Lengthy content. (cont)
Getting cold feet
Verdict: this company needs money just to tick over. At this point our feet are beginning to feel cold, less because of the scary numbers we are hearing than from the temperature in the room. Like his counterpart at Erzhong, the manager looks worn down. He is from Wuhan and was assigned to the job with the assurance that it "would be spring all through the year once the Three Gorges Dam project was complete".
Suddenly he becomes candid. There is a problem working as a manager in an SOE: the pay system needs to be reformed. He cites the real example of a large and unusually profitable SOE. The chairman and financial controller of this cigarette company were paid just Rmb2,000 a month, but the company made Rmb4 billion of profit. They were caught embezzling $3 million and were recently put in jail. "The problem is, you turn an entrepreneur into a criminal."
In a brief cultural interlude, we go to the city's famed artists' colony. We are lucky, the renowned woodcut artist Lin Jun is in his studio - where he has worked for 45 years. During the Cultural Revolution the Red Guards wrecked it and made him watch while they broke his paintbrushes in two. Tsiang's sleek Nokia 8810 goes off as he is sizing up a picture of a panda. An engraving from the 1960s sits in the corner. It features a fat capitalist with a cigar eating from an overflowing plate of food while a score of poor starving workers look in through the window.
Tsiang buys a picture. Do you have fat capitalists in China today?, he asks. "We certainly do," says the 78-year-old.
As we leave the colony, we pass a "mom and pop" motorbike assembly plant. It's putting together copies of a locally made Yamaha joint-venture bike - with cheaper parts. Where the Yamaha costs Rmb5,000, this costs around Rmb3,000.
At the Chongqing Foreign Investment Bureau we meet its head, Zou Xiao Ping. She notes that Chongqing has a "heavy burden": to find jobs for all the immigrants coming from the Three Gorges project. Foreign investment is urgently needed for this. Last year it got $420 million, which led to 8% growth. Nevertheless, 3.7 million citizens live below the poverty line.
Chongqing, she says, is trying to differentiate itself from other Chinese cities by being more transparent. It lists its fees and taxes on the internet so that if an official tries to charge a spurious fee - spiritual civilization tax is a favourite - the foreign firm can come to the government and refuse to pay it. All fees are paid to the bank, and so are better audited.
But it's clear that Chongqing has serious problems. Its core industries - such as automobiles - are suffering, as is the defence industry it once relied on. Unemployment is worse than in Chengdu.
"It's clear to me now," says Tsiang as we leave: "They want foreign money just to keep the SOEs here ticking over - like that one this morning. A lot of foreign companies will be attracted here to set up regional offices and there'll be a property bubble and some people will get burnt."
We fly to Yichang in a Chinese-manufactured, Soviet-designed, Y7 prop aircraft. Benjamin tells us that in Sichuanese dialect the word wai (Y) means fake. Yichang has the smartest air terminal in China, a white, Richard Rogers-style exoskeleton. This is close to the Three Gorges Dam and we set off to see the project that employs 50% of the city's population.
Tsiang admits he's overawed. As far as the eye can see, things are being blown up, knocked down or constructed by teams of workers - around 25,000 of them. After stage one is complete in 2003, an artificial lake 500km long will be created. The construction cost is $30 billion, and thus far has been financed within China with government bonds.
The 26-million-tonne concrete dam will eventually produce 18 gigawatts of power, more than four times the capacity of any power station in Europe and eight times that of the Aswan High Dam in Egypt. But there are some risks. Hydrologists say the river throws down boulders and cobbles, which no dam devices are able to flush out, so they could cause chronic silting of the reservoir. To combat pollution, around 18 water treatment plants will need to be built in Chongqing alone; otherwise the lake is forecast to become a "reservoir of death". If the dam ever breaks, 400,000 cubic metres of water a second would explode down the Yangtze. This is hardly the "Geneva of Asia" once foreseen by former prime minister Li Peng.
Yichang's vice-mayor Zhang Jian Yi tells us the Three Gorges project is "like an incredible opportunity given by god". After our next meeting, with the Yichang Economic & Trade Commission, we conclude divine help is mightily needed. We spend 45 minutes trying to get numbers on what proportion of Yichang's Rmb38 billion GDP is produced by SOEs and how many SOE employees there are, after which we are told that 100,000 people work for SOEs, which is a mere 2.5% of the population. Then it emerges that the 100,000 denotes only those SOEs that report to Yichang prefecture. There are SOEs that report to other authorities such as the central government and they don't have figures for them here. We never get to the bottom of these numbers. "This is why due diligence is so impossible in China," fumes Tsiang. To make amends, an official at lunch confides that he has seen a qi gong master move a glass across a table from a distance of five metres.
