About China blogosphere, travel, and entrepreneurship

Thanks to Bill Bishop (see below), I read Brad Setser’s post entitled “If you only read one thing on China this fall” praising the World Bank China Quarterly report by David Dollar and Louis Kuijs.  In fact, there is a online Q&A with the authors  in a live online discussion on December 1, 2008 at 8am EST, which is 13:00 GMT/UTC and 9pm in Beijing. More information here.

I’ll follow Setser’s lead and not try to summarize the 23 page report.  But here are my quick takeaways:

1. Export - Slowing growth has so far affected different segments at different levels.  For example, light manufacturing including toys and textiles have declined quickly, but higher-value machinery, equipment and electronics have held up better.  Not sure if this will persist in a rougher 2009.  But this means certain areas (like Guangdong’s Pearl River delta) are affected more greatly than others.
2. Real Estate - There has been a “pronounced slowdown” in real estate, in part because of government policy aimed to control speculative excess in this market.  But as a result, “real estate investment growth is  now close to zero” and “upstream” industries like steel and cement have been affected sharply.
3. Financial Sector - However, this real estate weakness will not affect the financial sector or households as much as they have in the West because of lower levels of leverage.
4. Domestic Consumption - So far, domestic consumption has not been affected that much.
5. Inflation - Inflation is no longer a concern.
6. RMB Exchange Rate - RMB has appreciated as the USD has appreciated vs. other currencies (except JPY).  This is not likely to change.

Everything is consistent with my earlier post on the effects of the economic crisis on China and my uncle’s three-legged stool model (with two legs broken) of Chinese growth:  export, real estate, government spending.

I found one statement disturbing:

The experience in earlier global downturns suggests very weak export growth in
2009, even though China’s exports are likely to outgrow world imports significantly.
Box 1 describes how continued gains in global market share have allowed China’s exports
to keep growing during previous global downturns. In line with this experience, we expect
that China’s exports will continue to gain overall market share in 2009, allowing for
positive export growth in a depressed world market.

This means that China will still be increasing its overall export share and exporting the problem of overproduction to the rest of the world.  This means that China will be a deflationary force as products are dumped onto the world market as companies and provincial governments in China try to maintain employment.

Setser’s highlights seven key takeaways:

1. China was no workers’ paradise during the boom years
2. China really is a manufacturing and investment driven economy.
3. China’s current slowdown was made in China, not in the world
4. There is more bad news ahead
5. The fiscal stimulus is real, but modest.
6. The last thing anyone needs to worry about is fall in Chinese demand for US treasuries.
7. The way China manages its reserves matter immensely for the world not just fo China.

See the Setser piece for more explanation.

A hearty hat-tip to Bill Bishop for highlighting this Setser piece.  An excellent source of China financial and business infomation is from Bill Bishop.  I follow him via his excellent Google Reader Shared Items feed and also on Twitter at http://twitter.com/niubi.  Thanks Bill!

Right after we posted on why the global financial crisis will hit China harder than the US and Europe, the World Bank published its estimate for 2009 growth (h/t Managing the Dragon and The Standard HK):  7.5% growth, which represents a 19-year low.  In my previous post, I shared that many economists think that 9.0% growth is needed to fully absorb the new market entrants and to maintain the current unemployment rate, which is somewhere between 4.0% (official) and 10% (worst case unofficial).

Managing the Dragon has a nice summary, which I’ll excerpt here:

Growth will slow to 7.5 percent in 2009 as the global financial crisis takes a greater toll. (Revised down from its previous forecast of 9.2 percent growth next year.)

Beijing’s multibillion-dollar stimulus plan will help smooth the sharp edges of steep declines in global and domestic demand. China’s downturn — signs of which emerged in the third quarter — will worsen in the first half of 2009 as exports weaken.

7.5 percent growth in 2009 will represent the weakest since 1990 when it was 3.8 percent, and just below the 7.6 percent reported in 1999.

In an earlier post, Managing the Dragon’s Jack Perkowski made a great point about the relative size of China, and that even if it were delinked from the global economy (which it is NOT) it is simply too small to save the day:

For all of its double-digit growth over the past five years, and despite the fact that it has most likely already surpassed Germany as the third-largest economy in the world, China’s GDP in 2007 was just under $3.3 trillion, or only 6 percent of global GDP. No matter how fast China grows in 2009, it simply cannot by itself offset the impact of recessions in the United States and Europe. In fact, there is no country or region of the world that can.

For the record, the five largest economies in the world in 2007 were: (1) the United States at $13.8 trillion; (2) Japan at $4.4 trillion; (3) Germany at $3.3 trillion; (4) China at just under $3.3 trillion; and (5) the United Kingdom at $2.8 trillion.

Michael Pettis expects that the World Bank will be continuing to revise their projections downward.  He also comments that the ruling party in China will use all the policy tools they have by virtue of their authoritarian control, which includes suppressing demonstrations and pressuring businesses not to lay off people:

The government has also warned, more than once, that as a consequence of the slowdown they expect an increase in social disturbances (a euphemism for rioting). They are also trying to control the process of layoffs, with some provinces requiring companies to get approval before they fire more than a certain number of workers.  This obviously can have negative impacts on the adjustment process for businesses, but I think that one of the ways that China can boost private consumption is by various forms of income redistribution, and raising minimum wages and preventing firings may have some positive impact here.

