thinking about China: economic growth and metals

In the late 1970s, Beijing decided that its central planning model of economic development wasn’t working because the domestic economy had become too complex.  It reluctantly shifted to the model Japan had used to recover from WWII–concentrating on export-oriented manufacturing, offering cheap labor in exchange for technology and industrial craft skill transfer.  China became an increasingly large user of natural resources (oil and metals) as it created industrial infrastructure, industrial plants and provided housing and other public services for its large population.

Maybe ten years ago China realized that it was soon going to run out of low-wage farm workers willing/able to switch to manufacturing in order to sustain the export-oriented model.  Associated pollution and other environmental problems were also becoming more acute.  So the natural resource intensive, export path to growth was nearing an end.

Five years or so ago, China, now out of cheap labor, began the shift to a consumer-oriented, domestic demand approach to GDP growth.  Government stimulus to offset the negative effects of the recent recession gave exporters one final surge of vitality.  Still, for years manual labor-intensive businesses have been leaving China for, say, Vietnam or Bangladesh.  Beijing has also been cracking down on relatively primitive steel and aluminum processing operations.

Politically and socially, as well as economically, this is a difficult transition to make, because rich and powerful forces of the status quo don’t want things to change.  Japan, Singapore and Hong Kong (multiple times) have made the shift; Malaysia, Thailand and much of South America have not.

One of the main characteristics of this period of change is a slowdown in demand for base metals and other industrial inputs.  For China, which had been the dominant customer for almost any base metal, the transition comes just as global mining companies have made (inexplicably, to my mind) huge additions to productive capacity.

The result of increasing supply at a time of flagging demand is easily predictable–lower prices.

Why write about this?

Many financial markets commentators have been pointing to low base metals prices as evidence of cyclical economic weakness in China.  That may ultimately turn out to be the case.  But it’s equally a sign of:  1) structural change in the Chinese economy, which would be a good thing, and 2) witless mining companies.  So it’s by no means a sure thing that bears on China are correct.

By the way, the last global collapse in base metals prices came in the early 1980s.  That followed a decade-long period of mine expansion that was based on the idea that the United States couldn’t grow economically without using copper, lead, zinc and iron in amounts that would increase in a straight line with GDP expansion.  In hindsight, what a mistake!  Although Peter Drucker had been writing about knowledge workers from the 1950s, no one put two and two together.  It took almost two decades for world growth to absorb the excess capacity that miners added back then.


Toshiba and the Japanese business establishment

First there was the Fukushima Dai-ichi nuclear disaster, where nuclear power plants were installed incorrectly and both the utility and government regulators falsified inspection reports to cover this up.

Then there was Olympus Optical, whose tip management lost billions in stock market speculation because it was unwilling to restructure loss-making operations and covered up the fact for over a decade by fabricating its financial statements.

Now there’s Toshiba, which falsified results for years, under pressure from unrealistic profit goals set by a series of CEOs  (shades of Jack Welsh at GE).


Not that surprising, in my view, given the Japanese corporate world’s widespread adherence to a samurai-like code of absolute, unquestioning obedience to instructions given by older/more senior managers in one’s company.  After all, many of these enterprises have their origin in samurai cast adrift as regional warlords were marginalized during the early shogun days.

This mindset is also a reason why a lot of Japanese business is still stuck in the 1980s–that the world is changing at a fast clip, but you pretty much have to have white hair before anyone will listen to what you have to say.  To be clear, I don’t think this samurai-ness is a universal attitude in Japan as a whole.  Unfortunately,it thrives in the Tokyo/Osaka-based, export-oriented industrial sector which is the primarily beneficiary of the deep depreciation of the yen engineered by PM Abe.

Why don’t out-of-date sixty- and seventy-somethings just retire and let a younger generation take the reins?

For one thing, speaking as a sixty-something myself, it’s hard to go from being king of the world to being just another nameless retiree.

I think, however,that there may also be a deeper, more damaging reason than the ego problems of the people in charge:

One of the first companies I followed as an analyst was a small copier manufacturer/distributor.  The firm was in enough financial trouble that it bought breathing room by selling a large chunk of its plant and equipment and leasing it back from a bank.  That netted $50 million or so in cash.