After lunch a visit to Yichang Chemical, a listed company that makes fertilizer. Tsiang is quite at home, having previously been a chemicals analyst in Australia for Roach Tilley Grice (now Merrill Lynch Australia). "This is a company working on a price-earnings
multiple of 18, with a net profit margin of 18% and a return on fixed assets of 22%, and return on capital of 16%," he observes. "There are 47 companies of similar size. Supply and demand are equal. Prices are at an all-time low and fertilizer is a commodity business. My observation is that very few companies in the world like this earn such high margins. Most chemical companies in the west are on a PE of seven to nine."
We are 30 minutes into a meeting with the manager, who begins to explain why the profit margins are so high. He writes a complex chemical equation and explains it is a new high-margin fertilizer pioneered by the Hoechst group of Germany. It accounts for 30% of his sales and moreover the Hoechst group wants to do a joint venture with him. "They enjoy the best technology," he says. "and they want 80% of the Chinese market." We ask whether the government will approve of a foreign company taking so much market share. "The government won't oppose it," he says. "We will have 51%, so the government will agree to that." Tsiang says that if he can sustain these margins it will be a wonderful achievement.
On our drive back to Yichang, traffic going our way occupies all four lanes of a two-way highway. When our driver encounters a car quite legally coming the other way, he has the audacity to blast his horn.
That evening we hear about the bankruptcy of the Guangdong International Trust & Investment Corporation (Gitic), which casts a whole new light on our trip thus far. Western bankers are stunned to find that the Chinese-style promises and guarantees have proven worthless. Half the foreign debt wasn't approved by the State Administration for Foreign Exchange and worse - after investigation - it emerges that the Rmb35.8 billion of assets attributed to Gitic are valued at Rmb21.1 billion. All things Chinese start to melt down in Hong Kong. Tsiang has to make a detour to Chengdu to spend a day on the phone assessing his positions.
Benjamin and I left to our own devices board a hydrofoil that will carry us to Wanxian in seven hours - on a conventional boat it would take three times as long. For those uninterested in some of the most stunning scenery on the planet there are movies to watch. As we disembark at Wanxian, we are pawed by old men who want to carry our bags up the long stairway - for a fee. Wanxian is extremely poor. Prostitution and gambling have been legalized for foreigners (meaning anyone who is not a citizen of the city). It seems any attempt to reduce the chronic unemployment problem is acceptable.
Our guide used to be a civil servant in Bombay. He became a translator in Wanxian after the civil service was reformed last year and he found he no longer had a job.
He helpfully informs us of our altitude as we climb the hill in our Volkswagen. "This is 165 metres above sea level. Yes this will be under water once the Three Gorges Dam is finished. Now we're at 175. This is where the water level will be."
Sitting in Zhu's chair
In the VIP room at the Sote group's two-star hotel, the air conditioning is broken and again our breath forms clouds. On the wall the customary pictures of Jiang Zemin and Li Peng. They're still framing the photographs of Zhu Rongji who was here a couple of months ago. "You are sitting in the same chair that prime-minister Zhu sat in," translates Benjamin.
Sote is a salt factory founded in 1990, although the first salt wasn't produced until September 1992, says chairman of the trade union Chen Dexiang. The company was reasonably efficient until it was "asked" to merge with five other salt producers last year. Before the merger it produced 260,000 tonnes; afterwards 300,000. Before the merger it made Rmb14 million profit; after it made Rmb16 million. So it's safe to say the 3,600 employees that were added to the company's original 850 didn't add much value.
But the workers' wages rose 11% in 1998, says Chen, and he predicts a further 17.6% increase by the end of the century - meaning next year. Asked how he justifies an 11% increase in wages when inflation was 0.6% and by some measures prices have been falling for 13 months, he replies it is justified by the profit the group makes. It emerges that almost 100% of its profits come from edible salt, which comprises 50,000 tonnes of its output. The other 250,000 tonnes is "break-even" industrial salt.
He also points out that the factory closed for several months last year because the Yangtze flooded. When it reopened the workers worked "very hard" and miraculously produced 46% of the year's output in just 100 days. The management threw a banquet in their honour and let off firecrackers.
The company is planning to diversify. It will receive Rmb300 million from the central government for its help resettling workers displaced by the dam, and in addition intends to raise Rmb300 million when it lists. It reckons it can leverage this with bank loans to
Rmb1.2 billion. It wants to invest in a manufacturer of TV outside-broadcasting equipment in Shenzhen - Chen notes there was a shortage of such equipment when the flood happened last year. But when asked what the expected return on investment will be, he says: "It isn't clear yet".
Into the black hole
It's time to meet Tsiang in Chengdu. At the military airport two hours out of Wanxian we chat to an engineer with some investors from Thailand. He mentions a project he worked on in Wanxian that recently fell through. It was a $300 million investment to produce chlorine and PVC, with methanol as a by-product. The project was stopped by central
government auditors after the general manager had upped the project's costings in order to secure funds for real-estate speculation. Meanwhile the Japanese equipment had already arrived, a school for employees' children had been built and 3,000 were already employed. The current state of play is no less bizarre. The "workers" won't allow the Japanese company to repossess its equipment since as soon as it leaves they will be unemployed.