This is another example of the pragmatic approach that China’s leaders have to address this downturn.  For those of us with a strong grounding in the principles of free speech, free markets and minimal government interference with business, the idea of preventing layoffs and preventing rioting seem highly objectionable.   But some might say that these policy tools will be well used to deliver the right mix of stability and growth to China during these difficult times.  All I can say is that I’m glad I’m not running China.

I had coffee with Philip Johnson, former Silicon Valley Bank executive who is now a Beijing-based financial adviser to start-up companies in China.  On his visit to the US, one of the most frequent questions people asked him is “How is China affected by the global financial crisis?“  I’ve had similar questions myself:  How badly will China be affected?  Does the US need China more, or does China need the US more?

When I was in Hong Kong, I asked some of these questions of my Hong Kong based uncle who is in the apparel manufacturing business.  He responded that China would be deeply affected by the crisis, maybe even more than Western countries.  He then provided a simple, easy to understand framework that I then double-checked against the writings of Michael Pettis, Nouriel Roubini, Brad Setser, and other economists on the Web.  Based on this research, I’ve sadly concluded that my uncle is right.  Instead of coming to the rescue of the global economy, China will suffer more deeply from the crisis than the US or Europe.

Uncle’s simple but powerful framework:  China is supported by a three-legged stool, but two legs are now broken

China’s economic growth is supported by three primary legs:

1. export-led growth
2. real property growth
3. government spending

The first leg is clearly broken.  US and European consumers can no longer consume at the debt-supported levels they have at the past.  The second leg is also broken, in part because of the first.  Rising unemployment, declining Chinese consumer confidence, and significant price declines in real property have slowed sales.  So what is left is government spending.  Government plays a more significant role in the Chinese economy than Western economies, but can increased government spending make up for the other legs of the stool?

The consensus among economists is “no.”  And even more worrying, is the belief that Chinese government policy response could make the global financial crisis worse.

Roubini: The Rising Risk of a Hard Landing for China

Nouriel Roubini, the NYU economics professor that predicted many elements of this global meltdown, writes (at RGEMonitor, reprinted with commentary at JapanFocus) that there is strong evidence that China is facing a hard landing.  Roubini points out that a hard landing actually still means a 5-6% growth rate.  9-10% growth is needed to absorb 24 mm new entrants into the labor market, including 12-14 mm poor rural farmers.  A 5-6% growth rate means a significant risk to social stability and continued political control, so its clear that Chinese leaders are in a tough place.  John Pomfret concurs.

Unfortunately, according to Roubini, China is still an export-led economy without the ability to crank up domestic consumption to absorb its domestic production capability.  Roubini:

Note that China is an economy is structurally dependent on exports: net exports (or the trade balance surplus) are close to 12% of GDP (up from 2% earlier in the decade) and exports represent about 40% of GDP. Real investment in China is about 45% of GDP and, leaving aside the part of this investment that is housing and infrastructure spending, about half of this capex spending goes towards the production of new capital goods that produces more exportable goods. So, with the sum of exports and investment representing about 80% of GDP, most of Chinese aggregate demand depends on its ability to sustain an export based economic growth.

Because China’s GDP growth is dependent on exports, when exports go away, there is no domestic consumption to keep fueling growth.  Which means that factories need to get shut down and people laid off.

Financial Times:  China needs a true change of course

The Financial Times, on 11/10, published an editorial that applauded China for cutting interest rates and announcing the large RMB4 trillion stimulus package.  But at the same time, the paper criticized Chinese policy makers for doing too little, too late:

China’s growth to date has been phenomenal, but it was based on exports and investment, at the expense of consumption. China almost aimed to be a supersized South Korea: in 2005, capital investment made up more than half of China’s gross domestic product. The capital-intensity of its growth also meant profits grew strongly as a share of GDP. But employment growth has slowed since the 1980s, so workers have gained small benefit.

Undervalued RMB and a lack of domestic safety net have caused Chinese households and companies to save.  This “Supersized Korea” inadvertently created a “savings glut” which poured Asian savings into Western countries, flooding the markets with cheap capital.

Setser: Unhelpful - China never did what it needed to do.

According to Brad Setser, Chinese policy makers knew that China’s “Supersized Korea” strategy needed to change and that the strategy was not sustainable on a global level:

…it also turned out that China never really carried through on its 2004 and 2005 and 2006 and even 2007 rhetoric that it planned to rebalance its economy.

Back in 2004 China’s leaders generally got the benefit of the doubt…most observers expected that China’s leaders would be able to deliver when they announced their plan to shift the basis of China’s growth away from exports and investment. Chinese policy makers generally had a pretty good track record of doing what they said they would do.

But four years after China indicated that it wanted to rebalance its economy, its economy looks more unbalanced than ever – its current account surplus is far far larger than in 2004, and investment accounts for a higher share of GDP than in 2004…

The underlying problem we are faced with is a global shortfall in demand.  Because China did not allow its currency to appreciate when times were good, and did not stimulate domestic consumption, China can only help soak up their own production overcapacity through government spending.