Soon afterward, Carl Icahn bought  5%-10% of the company’s stock and threatened to make a hostile bid for the rest.  The firm quickly bought back Icahn’s shares for, as I recall, about a 30% premium.  I was shocked.  I didn’t get it at all.

Only when the firm subsequently went into Chapter 11 did I learn the CEO, a former accountant, had been fiddling with the books for years.  That fact was the real leverage Icahn had over his target, whether he knew it or not.  The CEO couldn’t let an outsider in, because the accounting shenanigans would be discovered and he would be disgraced.

I don’t know, but I suspect–because I’ve seen the same pattern in numerous smaller firms in Japan that Olympus and Toshiba are only the tip of the iceberg in Tokyo.  If I’m correct, Abenomics is even more problematic than I’ve been writing.







Abenomics and outside corporate directors

The original plan—and, in my opinion, fatal flaw—of Abenomics regarding reform of industry in Japan to make it more profitable was to depreciate the yen in a significant way that would supposedly compel now-more-profitable corporation to invest in expansion.  That would increase the number of employed and boost wages for all.  This would, in turn, generate a positive, self-reinforcing spiral of economic activity.

The depreciation has happened.  The hoped-for wage increases, employment gains and new investment haven’t.  This has been devastating for ordinary Japanese citizens, for whom a sharp decline in the currency has only meant an increase in the cost of living and a tremendous loss of wealth.

Tokyo has recently decided to try to force recalcitrant firms to use the increasing piles of cash that depreciation has brought them.  The vehicle is new legislation that mandates that publicly traded concerns install board members who are not insiders—that is, who have no connection with the firm.

The idea is that these fresh eyes and new voices will somehow compel companies to change their ways.  The initiative has received lots of praise from brokerage firms and the financial press.  For Japan’s sake, I hope they’re right.  Unfortunately for the country, my guess is that this enthusiasm is misplaced.

My son-in-law and I were talking about this the other day.  He immediately said what I have been thinking from the start—“What about Olympus?”

The Olympus in question if Olympus Optical (8831).

Several years ago, the head of that company’s European operations was made CEO of the entire company.  An outsider but an accomplished businessman, the new CEO found that he was not given the full access to corporate information he (justifiably) expected.  His requests for certain data were routinely deflected by the rest of the board.  Through a combination of whistleblower information and forensic accounting he conducted in secret, the CEO discovered a massive accounting fraud Olympus had been perpetrating since the early 1990s.  (The company hit hard times in the late 1980s.  Embarrassed, and unwilling to restructure, Olympus decided to supplement profits with stock market speculation.  The company, of course, experienced massive losses and covered the whole mess up.)  After confronting key board members, he ended up resigning and fleeing the country, saying that he feared for his life.

I’m not contending that the introduction of outside board members it going to create a whole raft of new Olympus-like incidents (although if there were a way to wager a small amount that there would be at least one, I’d be willing to bet).

am saying that I think the culture of protecting the status quo and of regarding any sort of restructuring as meaning creating/enduring life-shattering shame is still pervasive in Japan–and that simply adding a few outside directors won’t be enough to change that.

To my mind, the obvious thing to do is to dismantle the legislation enacted in the 1990s to protect Japanese companies from potential foreign acquirers–and therefore from activists.  But I don;t see that as on the cards any time soon.

inheritance tax changes as a lever for structural change in Japan

value investing and corporate change…

One of the basic tenets of value investing in the US is that when a company is performing badly, one of two favorable events will occur:  either the board of directors will make changes to improve results; or if the board is unwilling or incapable of doing so, a third party will seize control and force improvements to be made.

…hasn’t worked in Japan

Not so in Japan, as many Westerners have learned to their sorrow over the thirty years I have been watching the Japanese economy/market.

Two reasons for this:

culturally it’s abhorrent for any person of low status (e.g., a younger person, a woman or a foreigner) to interfere in any way with–or even to comment less than 100% favorably on–a person of high status.  So change from within isn’t a real possibility.

–in the early 1990s, as the sun was setting on Japanese industry, the Diet passed laws that make it impossible for a foreign firm to buy a large Japanese company without the latter’s consent–which is rarely, if ever, given.