At the Holiday Inn in Chengdu, Tsiang is carrying today's Economic Daily, which contains a report entitled the The Black Hole": it chronicles the widespread corruption in China's 120,000 SOEs. The newspaper is quoting from a national audit report and among the sins is the extraordinary revelation that managers of the Three Gorges Dam project had embezzled nearly $28 million of funds. This is particularly galling for Benjamin who asserted, only a couple of days before, that the dam is too prestigious for the managers to behave dishonestly.
The bureaucrats in Chengdu are getting a bit nervous about our meeting the governor and we are told he "might be in Beijing" the next day. Tsiang tries to calm them by insisting it would only be a "courtesy call".
The Hope Group, reputedly China's biggest private enterprise, is run by four brothers and has a product range that includes animal feed, air conditioners, real estate and computer software. Like many emerging-market conglomerates it also has a big stake in a bank -
Minsheng Bank.
We meet two of the brothers Liu Yongyan (the eldest) and Liu Yongmei (the third eldest) at their residential complex - designed for expatriates. Just in front of the complex a five-star hotel is under construction. Refreshingly they don't look like a couple of China's richest individuals. "Look at the way I dress," says the elder brother. "I dress like a normal person." There are no Rolexes on their wrists and their clothes are the local shabby suit. Do they invest in the stock market? "No. Then other people have control."
The company began with the eldest brother selling pigeons in the early 1980s, and is now Chengdu's biggest taxpayer. "The only help the state gave us was leaving us alone," says Liu Yongmei. The brothers have been asked to take over SOEs but they have refused. Their attitude to SOE reform is simple. Do it quickly: "No pain, no gain," says Liu Yongyan.
The Holiday Inn's sky lounge bar is the closest thing to Hong Kong. One of the waitresses has a book entitled Practical English, which includes such choice lines as: "I know my job is boring but I also realize it is important to the company".
There's a television crew waiting next day as we arrive for our meeting with governor Song Baorui. They ask us whether we consider Sichuan a good place for foreigners to invest. Tsiang is non-commital. A few minutes later, the governor strolls across the
forecourt in casual dress and we enter the state meeting room.
"So far it looks like the SOE reform in China is difficult," he begins. "My personal point of view is to combine international methods with the local conditions. Enterprises in a deficit situation must lay off staff. If the costs are still too high you reduce the salary of the existing staff. If you still can't reach the objective the board of directors will fire the chief executive. The target is quite clear now, and we must implement it."
He continues: "There was deflation last year. So infrastructure development is necessary. But this should be short-term. The New Deal from Roosevelt and also Keynes's theory are appropriate in this stage but they can only work in this stage. There is a danger of a boom-bust economy. So investment in infrastructure can be done this year and last year, but if done again next year there will be a bubble economy. From my point of view we are very clear about the situation. If we invest blindly then the result could be quite serious."
Song is clearly a man in premier Zhu's mould. He notes: "If you would like a contract in Sichuan we can give it to you. Anyone is welcome. We, the government, benefit from jobs and taxes. In the past, enterprises in China were set up by the government. This is not the right way. If we set up 10 enterprises, maybe nine would be broke today."
He concludes: "We must keep a good reputation. When we sign a contract, it must be followed."
The bureaucrats are tremendously relieved that the meeting with the governor went off well and invite us to go tenpin bowling. This is something of a passion with them. One scores over 200 in a single frame.
We fly to Shanghai and meet a local investment banker for dinner. He notes that the slowdown has hit the city severely. Office rents on grade-A property have fallen from $1.50 a square foot to 60 cents. One investment bank has cut back from 1,000 square metres to 200, and driven down its rent from Rmb90,000 to Rmb7,000. The Shanghai government has apparently ordered developers in Pudong - where until recently more than half the world's construction cranes were at work - to put cladding on unfinished buildings to make them look occupied. In his luxury block only 10 apartments out of 80 are let.
Look to the townships
The banker says forget the SOEs. In his view China's entrepreneurial gems are often the township enterprises. But tracking down a suitable township enterprise is like looking for a needle in a haystack. Not all of them are good; but many are excellent. They are medium-size enterprises that lack many of the overweening social burdens of the SOEs. In fact they often understate their profits to avoid tax and hence, to the untrained eye, seem as mediocre as the SOEs. But finding out who their owners are is the biggest challenge. "You know the state owns a portion," says the banker. "But then a lot of shares are owned in one way or another by the managers or key people in the township. It's not defined in concrete terms. If you're lucky you eventually find out who is in control, and you can deal with him."