Michael Pettis - China Financial Markets

11/20 - Rising unemployment increases the pressure for misguided trade policies

11/16 - Would a trade war help solve the problem of excess capacity?

11/13 - Can Smoot-Hawley return in a wholly different guise

Michael Pettis, professor at Peking University’s Guanghua School of Management, has been the premier blogger on China’s economy and financial markets.  Earlier this year we followed his writings on RMB appreciation and the need for a one-time maxi-revaluation of the RMB.  Obviously, things have changed.

He has written on a few themes recently, influenced in part on his reading up on the Great Depression.  Here are some of the key insights:

1.  Unemployment is putting a lot of pressure on Chinese policy makers–potentially to do counterproductive things like export subsidies or even RMB depreciation.

The employment outlook is looking worse and worse.  According to a Financial Times report, the official urban unemployment rate is only 4% but this excludes all rural migrants to the cities. According to Pettis, most people believe official urban employment rate significantly understates real urban unemployment, and the real level could be as high as 10-11%.

The key to social stability is adequate employment growth.  That growth either has to be fueled by maintaining exports, or increasing domestic consumption.  But there are important reasons why domestic consumption won’t increase.  For one, the lack of safety nets in health and elder care cause Chinese households to save in order to self-insure their risks for illness or health care emergencies.

The “super-sized Korea” response would be to stimulate exports, depreciate the RMB, and try to get the export machine humming again.  But China is simply too big to play this game.  According to Pettis:

Export subsidies, depreciating RMB – all of this might seem to make sense if you look at China as divorced from the global balance of payments system. These measures to boost exports are, after all, pretty standard ways of increasing production.

But if you think of China’s role within the global balance of payments, it seems to me that this is little more that a form of Smoot-Hawley-with-Chinese-characteristics. Global demand is slowing, just as it did in the 1930s, and China as the leading source of global overcapacity is trying to address its global demand problem by shifting the burden abroad.

But it seems quite plausible that Chinese policymakers will do everything necessary to reduce unemployment, reduce social unrest, and maintain political legitimacy.  And shifting the problems abroad might work for a while until and unless Western countries respond with trade barriers and protectionism.

2.  The exporting countries that have more productive capacity than domestic consumption (the “current account surplus” countries like China) will bear the most pain in the recession.

Most people are comparing the United States of today to the United States of the 1930s.  But Pettis argues that this is not the right analogy.  The correct analogy is between the US of the 1930s and China of today. In both cases, each country was the source of massive productive overcapacity, and export-led growth.  In both cases, domestic consumption was not sufficient to soak up domestic production.  And in the case of Smoot-Hawley, US policy makers responded with protectionism because European demand for US goods crashed by 70% in 3 years.  And ultimately, the US bore the brunt of the pain.

Today it is China who is exporting overcapacity and it is the US who is consuming too much, fed by Chinese financing.   With the collapse of bank intermediation US households and businesses are cutting consumption and raising savings.  This is a necessary adjustment. Calling on the US government to engage in massive fiscal expansion to replace lost private demand is crazy.  It means that we should continue the current game that has led us into so much trouble, but instead of having US over-consumption and rising debt at the private level we must have it at the public level.

If Keynes were around today he would probably make the same point he did over 60 years ago.  Demand must be created by the current account surplus countries, which have, to date, relied on net exports to protect themselves from the consequence of their overcapacity.  They must force demand up quickly in order to close the gap, and since expecting private consumption to rise quickly enough is unrealistic, it has to be public consumption – a large fiscal deficit.

Just as the US stupidly tried to increase its ability to dump capacity abroad by creating import restrictions (which has the effect of further expanding domestic production), China seems to be hoping for the same thing by increasing export rebates and slowing the currency appreciation (there is even increasing talk of depreciation).

The responsibility is for the Chinese government to close the gap in Chinese production and Chinese consumption, and that means public spending since private consumption is not going to rise fast enough.  Lets hope that Smoot-Hawley with Chinese characteristics does not come to pass.

3.  The only way out is massive fiscal stimulus from the “current account surplus” countries like China

China’s RMB4 trillion stimulus package is a good step in the right direction.  And the provinces have put together a wish list of projects totalling RMB 10 trillion or more, according to AP and CCTV (h/t China Digital Times).  But its not clear that all of these projects are actually incremental projects and many were already planned.  This is headed in the right direction but there seems to be a lot of skepticism that fiscal stimulus in China, where graft and corruption could soak up some of the money, will be successful.

Morgan Stanley: Further Growth Forecast Downgrade amid Deeper Global Recession

Morgan Stanley also indirectly confirms my uncle’s three legged stool framework.  According to Morgan Stanley, 45% of China’s exports go to US, Europe, and Japan.  And 30% of total fixed-asset investment goes into export-oriented manufacturing.  So the first leg is highly dependent on the developed economies.  Secondly, consumer confidence in the property sector is damaged, with people holding back.  Slow property sales will lead to slow investment.  Finally, fiscal stimulus is the third leg.

According the Morgan Stanley, likely policy response will be:

1. more base-interest rate cuts
2. more bond issuances for infrastructure e.g. railway
3. reduced taxes
4. boosting property sector
5. energy price normalization
6. agricultural support to farmers

Biggest downside risk is collapse in real estate investment.

