China's Media Mirage

Implications: Recent discoveries regarding Chinese distribution of poisonous toothpaste, dog food and candy should cause us to reassess China's position as an Economic powerhouse. Sure, the Japanese and Koreans once made dodgy products, but their mistakes were due to their learning curve, as opposed to a deliberate deception in order to save money by swapping poisonous materials for more expensive ones. In this article, Nicholas Vardy cogently compares the mirage of China created by the media with the cold reality of its shaky economic state.

Analysis:  

The discovery of China’s recent attempt to lower manufacturing costs by substituting dodgy and in some cases, poisonous, ingredients, in order to save money, will no doubt impact any company thinking of outsourcing work to China –but how long will investors remember this?

Clearly, China is the go-to place for growth. Sustaining impressive GDP growth rates year after year means they must be doing something right. China is well on its way to surpassing Germany as the world’s third largest economy by the end of this year. China’s 1.2 trillion in foreign currency reserves gives them a weighty position in the global debt and equity markets. China Development Bank’s recent commitment to purchase Blackstone stock before its IPO no doubt sparked the interest of other investors and contributed to the success of the IPO. Goldman Sachs, HSBC, Morgan Stanley and a seemingly infinite list of the largest and most profitable institutions have all, or are in the process of, purchasing equity in a Chinese partner, usually a formerly government owned bank. Who wouldn’t want to rush-in?

Not me, at least not yet. As Mr. Vardy’s article points out, for several reasons, including the dodgy toothpaste, that China’s current management of its economy cannot be sustained.

This should be of no surprise, as Mr. Vardy states in the article “Communist political systems and economies tend to consistently overestimate their economic achievements and underestimate the costs that the culture of corruption has on future development." Russia, which defaulted on its government bonds, shocking investors worldwide, is the most recent large-scale example of how one can get burned by cooking the books.

Take China’s enviable 1.2 trillion dollars in foreign currency reserves –it is equal to the amount of bad debts on its banks’ balance sheets, which is equal to 50% of China’s GDP. These banks with bulging non-performing loan portfolios are the same financial institutions that completed successful overseas IPOs over the past three years. As BusinessWeek pointed out a few weeks ago, while it may seem that maintaining such large reserves and rising export surpluses are a sign of economic strength. in a real economy, they are signs of an over-reliance on exports, weak domestic consumption and a primitive financial system.

I’m not sure if I believe, as some do, that China can only achieve a sustainable economy by changing its politics.. I believe that China’s slipshod management of its economy can actually create opportunities . The recent bad press may make it more difficult for China Focused Hedge Funds to attract more investors, if they even need to. The insolvency of Chinese Banks may make it difficult to mark-to market fund investments –if you think Bear Stearns had a hard time ….