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The Forgotten Communists
July 2007
This article is published exclusively for clients of Brait Specialised Funds, and is not to bedistributed or circulated without prior permission.
1
This piece was inspired by a recent visit to China. I have tried to restrict opinion as much aspossible, and referenced the facts we were given to the sources we heard present andinteracted with (which were highly reputable). Our own observations, from a few days in whatmust be one of the world’s most complex and multi-faceted nations, while personally enjoyable,provided inspiration rather than information and are not heavily relied upon.
The economic failure of central planning – and its subsequent political demise – was the stand out feature of the late 20
th
century. One can argue the motives ofthose directing the command economies as anywhere between altruistic andcorrupt, but either way the communist regimes could not survive the persistentmisallocation of resources and subsequent economic hardship of the majority oftheir citizens. That communist economies fail is no longer a contentious issue,especially amongst the world’s financial market participants, the “epicentre” ofcapitalism as it were. Yet today many of the world’s markets stand dependent onthe continued success of a centrally-planned juggling act. China is now amassive proportion of global demand for basic materials. China is also one ofthe largest buyers (and owners) of US treasuries. So despite reviling theideology and belittling its potential for success everywhere else on the planet,investors hang their hat, or rather their client’s money, on China being different.
The Two Chinas
“Everything that has been done in China over the last 30 years has been doneby 300 million people. The 750 million people in the countryside, whose lives areunchanged, live on less than $500 each pa.”
Jack Perkowski, CEO Asimco Technologies (“Mr. China”)
 
I had an idea that China’s fantastic growth over the past decade or so hadresulted in widespread development, with China leapfrogging much of the thirdworld as it became a more affluent country. In fact, China’s GDP per capita ismore than 40% lower than that in South Africa (SA $12,796, China $7,598
on aPPP basis, International Monetary Fund World Economic Outlook Database April 2007
). As well as beingpoorer than SA, the income skew is as pronounced. The gap between urbanand rural households is enormous and growing. Within 2 years there areanticipated to be more urban households than rural, driven by the 15 – 39 agegroup being over represented in urban areas (the source of new households)and the migration of the brightest children away from rural communities. Inaddition, urban incomes have grown more than 3 times faster than rural.
The Urban Rural Split
Urban RuralTotal Households 46% 54%Total Household Income (2005) 73% 27%Income growth (2000 – 2005) 10% pa 3% paPercentage of Households earning > RMB 40,000 31% 1%
(Reference 4)
 
The Forgotten Communists
July 2007
This article is published exclusively for clients of Brait Specialised Funds, and is not to bedistributed or circulated without prior permission.
2The so called middle class, households earning >RMB 40,000 pa are almostentirely urban. Note the RMB is about equal to the ZAR so we are not talking ahouse in the suburbs and a SUV here! There is a further divide within urbanareas, as the urban wealth in turn has not spread. Just 9% of urban areascontain 50% of the middle class households and 63% of the “consumptionhouseholds”, those earning >RMB 60,000 pa who in theory could afford avehicle.
(Ref.4)
. Other estimates of the middle class, using those earning >USD5,000 pa, are that these number between 150m and 300m people (out of apopulation of between 1.3 – 1.5 billion), and are very concentrated within threeregions
(Ref.1).
 
No Safety Nets
In China there is little effective Social Security. Because of this, retrenchmentsare not considered an acceptable solution when attempting to restructure ailingcompanies
(Ref.3)
. Medical care must be paid for, and while facilities are excellentin the cities, they are rudimentary at best in the hinterland. Complex medicalprocedures are not affordable to all bar a very small minority who have boughthealth insurance. People “would rather go home and die than bankrupt theirfamily and clan”
(Ref.1)
.Schooling is supposed to be free, but away from the major centres local officialslevy a myriad of fees that exclude the most needy. Overall, the level ofeducation is sound, with some 10% of people more than 15 years old havingreceived no schooling at all, compared to a shocking 43% in India
(“The Achilles heel ofthe Indian economic boom” Ref.4)
. The quality is variable, however, and of the 15.7mstudents forecast to graduate over the period 2003 – 2008, some 14.5m of thesewould not be considered qualified to a global standard or employable asgraduates by multinationals.
(McKinsey Global Institute Labour Supply Data Base 2005)
 