My conclusion

Here’s my conclusions:

• China’s equity markets could fall further.  Many listed companies are dependent on real property or export markets.
• China’s property markets could fall further.  Not only are private individuals freezing up, but the government is also making significant investments in public housing.  That might have some effect on price levels for private housing.  To early to buy.
• RMB will neither appreciate or depreciate.  It will likely hold the dollar peg at the current level, for quite some time.
• China’s labor markets will get more attractive to employers, but less attractive for employees and job seekers.  There will be a large number of unemployed new graduates.  There is risk of social unrest.
• Freedom of speech and media will likely be curtailed further in the future as the risk of social unrest increases.

In summary, the world doesn’t look as wonderful as it once did.

In a rare interview with foreign media, Chinese Premier Wen Jiabao (the popular “Grandpa Wen”) was interviewed by CNN journalist Fareed Zakaria. Although it’s annoying to listen to the translator’s voice dubbed over Wen’s–hasn’t CNN heard of subtitles?–Zakaria and Wen touch on a variety of issues, from the economy to the Dalai Lama.

At the beginning of the first clip, Zakaria explains that one of his conditions for the interview was that he was allowed to ask any question that he wished. While watching the video, there’s certainly a sense that in his carefully phrased answers, Wen is speaking both to the American and to the domestic audience.

Before watching this video, it’s well worth reading this insightful article by James Fallows on the delicate economic balance between China and the US.

Part One:

Part Two:

Some particular highlights:

• Wen refutes the idea that China is a superpower, because of the large gap between the rural and urban areas
• Wen turns the table on Zakaria and asks if he, Zakaria, agrees with him on China’s role in negotiations over North Korea’s nuclear threat
• Zakaria asks Wen about the famous photo of Wen during the Tian’anmen Square protests (Regarding that photo, Richard Spencer has an excellent analysis of Wen’s place as a “good official” in the Chinese political narrative), Wen diplomatically turns that into a question about democracy
• Citing Adam Smith, Wen reconciles the inherent contradiction in having a market economy within a socialist system
• Zakaria asks about the Great Firewall and if it is possible for an advanced society to develop under this kind of censorship

The transcript of the video is also available.

Fiona Lee is a freelance writer/marketer/blogger based in Beijing. She blogs at quirkyBeijing.com

Year 2008 is the 30th anniversary of the introduction of Reform and Opening-up Policy (改革开放政策, Gǎigé Kāifàng Zhèngcè) in China, as well as the One-Child Policy.  Year 1978 was a most significant milestone year in the history of economy for P.R. China.

<South China People Weekly> (南方人物周刊) by South China Weekend (南方周末) has a serial reports called <Reform 30 Years: Everything is from 1978 > (《改革30年：一切从1978开始》) which are very interesting to follow. The recent report  <历数三十年阶层跃动：改变命运的九次机遇> (Counting the changes of classes in 30 years: 9 Opportunities to Change Fates) uses 9 “keywords” to summarize the must significant changes in the past 30 years.  I think these 9 terms are must-known for people want to learn and understand China and Chinese people.

1. 高考 (Gāo Kǎo) : literally means “high exam”. A contraction for “advanced education entrance examination”. The university admission had been suspended for 10 years during the Cultural Revolution from 1967-1976. 1977 was the year for Chinese talents to change their fates when  Gāo Kǎo restarted.   In 2008, the colleges admission rate has reached a record high: ranging from 33%  to 76.8% for different provinces.

2. 倒爷 (Dǎo Yé): were referred speculators who took advantage of a price policy reform in 1979.  There was a “double-prices” system: planned price and market price during the reform. People always found the price difference between the two systems and thus they can perform “倒” (Dǎo) -  buy low and sell high. There was a saying ” 0.9 billion out of 1 billion people is ‘daoing’, the left 0.1 billion are looking for something to ‘dao’. “倒爷” was not a famed class back then, but they helped to break the ice of planned economy.

3. 打工潮 (Dǎ Gōng Cháo):  The government allowed farmers to “reside” in cities and towns in 1984. Since then, thousands of millions farmers have migrated from remote farms/villages in inner China to the coastal cities from late 1980s to early 1990.  I believe the term “打工” (Dǎ Gōng) is from Cantonese which means “to work for an employer instead of being a boss”.  打工潮 means a wave that farmers (most are young people) left hometown to work in the cities. The people are called “打工仔“ (Dǎ Gōng Zǎi, young male) or ”打工妹” (Dǎ Gōng Mèi, young female).  They are the most importance source of labor in China’s economy.

4. 裁军 (Cái Jūn): means disarment. There have been 10 disarments since the country was foundǎě. The largest scale one - a million disarment - was in 1985.

5. 炒股 (Cháo Gǔ): “炒 (Cháo)” means “stir fry” and “股 (Gǔ)” means “stocks”. “炒股“ together means “to keep buying and selling stocks, like stir-frying the stocks”. 1990 was the year that Shanghai Stock Exchange and Shenzhen Stock Exchange were founded. The first generation of “股民” (Gǔ Mín, stock holder) were less educated in value investment or long term investment. They are an emerging group who would learn a painful lesson in the stock market or made their fortune overnight.

