How China Will Succeed By Failing

Something new just happened in China. For the first time ever, a state-owned company defaulted on its lenders … and the government let it happen.

That’s a big step toward economic maturity. In the end, it should help China grow — but only after hurting many investors.

Don’t be one of them.

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Chinese factory activity is contracting at its fastest pace in a year, according to HSBC/Markit Purchasing Managers Index data released this morning.

China’s industrial economy appears to be slowing despite increasingly aggressive monetary easing by the central bank this year. It’s starting to take a bite out of business.

Here is a report from The New York Times:

On Tuesday, a little-known power equipment manufacturer became the first state-owned company to default in China’s huge domestic bond market, throwing doubt on the long-held notion that such businesses have implicit government backing.

The company, the Baoding Tianwei Group, controlled by one of China’s biggest military contractors, said that it had missed a Tuesday deadline to pay about $14 million in interest due on bonds worth 1.5 billion renminbi, or $242 million.

Obviously, a $14 million loss isn’t going to bring down an economy the size of China’s — but big changes begin as small ones.

One reason China has grown so fast is that Chinese businesses, state-owned or not, have been able to borrow money on very favorable terms. The government also protected them from the consequences of their mistakes.

This practice can help generate growth, but eventually it causes bigger problems. Investors start to lose trust and stop lending their money. In a strange way, failing businesses actually help a country’s economy.

Here in the U.S., for instance, we have a well-developed system to handle failure via bankruptcy and liquidation. This structure gives bond investors’ confidence that, if the worst should happen, courts will divide the debris in a fair-handed way.

China doesn’t have this. They’ve never needed it … until now.

Here’s more from the NYT story on the Baoding Tianwei Group’s default.

“I think it’s probably just the beginning,” said Ying Wang, a senior director of corporate ratings at Fitch Ratings in Shanghai.

“It makes sense for more commercially unviable, inefficiently run state-owned enterprises to default, because otherwise capital can never be allocated efficiently among state and private enterprises,” Ms. Wang said. “And that runs against the government’s reform agenda.”

Ms. Wang is exactly right. Letting inefficient companies fail will reallocate capital to better ones, ultimately helping everyone.

I think the Chinese government knows this. The leaders are smart people who think long-term. They are right now trying to shift the economy out of the capital-intensive infrastructure phase to a consumer-driven era.

To be blunt, they need to clear out some dead wood, which is very bad news if you invested money in that wood.

Fortunately, they will do this slowly — but it’s going to happen.

I wouldn’t buy any Chinese corporate bonds right now. I would be very selective about Chinese stocks, too.

Dodging the fallout won’t be as easy as just avoiding Chinese stocks and bonds. Just about every large American company does business in China. Many will find it harder to make a profit there as this change unfolds.

Change is always hard. Much depends on how China handles this one.

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Here’s a response to my Wednesday article, Flash Crash Bandit Nabbed.

Reader Simon W. says:

“I am VERY suspicious when a ‘small guy’ is nabbed for a major financial scandal. Are the authorities really telling me that the major investment banks did not have any hand in this or that they have not used similar tactics at other times? But then, ever since the sub-prime melt-down and the ensuing global crash we know that they are immune to criminal prosecution.”

“I am even more suspicious when US authorities pick on a non-US national as their victim — it all helps to build the smokescreen that protects the enormously rich and well-connected investment banks.

“Not that I am suggesting that he is an angel — it does look like he adopted some very aggressive tax planning measures to protect his ill-gotten gains — not that that is criminal (yet!) in the UK.”

Brad: I agree with you, Simon. Something doesn’t add up here.

As I read more about the case, it looks like the suspect used his same trading techniques hundreds of times over a multi-year period. Yet, there was only one “Flash Crash” in those years. That tells me he was a minor factor, at best.

I’m keeping an eye on this case. Maybe we’ll learn more when it reaches a courtroom.

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What you think about the default in China? Am I right to think this is an intentional change for them? What will be the consequences?

I always welcome your feedback. You can leave a comment on our website or send me an e-mail.

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U.S. markets hit a milestone today. The Nasdaq Composite traded above its all-time closing high, which was 5,048.62, set back at the tech boom’s height in March 2000. The index changed a lot since then, but breaking that record is still a big accomplishment.

The S&P 500 touched a new record, too. Here’s what drove today’s action.

•  A weaker greenback gave U.S. stocks a solid foundation today, as did higher oil prices and a seasonal tendency for stocks to rise in late April.

•  Today brought a multitude of quarterly reports. EBay (EBAY) shares rose after a positive revenue surprise in its PayPal unit.

•  Caterpillar (CAT) had better-then-expected earnings and raised its full-year outlook, while General Motors (GM) disappointed, plagued by the strong dollar.

•  Facebook (FB) gave a mixed report last night, but CEO Mark Zuckerberg has been warning expenses would rise as the company develops new products. He wasn’t kidding.

•  Gold stabilized and recovered some of Wednesday’s big drop. The weaker dollar definitely helped.

•  Amazon.com (AMZN), Google (GOOGL) and Microsoft (MSFT) are all set to release quarterly reports after today’s close. Tomorrow should be interesting for the tech sector.

Good Luck and Happy Investing,

Brad Hoppmann

Publisher

Uncommon Wisdom Daily

Your thoughts on “How China Will Succeed By Failing”

  1. Brad,

    It would be nice to leave your name at the top of the article. That way we know who the author is instead of having to scroll down all the way. Most of the other guys at Uncommon Wisdom and Money and Markets do that.

    Thanks,
    Marc

  2. I think the Chinese situation is a learning situation for them.

    But, regarding the flash crash “bandit”. When is the world going to stop thinking the government is behind everything that ever happens. What a load of smelly baloney.

    Now, I am sure that our government, like all others, does things and has secrets. Of course! But, I am sick to death of all the conspiracy theories. Not blatant stupidity like the IRS or Benghazi situations, which are known to all, and are not in the league of which I speak, but the supposed conspiracies of our evil empire government preying on all individuals. Come on people, this is the greatest nation on earth, even with all of its foibles, and warts, many of which we are eliminating by election.

    If you don’t like it, either do something about it, or get out. As a disabled veteran, I have been all over the world, and believe me, this is the very best there is by a long, long shot.

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