP, suspended audit of the company’s financial statements just because of a few “inconsistencies” in bank documents, assets and invoices.  How dare they!

Now, the OSC is saying it will be unveiling “a number of cases” in the coming months.  My friends are all worried that this is the end of the easy life.

So, I am asking you - the employees of the securities exchanges - to please back off.  If you do, there is a nice fat red envelope full of cash waiting for you in locker number 6 at the local train station.

Sincerely,
"Entrepreneur"

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Certainly, the vast majority of Chinese companies are legitimate business enterprises.

However, small-cap Chinese companies must be investigated fiercely before being bought as investments - fantastic sales numbers and low debt levels don’t mean much if the numbers are simply fabricated.  For the majority of investors, your best bet is to simply stay away.

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Time Machine - 1111 and the US National Debt

INVESTOR PSYCHOLOGY

Recency Bias is the tendency for people to remember recent events more than past events, and to believe that the most recent situation has always been so.  Put another way, people tend to frame their memories based on recent events, and to remember what they want - and likewise, to forget what they want.

I mention all this because it seems like lifetimes ago that the US national debt was not only in control, but people were actually talking about paying it off.  That moment was 11 years, 1 month, and 1 day ago today.

Bill Clinton had just finished his term in the White House, stained by political scandal (ie. the Monika Lewinsky affair).  Many viewed Clinton as a very unpresidential, even embarassing president.  Yet, no one could deny the positive economics of his term.  At the end of the Clinton presidency, the National Debt stood at 5.73 trillion dollars - a relatively small sum for the massive US economy.  After three straight years of budget surpluses, economists were estimating how long it would take to pay off the National Debt completely.

Presidential hopeful Al Gore, for example, outlined an economic plan that would eliminate the National Debt by the year 2012.  When candidate George W. Bush was asked if he had a similar plan, he said that although he agreed with paying off the debt in principal, he would not commit to a specific date.

Soon thereafter, Bush was elected as President.  He immediately began a series of tax cuts for high-income families, which he (and his economic advisors) believed would stimulate the economy so much that the end result would be an overall increase in tax revenues (known as "trickle-down economics."); unfortunately, it didn't work .  Tax revenues declined drastically with each cut.

Bush ran a budget deficit (increasing the national debt) in 7 of his 8 years in office.  In 2003,  he set a record for the largest annual debt increase in US history.  Due to a combination of tax cuts and expensive foreign interventions, by the end of the Bush term the US National Debt had nearly doubled - from $5.73 to $10.69 trillion.

People now talk about the National Debt as if it was meant to be, always was, and always will be.  Many cannot remember the time - not so long ago - when there was talk of the United States of America having no debt at all.

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"I've abandoned free market principles to save the free market system."

George W. Bush, 2008

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