6. 下海 (Xià Hǎi): literally means “walking down to the ocean”. It was a phenomena that government officers quit their “iron-bowl” jobs and started to do business, encouraging by Xiaoping Deng’s South Talks in 1992. The term is a metaphor that  to leave a government job is like to risk walking into an ocean where danger and fortune were unknown.  It was estimated that 100,000 officers have Xià Hǎi.

7. 留学 (Liú Xúe): means “studying abroad”. More and more people who studied abroad have become returnees (海归，Hai Gui) and make great contribution to the technology innovation since 1990s.

8. 新经济 (Xīn Jīng Jì): means “new economy”. The representative of “new economy“ was the class of young entrepreneurs emerging with Internet and dot com booms.

9. 海选 (Hǎi Xuǎn): literally means “select from the sea”. The term became popular along with a Chinese version of “American Idol” reality competition show. The idol in China is called Super Girl (超女, Chāo Nǚ) and the show is a girl’s only singing competition. Li Yuchun (李宇春) was the first Super Girl whose fate was changed by all people voting for the first time in China.

Stories behind each of these terms can be a book, and I am not going to expand them here. Try to learn these words if you will, and brag about them with your Chinese friends. I guarantee great discussions will be followed if you bring up any of them. (Tip: Generation 90s might have very limited knowledge of above topics.)

If you have a foreign bank account, foreign currency account, and are a U.S. person, you need to have reported those accounts by June 30, according to this reminder IRS press release (dated 6/17). As you can infer from the date of this post, I blew it and now have to beg for mercy from the Department of the Treasury and IRS.

Dear Department of Treasury, I beg for your mercy.

I now endeavor to help others not make this same mistake by providing some FAQs on the process of submitting the appropriately named FBAR (Report of Foreign Bank and Financial Accounts) form.

But first, some background on how I lost faith in the U.S. dollar

Image courtesy of Freaking News

• On 3/20 I posted about the new CNY exchange traded notes announced by Morgan Stanley & Van Eck Global on 3/17, as a way of hedging RMB appreciation.
• By 3/30 this year, I concluded that RMB appreciation was inexorable and might even require a “one-off maxi-revaluation” to stem speculative inflows.
• On 4/2, I posted about the decline of the US dollar’s reserve currency status as another contributing factor toward USD/RMB exchange rate.
• On 4/11, I posted that I exchanged USD for RMB at the rate of 6.9835 into my China Merchants Bank account, and that I had established an Everbank RMB account (in the US) at 6.9544. On 4/10 the central parity rate was set at 6.992.
• On 7/11, Xinhua announced that the central parity rate of the RMB was set at 6.8397 (see China Foreign Exchange Trading System website Chinamoney.com.cn (zh) for more info). So the RMB has appreciated by 2.2% in 3 months, or a 9.2% annualized appreciation rate. So clearly, putting all my spare cash in RMB (even in the 0% interest Everbank WorldCurrency Access Deposit account) is a no brainer.

USD-RMB exchange rate chart, 2008. See a pattern?

Source: Yahoo! Finance

Now back to the FBAR. I choose to pronounce this “fubar” which has another meaning in English.

Q: Who needs to file the FBAR (Report of Foreign Bank and Financial Accounts)? I mean, I really don’t have a lot of money abroad.

A: If you have a foreign account, and the value of that account exceeds $10,000, you need to file a FBAR. More at IRS.gov here.

Q: Is this part of my Federal Tax Return? Can I get an extension?

A: No and no, that would be too easy and too obvious. According to the IRS:

The FBAR is not to be filed with the filer’s Federal income tax return. The granting, by IRS, of an extension to file Federal income tax returns does not extend the due date for filing an FBAR. There is no extension available for filing the FBAR. Account holders who do not comply with the FBAR reporting requirements may be subject to civil penalties, criminal penalties, or both.

Q: Umm, how was I supposed to know about this?

A: Well did you monitor the press releases on the IRS website? The IRS published a press release IR-2008-79 on June 17 specifically to remind taxpayers to report certain foreign bank and financial accounts by June 30. An interesting fact from the press release:

Since 2000, the number of Report of Foreign Bank and Financial Accounts (FBAR) forms received by the Treasury has increased by nearly 85 percent, from 174,528 in 2000 to 322,414 in 2007. Despite this significant increase in filings, concern remains about the degree of reporting compliance for those who are required to file.

Only 322,414 were received in 2007, and I’m sure that there isn’t 100% compliance with this requirement. But even then, it seems like a very small number of U.S. persons actually have a foreign account.

Q: What’s the deadline again?

A: June 30, 2008 for the 2007 calendar year. Yes, if you haven’t done this already, you are delinquent.

Q: OK, what form do I use?

A: Form TD F 90-22.1 (pdf) located on the IRS website. If you only have 1 account, its less than 1 page long.

Q: Where do I send it?

A: Don’t send it to where you send your normal tax returns. According to the IRS, you should send it here:

U.S. Department of the Treasury
P.O. Box 32621
Detroit, MI 48232-0621

Q: No offense, but I don’t trust anything in the blogosphere these days! Where can I get the official information?