Good luck buying the starter home…
It’s well known that luxury apartments in Shanghai and Beijing command“Manhattan” prices, with rentals in the USD20 – 60 per m2 per month range.However, the price of mass housing has also escalated dramatically across boththe major and secondary cities in China. For example in Beijing, the averageprice per m2 reached RMB 7,960 in 2006. Given an average size of 90m2, andthe Beijing GDP per capita of RMB 48,748, we can derive a ratio of the averageproperty price to GDP per capita for Beijing of 14.7x. Shanghai is even moreextended. This compares to the World Bank’s guideline range of 3 – 5x, abovewhich they believe a market to be unsustainable. The central governmentresponse to price escalations is regulation. 70% of all new properties developedmust be < 90m2 in size, and there are a myriad of taxes and regulations tryingto prevent geared speculation in properties and minimise foreign involvement indevelopment. While these regulations were promulgated more than a year ago,like many of the central governments edicts, they are only being enforced insome cities, and even then with varying interpretation
(Ref.5)
.
 
The Forgotten Communists
July 2007
This article is published exclusively for clients of Brait Specialised Funds, and is not to bedistributed or circulated without prior permission.
3
 Tiananmen II?
Conspicuous consumption by the wealthy has recently created a massive visibledivide between the few haves and many have-nots. While historically the verywealthy kept a low profile, this reticence has definitely ended. More emotionallycharged issues, such as the very wealthy flouting the one child policy (theresulting fine, some RMB 100,000 per child and a prohibition on stateemployment for the household being little deterrent) perhaps have morepotential to create social unrest.The government learnt a very hard lesson in 1989. While some types of protestsare tolerated (generally workers, pensioners or peasants on local issues, or if itis students, on state-approved issues such as protests after the US bombing ofthe embassy in Belgrade and the Japanese prime minister’s visit to a warshrine) any attempts to organise against the authorities will be crushed, a 10year prison term being typical. In 1989 students organised demonstrations thatbrought the country to a coordinated standstill in most cities across China.Attempts to organise national protests are now dealt with very harshly
(Ref.1)
.
Free Markets Need Information
Information is not open in China. All information must be cleared by theauthorities before release. There can be no “Chinese Bloomberg” under thecurrent political system. The Chinese press are not permitted to travel withoutthe prior permission of the local authorities in their intended destination. In mostcases, company information is not disclosed at all, even for the very largeststate-owned enterprises (“SOE”). Where a company is listed, disclosure isgenerally of limited value due to the web of SOE relationships and related partytrading.China Mobile, the world’s largest mobile phone company, is listed in Hong Kong.It is 74.6% owned by China Mobile Communications Corporation (“CMCC”), a100% government owned SOE that does not publish any information. Inaddition, CMCC does extensive related party business with China Mobile, as doa number of other SOE’s, none of which are in the public domain. While thedirectors of China Mobile claim that all the related party transactions are fairlypriced, without the ability to analyse CMCC’s figures, there is no way to know ifthis is the case. Given that the majority of the China Mobile executive directorsare also on the board of CMCC, and the CEO and Executive Chairman of ChinaMobile is the President of CMCC, the conflicts of interest are clear. And this inone of China’s leading companies.Similar structures exist around most of the listed SOE’s, including Asia’s largestcompany, Petrochina. Its parent company, the Chinese National PetroleumCorporation (“CNPC”) and other SOE’s, are buyers of RMB 185.1 billion ofgoods and services from Petrochina, some 27% of total turnover. They also
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