The resulting enshrinement of the status quo circa 1980 has resulted in a quarter century of economic stagnation.

Abenomics to the rescue?

Abenomics, which intends to raise Japan from its torpor, consists of three “arrows”–massive currency devaluation, substantial deficit government spending and radical reform of business practices.

Now more than two years in, the devaluation and spending arrows have been fired, at great cost to Japan’s national wealth–and great benefit to old-style Japanese export companies.  But there’s been no progress on reform.  The laws preventing change of control remain in place.  And there’s zero sign that corporations–many of whose pockets have been filled to the brim by arrows 1 and 2, are voluntarily modernizing their businesses.  Mr. Abe’s failure to make any more than the most cosmetic changes in corporate governance in Japan is behind my belief that Abenomics will end in tears.

One ray of sunshine, though.

Japan raised its inheritance tax laws at the end of last year, as the Financial Times reported yesterday.  The change affects three million small and medium-sized companies.

The top rate for inheritance tax is 55%, with payment due by the heir ten months after the death of the former holder.   This development is prompting small business owners to consider how to improve their operations to make their firms salable in the event the owner dies.  More important, it’s making them open to overtures from Western private equity firms for the first time.  Increasing competition from small firms may well force their larger brethren to reform as well.

For Japan’s sake, let’s hope this is the thin edge of the wedge.



Shaping a portfolio for 2015 (vi): the rest of the world

world GDP

A recent World Bank study ranks the largest countries in the world by 2013 GDP.  The biggest are:

1.   USA         $16.8 trillion

2.  China         $9.2 trillion

3.  Japan          $4.9 trillion

4.  Germany          $3.6 trillion.

The EU countries taken together are about equal in size to the US.

stock markets

From a stock market investor’s point of view, we can divide the world outside the US into four parts:  Europe, greater China, Japan and emerging markets.


In the 1990s, Japan choked off incipient economic recovery twice by tightening economic policy too soon–once by raising interest rates, once by increasing its tax on consumer goods.  It appears to have done the same thing again this year when it upped consumption tax in April.

More important, Tokyo appears to me to have made no substantive progress on eliminating structural industrial and bureaucratic impediments to growth.  As a result, and unfortunately for citizens of Japan, the current decade can easily turn out to be the third consecutive ten-year period of economic stagnation.

In US$ terms, Japan’s 2014 GDP will have shrunk considerably, due to yen depreciation.

If Abenomics is somehow ultimately successful, a surge in Japanese growth might be a pleasant surprise next year.  Realistically, though, Japan is now so small a factor in world terms that, absent a catastrophe, it no longer affects world economic prospects very much.


In the post-WWII era, successful emerging economies have by and large followed the Japanese model of keeping labor cheap and encouraging export-oriented manufacturing.  Eventually, however, everyone reaches a point where this formula no longer works.  How so?    …some combination of running out of workers, unacceptable levels of environmental damage or pressure from trading partners.  The growth path then becomes shifting to higher value-added manufacturing and a reorientation toward the domestic economy.  This is where China is now.

Historically, this transition is extremely difficult.  Resistance from those who have made fortunes the old way is invariably extremely high.  I read the current “anti-corruption” campaign as Beijing acting to remove this opposition.

I find the Chinese political situation very opaque.  Nevertheless, a few things stand out.  To my mind, China is not likely to go back to being the mammoth consumer of natural resources it was through most of the last decade.  My guess is that GDP growth in 2015 will come in at about the same +7%or so China will achieve this year.  In other words, China won’t provide either positive or negative surprises.

For most foreigners, the main way of getting exposure to the Chinese economy is through Hong Kong.  Personally, I own China Merchants and several of the Macau casinos.  The latter group looks very cheap to me but will likely only begin to perform when the Hong Kong market is convinced the anti-corruption campaign is nearing an end.


In many ways, the EU resembles the Japan of, say, 20 years ago.  It, too, has an aging population, low growth and significant structural rigidity.  The major Continental countries also have, like Japan, strong cultural resistance to change.  These are long-term issues well-known to most investors.