A: Yes, in general, don’t trust bloggers for legal, tax and compliance information unless they happen to be licensed professionals in the right field. So go get the real deal here:

• IRS FAQ on Report of Foreign Bank and Financial Accounts (FBAR)
• IRS copy of Form TD F 90-22.1 (pdf)
• email the IRS: FBARquestions@irs.gov
• call the IRS at (800) 829-3676

Q: Why do I have to do this?

A: This seems to be under the Financial Crimes Enforcement Network (FinCEN), an agency of the US Department of Treasury. It seems partially motivated by tax compliance and partially motivated by addressing money laundering for drug trafficing and terrorist activity.

A few weeks back on May 6, I briefly attended two sessions of Zero2IPO’s China Venture Capital & Private Equity Forum (CVCF). I wrote this post up but then the Sichuan earthquake happened and I was focused on that.

I only had time to attend two sessions that day. Here are my notes and key takeaways from first of the two panels I attended.

Session 1: Venture Capital - Behind the Scenes of 2007 China VC Industry & Projections for 2008

Elliott’s key takeaways:

• There are diverse investing styles among China VCs. Some like innovative, technology-driven deals targeting global markets. Others like execution plays targeted toward fast-growing domestic markets.

• The consensus is that early-stage has the least competition, with growth and mezzanine stage seeing high degrees of deal competition.

• Sectors that seem to be hot include: clean tech, health care, consumer products, consumer services. This is in addition to the traditional VC sectors of semiconductors, computer hardware, software, internet, and media.

• There is increasing regulatory pressure on traditional company structures like the “Sina model” and increasing barriers to foreign direct investment. An alternative joint venture structure is preferred by regulatory agencies like MOFCOM but are more onerous to set up.

• RMB funds are emerging as a new factor. They can be used to invest in new sectors, potentially in partnership with municipal governments. There are significant challenges in making this fund structure work with foreign Limited Partners.

• RMB funds also face challenge from a domestic investing environment where there is a lot of Chinese domestic money that is less demanding from a rights and preferences basis.

• The market feels a little “frothy” as there are lots of first time entrepreneurs and first time VCs. The legal and accounting support for these deals is also in scarce supply, forcing VCs to do more of the deal work themselves.

Panelists:

• Danny Lui, moderator. Zero2IPO Group, Vice Chairman Startup Capital Ventures, General Partner

• Yan Huang. CDH Ventures, General Partner
• Gary Rieschel. Qiming Venture Partners, Managing Director
• Alan Song. SoftBank China Venture Capital, Managing Partner
• Lip-Bu Tan. Walden International, Founder & Chairman
• Yang Xia. Legend Capital, Managing Director
• Joe Zhou. Venture Capitalist

Question: In 2007, how many deals have you done? How much money has gone in?

Yan Huang, CDH Ventures

We’ve invested $200 mm in 18 companies; 1/3 early, 1/3 mid stage, 1/3 inflection point. We invest in clean tech, medical device, internet, education. We focus on growth rate, not initial profitability.

Gary Rieschel, Qiming Venture Partners

We’ve made 14 investments; 10 are pre-revenue. We led 12 deals, and invested $100 mm. We are focused on early stage, where many investors are not comfortable investing.

Alan Song, SoftBank China Venture Capital

We invested in 12 companies, $75 mm. Our fund size is relatively small. Our first fund was $100 mm, our second fund was $200 mm, and today our 3rd fund is a $300 mm fund. We are still focused on early and middle stages. We are opportunistic with late stage deals, where late stage is defined as pre-IPO in China H Shares (Hong Kong stock exchange IPO)

Lip-Bu Tan, Walden International

Walden international is 40% in China, investing in 4-6 companies/year. Our focus is very early stage with 70% investment, and expansion stage with 30% of our investments. We are interested in clean tech, and often traditional businesses like a brick manufacturing machinery company we invested in.

Yang Xia, Legend Capital

We’ve invested in 16 deals, and deployed about $60 mm. We are mostly invested in early stage investments, but in three deals we invested in growth capital. We invest in information technology, design, wireless services, CRO outsourcing

Joe Zhou, raising a fund

I’m interested in clean tech, technology-driven fields like semiconductors, media, advertising, and consumer service.

Q: What industry do you like best in CN? How much money is needed for startup to get to liquidity? How much time is required to get to liquidity? What multiples are you looking for?

Yan Huang
We like clean-tech and alternative energy. An example is the solar sector. This is not a typical VC investment because it is investment-intensive and manufacturing intensive. For example, one firm we invested in, LDK, raised $100 million in six months, and went from zero to IPO in 2 years. Returns, management required, and capital needed is not typical. In this case, we got a 5X return on our investment in nine months.

Gary Rieschel
We don’t look at specific industry sectors, but at technology innovation. We’ve done study tours of: synthetic biology, pharmaceutical, clean tech. There is still very limited innovation base in China. We’re interested in healthcare, such as clinical trial outsourcing, and we’ve made four investments to date in health care. It can require anywhere from $2 mm to 40 mm in capital to get to profitability, depending on the deal. We have the most sector experience to date in healthcare.

Alan Song
We like recession proof industries. With a 550 mm urban population in China, industries like food and beverage and packaging material are interesting, and trade at 30 price-earnings ratios. A deal might require $20 million and 3-4 years to reach IPO, and our return expectations on deals are 10X.

