Find The Hat: Looking for the Truth Behind China's Financial Reports

There is a wondrous, apocryphal tale of a young staffer's cleverness and prevailing justice against an unfeeling bureaucracy called "Find the Hat." It is familiar to generations of new financial service hires in New York and London.

In their February investment letter, Absolute Return Partners shares that story and uses it to introduce a detailed and perceptive glimpse behind the curtain of Chinese government financial reporting. Their cogent analysis puts numbers behind the all-too-often inchoate fear expressed by financial observers that all is not right in the Middle Kingdom:

The article excerpt begins here:

Many moons ago, long before I joined Goldman Sachs, a London based employee of the firm went to Chicago to attend a seminar on options and futures. This goes back to the 1970s when proper men still wore hats, and our friend was indeed proper, so he showed up in Chicago in full British-style attire, including his beloved woollen hat. Lo and behold, Chicago can be a very windy place and, shortly after arriving in the Windy City, his hat blew off and was completely flattened by a passing car.
Our friend thought it reasonable that Goldman reimbursed him for his loss so, after having acquired a new hat, the cost found its way to the expense report, which he submitted on his return to London. In those days Goldman was quite a small firm, and expenses were controlled with an iron fist by one very senior person in New York, who shall remain unnamed. When he saw the expense report, he went ballistic and immediately demanded for our friend to re-submit his expenses, this time without the hat.
Now, our friend was not giving in that easily. He was truly upset about the loss and only found it fair that Goldman compensated him, so he re-arranged his expenses, with the total adding up to the exact same amount, but the hat had mysteriously disappeared. Then he wrote in big fat letters across the expense report: “Find the Hat!”
For reference only Fast forward to China anno 2011. I suspect there is not one but many hats hidden in the national accounts of China and, thanks to Wikileaks, we now have a very public figure admitting as much. In a leaked 2007 cable Li Keqiang, who is the favourite to become the next premier, confided that official Chinese GDP figures are “man made” and “for reference only” (surprise, surprise), and that one should rather look at alternative measures such as electricity consumption, rail freight volumes and bank lending, if one wants a true picture of economic growth in China1
So let’s do precisely that. In chart 1 below I have plotted Chinese GDP growth against the electricity output over the past 15 years, and an interesting pattern emerges. During periods of low economic growth (the Asian crisis in the late 1990s, the US recession in 2001 and the global credit crisis in 2008-09), GDP grows much faster than the electricity output. Conversely, during periods of strong economic growth (2002-07 and 2010), GDP growth is lower than the power output. Clearly the GDP numbers are massaged.
Digging one level deeper reveals something rather more serious. Assuming the electricity stats tell the true story, and that the GDP numbers are ‘for reference only’ (remember, not my words!), China’s economy experienced a dramatic slowdown as 2010 progressed (see table 1). Total power consumption (year on year) grew by a whopping 22.7% in Q1 last year but only by 5.5% in Q4. The slowdown in Q4 was in fact so dramatic that the power output dropped 6.3% quarter on quarter! There were some restrictions in place on the use of electricity in Q3 and Q4 which did have some impact, but those restrictions were dropped in November, so it cannot be the only explanation. This story is largely ignored by the sell-side banks, most of whom have no interest in offending their new pay masters.
Turning to inflation, a similar picture emerges. According to the official stats, Chinese consumer price inflation moderated to 4.6% in December, down from 5.1% in November. However, anecdotal evidence suggests a much more serious problem, in particular in the largest cities, where actual inflation is running close to 20% according to my sources.
As I prepared for this letter I received an email from China specialist Simon Hunt, who notified me of the fact that the National Bureau of Statistics of China has just announced that the weight of food in the consumer price index has been reduced as of 1st January. In an emerging economy such as China, where 35-40% of disposable income is spent on food items, sharply rising food prices are actually likely to lead to food accounting for a higher percentage of overall disposable income, so the Chinese reaction defies all logic. There can only be one motive: to cook the books.
China can no longer rely on abundant supplies of cheap commodities and labour. This marks a fundamental change, which is likely to reduce the structural growth rate by several percentage points in the years ahead. As Andy points out, the structural change was lost on many as the financial crisis of 2008-09 took its toll. Consequently, monetary policy became extremely accommodating at a time where underlying inflation pressures were already at dangerous levels.
It goes without saying that when you create too much capacity, the return on invested capital will ultimately prove disappointing. But China is not a capitalist economy where one needs to worry about petty things like that (or so they seem to think). It is driven as much by its desire to dominate on a global scale, as it is by basic economic considerations.
One such example is the dry bulk shipping industry. Dry bulk freight rates tumbled over 40% last year despite a rapidly improving global economy. The collapse in freight rates was the result of global overcapacity caused by China’s expansion programme in this market. And it is not the only example. Signs of overcapacity are popping up everywhere. I hear that there are 3.3 billion (!) square metres of floor space available throughout the country, yet more is built every year.
However, China’s one-sided approach with a focus on investments to facilitate export growth at the expense of domestic consumption is a very risky strategy. Over the past decade, China’s foreign exchange reserves have grown from about $200 billion to a whopping $2.7 trillion (see chart 5), accounting for over 5% of global
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GDP. In the last century, only two other countries have pursued such a strategy to the effect where their reserves reached 5-6% of global GDP – the United States in the 1920s and Japan in the 1980s. Both ended in tears. Lots of tears!
If the Chinese overextend themselves, and the banking industry ultimately goes bust, one needs to bear in mind that it is always the consumer who ends up bailing out the banking industry in a banking crisis, either directly (through banks defaulting on their liabilities) or indirectly (through increased taxes). In China, however, with the consumer accounting for such a low percentage of GDP (36% today vs. 45% ten years ago), a banking collapse could create a very deep recession, as the consumer is not well positioned to cushion a sinking banking sector.
“China’s increase in manufacturing capacity is such that the country needs the rest of the world more than the rest of the world needs China.”
This fact has been lost on many. Instead it has become a rather childish discussion along the lines of: “do this or we will sell your government bonds”. The reality is that they have no interest whatsoever in destroying value, so this risk appears grossly exaggerated.
Now, let’s shift gear. As always, there are two sides to the story. And despite my concerns that the current investment boom will end in tears, China presents a hugely attractive long-term investment opportunity, as it grinds its way to becoming the largest economy in the world. China is a growth story unlike anything we have ever seen and anything we are likely to ever seen again. In short, it is the fastest industrial revolution ever experienced. In the 30 years since the economic reforms began, GDP has grown by a factor 10, and GDP per capita is now almost 20% that of the United States whereas, 30 years ago, it was only about 4% the US level6
Put slightly differently, China today is where Japan was in 1950. Would you bet against China continuing on a path similar to that of Japan? I have found an interesting chart in a presentation made by Kingdon Capital Management (see chart 8), which puts the opportunity into perspective. Despite the enormously aggressive investment programme conducted by the Chinese in recent years, and despite all the near term risks that follow, the magnitude of the opportunity going forward, which crystallises when one looks at the chart, is just awe-inspiring.