For 2015, the EU stands to benefit economically from a 10% depreciation of the euro vs. the US$.  As well, it is a major beneficiary of the decline in crude oil prices.  My guess is that growth will be surprisingly good for the EU next year.  I think the main focus for equity investors should be EU multinationals with large exposure to the US.

emerging markets

I’m content to invest in China through Hong Kong.  I worry about other emerging Asian markets, as well as Latin America (ex Mexico) and Africa.  Foreigners from the developed world provide most of the liquidity in this “other” class.  If an improving economy in the US and higher yields on US fixed income cause a shift in investor preferences, foreigners will likely try to extract funds from many emerging market in order to reposition them.  That will probably prove surprisingly difficult.  Prices will have a very hard time not falling in such a situation.


slowdown in Japan

People who like black and white answers and numerical precision–whether the situation calls for them or not–define a recession as being two consecutive quarters of decline in real GDP (“real” here meaning after factoring out the effects of price changes–in Japan’s case, deflation).

On this way of looking at things, Japan entered its fourth recession since the global financial crisis when the government announced early this week that the economy had shrunk by 1.3% on an annualized basis during the September quarter.  This comes after a fall of 7.3% during the June quarter, when Tokyo implemented the first of two planned increases in the national value added tax.

Today’s situation seems to me eerily similar to that in 1997, when Tokyo stopped a nascent recovery in its tracks with a similar value added tax rise.

Prime Minister Abe reacted to the new GDP data by postponing the second value added tax increase, which had been penciled in for 2015, and calling for a general election that he intends to serve as a referendum on his policies.

Almost two years in, the fundamental sticking point for Abenomics remains unaddressed.  The idea has been to induce a large depreciation of the currency–a loss of a third of its value, so far–to lower production costs for export-oriented industry.  This makes export goods more competitive in world markets and buys time for industry to streamline and expand.  Industrial renaissance gradually repairs the damage done to national wealth through the currency depreciation.  Prosperity also induces a gradual currency rebound, restoring at least some of the wealth lost through its decline.

In many ways, Abenomics is the successful template Japan used to recover after WWII.  This time, however, Japanese industry has shown no inclination to restructure itself that I can see.  And until now Tokyo has done virtually nothing to dismantle the barriers to change of corporate control which it put in place as its economic malaise began in the 1990s and that ensure ossified managements remain in place.

For the sake of Japan, one can only hope that the point of the upcoming election will be a mandate to force industrial reform.  Without this, Abenomics will wind up merely as creating a massive loss of national wealth and a similar drop in living standards.

Takata airbags (ll)

Today’s New York Times contains an article saying that two former North American employees of Takata have come forward to say the company knew about airbag defects as early as 2004.  The company reportedly conducted secret tests at night and on weekends, but ended them and covered up the results when they showed the metal container holding airbag propellant had a tendency to crack, potentially spewing shrapnel into the body of the car’s driver if the airbag deployed.

The article seems to confirm that Takata is another name to add to the long list of Japanese operational or financial coverups–from milk companies, to refrigerators, to solar panels to Olympus’s enormous losses in failed financial markets speculation, to Tokyo Electric Power and Fukushima Daiichi, to the “hot potato” practice of tobashi in the 1990s (see my post on Repo 105 and tobashi).

I want to draw a distinction between Takata and GM.  Maybe it’s right, maybe not.  Anyway,…

…what I’ve read about the GM ignition switch problems makes me think of the GM culture of the time as one that might be called shared conspiracy.  That is, everyone in middle and upper management knew the company was dysfunctional.  So they defended themselves from potential personal liability by taking care to leave nothing in writing and by employing an army of lawyers to advise them on how to dance around the potholes.  While outsiders may not have known details, the company had an aura that told people something was wrong and to stay away.

For Takata, on the other hand, my sense is that the officials who orchestrated the airbag coverup thought they were simply fulfilling an ethical obligation to their CEO, sort of the way a samurai would have protected his daimyo centuries ago.

You might say that this is a distinction without a difference, it involves only the motivations of the coveruppers, not the bad consequences of their actions.  My point would be that the latter behavior is much harder to detect–and is a reason to think twice before owning a Japanese industrial or financial.