Yang Xia
We like IC chip design/build opportunities. These deals generally require 3 rounds of capital to get from product to business success. They often take 6 years or more. there are lots of plays up and down the value chain in computing and IT.

Joe Zhou:
I don’t like hot sectors. However, we have been looking at clean-technology, semiconductor, media/advertisement, and the consumer service/direct marketing space. We’ve made three investments that went IPO. Respectively, we invested $40mm, $40mm, and $20mm, and achieved IPO valuations of $800mm, $500mm, and $250mm on that investment.

Q: RMB funds are starting to emerge. These funds allow you to make pure RMB investments into a joint venture with a local company, that then allows you to go public on China stock exchanges. What is the opportunity for these funds?

[caveat: I don't fully understand the regulatory issues affecting RMB and foreign funds and the companies that can accept funds from RMB or from foreign funds, so these notes may not make complete sense]

Alan Song
The emergence of RMB funds is in part due to government pressure against the prevailing company structures that have been used by venture backed companies. There are two models, one called the “Rev Trip Model” (Elliott: not sure I have this correct) and the other called the “Sina model.” In the Sina model, a British Virgin Island (BVI) or Cayman Islands holding company is established, into which foreign investors invest funds. Then a Wholly Foreign Owned Enterprise (WFOE) is established in China. That WFOE then contracts with a domestic company owned by a Chinese national. The contracts between the WFOE and domestic company insure that the assets of the domestic company (such as the ICP license) are controlled by the WFOE. Officially, this structure is not allowed by MOFCOM (Ministry of Commerce). They are not supporting this and discouraging the use of this structure.

MOFCOM wants to push the use of Joint Ventures, but there are other issues with that structure. Investors receive the same stock with the same rights, and there are no priority rights that can be offered. So in a venture-backed joint venture structure, the company has another set of agreements that enforces the preferences for the investor. (Elliott: in Western venture deals, investors receive a preferred class of stock that offers certain preferences like liquidation preference, class vote on certain issues, board directors representing the class, etc.)

RMB funds are difficult to set up. Softbank was one of the first foreign VCs to create a joint venture-foreign RMB fund. But approval from multiple regulators is needed: MOFCOM, SAIC (State Adminstration for Industry and Commerce), SAFE (State Administration for Foreign Exchange), and SAST (Elliott: not sure I have this correct: State Administration of Science and Technology). But once the RMB fund is set up, then there is no case by case approval for deals. There is also a tax advantage to the structure, by setting up a “non legal person entity” which acts like a limited partnership, we only need to pay a 10% withholding when funds are … (Elliott: didn’t catch this)

In summary, RMB funds are: hard to set up, but then much easier to invest.

Joe Zhou
There are two problems with RMB funds. As a General Partner, I need to raise funds from RMB sources but it doesn’t fit with current Limited Partner base. If I take care of LP base, then there is a lengthy process of approval for the fund. (Elliott: I think this means that there is a way to set up an RMB fund that receives foreign investment, but the approval process is more onerous, both on the fund setup and also on individual investments? RMB funds that strictly receive domestic investment are more easily approved, not sure.) With foreign LPs, we need to get approval at the point of the investment and then you do capital call from foreign LPs.

RMB funds are a totally different game, because you are competing with local funds for investment. There are different capital market dynamics. For example, we invested in Unipay. There was a different investor base, they didn’t demand any rights and preferences, and those local investors were so much less demanding that we couldn’t ask for what we usually do and still be competitive.

I am going to continue to target technology plays that will list in offshore markets.

Danny Lui

Yes, there seems to be so much local money not looking for much return!

Yan Huang

The RMB funds invest into local Joint Ventures. This creates an opportunity to invest in some different sectors. We can work with municipal governments to let them into the fund as special limited partners into the core fund. Then, we can make RMB investments that can go into foreign-prohibited sectors, with the support of these municipal governments.

Question: What do you think about the overall state of VC and the model?

Joe Zhou
The next two years is the best time for investment in the sectors that we are focusing on. Not worried about market. We are moving from 80x to 50x … (Elliott: did not catch what…price-earnings ratio?)

Yang Xia
There is more money coming in and lots of Chinese money. More people are educating entrepreneurs on how to raise money. There is limited bank capital, so entrepreneurs must seek venture capital. I feel valuations are going up, as “more hunters are in the market.” There is too much money, the market is hot, and deal access is the issue. Early stage deals are more stable, but growth stage deals are crowded.

Lip-Bu Tan
The change in Taiwan and Mainland China’s relationship is creating an opportunity. Big investments from Taiwan companies are investing in China, and there are cross border opportunities. There is lots of competition, and still disjointed valuations between public markets, US venture markets, and China venture markets.

Gary Rieschel
I went through Japan from 1988-1993, and Silicon Valley from 1993-2004. What makes me nervous is that I am seeing lots of first time entrepreneurs, and first time VCs, and Limited Partners interested in going to China. In 1996, the Kleiner Perkins (KPCB) $300 million fund was the largest ever raised. Also, in Silicon Valley, the accounting and legal infrastructure is in place. Banking infrastructure is also in place. But in China, there is less capacity, so VCs need to be prepared to do more of the work. Quote: “You think its competitive in SV? Bull—. In CN, you should see what entrepreneurs do to each other.” There are also lots of challenges. For example, we were involved in “rollup from hell” wher we took four companies in clean tech from four areas with municipal government involvement and needed to negotiate a deal that made sense for all four founders and their four local government sponsors.