We speak of short-termism and he recalls an incident in which a foreign firm was about to buy a Chinese business for $20 million. To celebrate, the owner held a feast in his restaurant. When the bill came it was for Rmb3,000. The acquiring company offered to pay. But by the time the bill came to them it had been inflated to Rmb5,000. "There was an uproar. This guy was prepared to risk a $20 million deal just to make a lousy Rmb2,000 that evening."
A local broker has arranged visits to three B-share companies. In contrast to all the companies we've seen so far, Tsiang can buy these stocks.
First is Zhenhua Shipping. Established in 1992, it makes cargo cranes, 80% of which are exported. It has 20% of the world market and its biggest competitor is Mitsubishi of Japan. We ask about yuan devaluation, a subject the company is reluctant to talk about.
Its current sales volume is $140 million, but the firm has the capacity to turn over $170 million. There is a lot of pressure from Korean competitors. A 10% devaluation would allow the firm to run to full capacity. However, the company is 70%-owned by the state,
whose policy is against devaluation. "This is a policy we fully support," the representative says loyally.
Next we go to glass manufacturer Shanghai Yaohua Pilkington which has the British multinational as a shareholder. Tsiang is keen on this company on moral grounds. "A couple of years ago I wanted to buy their shares at $1.10. They were so honest. They said don't buy. Last year the share price was 40 cents. Again they said don't buy. They have great technology, but there's chronic oversupply."
Secretary to the board Minli Jin is a forthright lady. The stock is now trading at six cents - a 90% discount to the net asset value. "Would she recommend I bought her shares?" Tsiang asks. There is a lot of uncertainty, she replies and overcapacity will continue for
two years. There are simply too many domestic competitors.
Nor can glass be readily exported as the freight costs are prohibitive. In addition the company has Rmb100 million of accounts receivable from last year - that is to say, bad and doubtful debts. Last year the company set up a special task force to reduce this
worrying figure. The company has a profit target of Rmb4.5 million.
This seems strange given the fact that in the first half of the year the company has already made Rmb9.6 million. It turns out the company had a Rmb36 million forex gain, so in fact it lost Rmb25 million. "Under China GAAP (generally accepted accounting principles) we made Rmb9.6 million. To get international GAAP we must take out the Rmb36 million." The discrepancy can be quite big. For example, the company made a profit of Rmb33 million last year under international GAAP but under China GAAP the number was Rmb70 million.
As we emerge, Tsiang says he's not going to buy the stock. "You know it's a real shame to see a good company getting killed," he says.
Our final call is to Shanghai Narcissus Electric Appliances. "I never thought I'd walk through these gates again," says Tsiang. "This company is amazing." But not, as it turns out, for the right reasons. "It's the worst listed company I've ever visited."
Shi Zheng Ming, the vice-director of the board, is also extremely frank. Narcissus is in dire straits. It lost Rmb60 million in 1997 and Rmb50 million in 1998 and these are China GAAP numbers. Its total debt is Rmb306 million and its total triangular debt is Rmb360
million. The company has an inventory of 130,000 washing machines, its sole product. "The unsuccessful performance of Narcissus," he says "is largely due to the unsuccessful joint venture with Whirlpool [of the US]."
This is an understatement. The joint venture has accumulated losses of Rmb200 million, wiping out half of Narcissus's equity. It turns out the Whirlpool washing machines didn't fare well in competition with Japanese washing machines, which were cheaper. It doesn't
help that the capacity of the washing machine industry is twice local demand - a familiar story throughout China for most products, hence the government's desire to stimulate domestic demand.
This is an amazing fall from grace for a company that was the biggest maker of washing machines in the 1980s when it was a pure SOE. The stock is trading at six cents (its high was 40 cents) and, according to the research analyst taking us round, Shanghai's mayor, Xu Kuangdi, frequently asks multinationals to take it over but without success. Even if it got new cash it is forbidden from making fully automatic washing machines under the terms of the agreement with Whirlpool. And no-one wants semi-automatic washing machines.
Even the banks have lost confidence, a truly remarkable sign. Shi tells us that ICBC is requesting the company mortgage its assets. It has one square kilometre of land plots in Pudong. How much are these worth? "It's hard to say," he responds.
We leave for the airport to catch our flight back to Hong Kong. It is pouring with rain, the road is blocked and we are stuck in a terrible traffic jam. It is Narcissus land - which is still indirectly 35% government-owned. Our driver says the reason for the traffic hold-up is that Narcissus can't afford to repair the road.
Tsiang bought no stock on the trip nor found any investment opportunities for his fund or his Fortune 500 clients. However he concluded that the trip helped to shape his opinion on crucial issues such as the stability of the yuan and the limitations of China's pump-priming programme - two variables that are part of his macro and asset allocation for the Asian region.
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