Yan Huang
The challenges are obvious. First, finding quality companies at a cheap price. Second, we need to work much harder - need to be lawyers, accountants, etc. and put more time into the deals. The consumer sector is strong. We invested in a soybean milk maker, a traditional industry that is growing 70%/year. Foreign direct investment is also geting worse because of RMB appreciation and hot money.

Gary Rieschel
There is no reasons why FDI would be relaxed.

Summary:

Venture capital in the US follows more clearly defined sectors–high growth, high market multiple opportunities driven by new markets and new technology. Venture capital in China is much more diverse, as the entire economy is high growth, and many sectors that are mature in the US are still at an early stage in China. As a result, there is a lot more diversity in fund strategy in China and the need to excel at pursuing that fund strategy.

Being an UpTake (formerly a Kango) for more than 400 days, I am proud to share with you that UpTake officially opens its Beta doors to everyone TODAY! Uptake is ”

a new vacation search site that has amassed the travel industry’s largest database of hotels and attractions (more than 400,000 in US) and analyzed more than 20 million online opinions from other travelers.

In the age that the “wisdom of crowds” are generated faster than ever, Uptake offers to collect and filter word-of-mouth from the web to make vacation planning easier. UpTake also got press at ReadWriteWeb, TechCrunch, SemanticWeb, SearchEngineLand, Les Explorers and the UpTake blog itself. It is only for United States for now. But Winser Zhao of SinoHotelReservation also wrote about us.
To describe the Uptake services using the geek’s vocabulary, it: uses a travel ontology and natural language analysis to extract meta-tags from the collective intelligence it has collected and returns unbiased, personalized recommendations based on travelers’ facts and feelings.” So how much do you understand from this description? Uptake is a global company with an R&D team in Beijing and Moscow. Based in Shanghai, I have been focusing on web marketing and analytics, and work closely with a web developer in Indonesia. Here are some learning from working in for a global company in China.

Beijing vs. Shanghai?

There are many theories and researches on infrastructure, culture, cost structure etc. to decide where to build an offshore R&D center. But I like the way a Shanghai-based Rob McCormick of Mustang Ventures says to “go back to your hometown” (to build your team if you have to outsource). You see, two core technical team members in UpTake are originally from Beijing. In reality, Shanghai doesn’t have a “Silicon Valley” while Beijing has Zhongguanchun. And people (around me) all agree that Shanghai doesn’t have as good as Beijing of an “academic environment” for research & development. So Beijing is better.

But don’t people in “Silicon Valley” Zhongguanchun “jump trough” (跳槽, job-hopping) a lot?

Recruitment site (zhaopin.com) paid two celebrities Xu Jinglei (徐静蕾) and Huang Jianxiang (黄健翔) to “advocate” people to “jump trough” on TV, subway and newspaper. And with the new Labor Contract Law, it is more costly for a company to lose employees especially after getting them trained. An ongoing trend is that a company would try to “dig” (挖) talents from competitors by offering 1.x salary. So, people in Shanghai, Shenzhen and Beijing are all as equally likely to engage in job-hopping.

I have heard executives in China saying Chinese employees would leave the jobs for very small increasing of salary. But from my observation, more and more people are thinking from a “career path” standpoint rather than “cash”. So the trick to keep employees is to understand what they value most in their career plan. For example, international training, travel and working experience are very important to my peers.

RMB (China Yuan) is appreciating v.s. US dollar, will it still be cost efficient?

Elliott has been watching this issue (see his posts on RMB appreciation) for a while. RMB has appreciated around 9% since May 2007. China is facing possible inflation in 2008 or 2009. April 2008 CPI increased 8.5% (near decade-high level). Shanghai Labor Protection Office (上海劳动保障局) issued a guide on “increasing employees salary” saying “enterprise can increase employees’ salaries 11% in 2008″ in late April. I don’t know how this guideline will affect the salary. But people are expecting to “get a raise” if the price of rices, vegetable oil and pork are keep going up like this.

In addition, Dan Harris from China Law Blog said that “Increased enforcement by Chinese regulators of means that compliance is more important than before”. One major compliance is employee social insurance and allowance. It is important to count these ”hidden” operations costs when budgeting. The regulation on this varies from city to city. In Shanghai, an enterprise pays less for a people who don’t have Shanghai Hukou (户口), but in Beijing, the Hukou doesn’t effect the cost. Be prepared to pay 40% of 5k monthly salary, or 20% -15% of monthly salary 10k- 50k (percentages are rough estimations). I guest I don’t have an answer for this question.

Culture Difference?

In a professional working environment, culture differences highlighted in David’s Mind the Gap posts are less influential than in daily life. Another difference I learned from Shanghai expat Kai Pan is that Chinese like to hang out with friends in a small KTV room (Elliott has very valuable advice on KTV team building), but westerners like to hang out and meet random people in a big room (such as a bar). But if the offshore team are engaging with oversea customers or consumer-oriental products, they need to get trained on the customers’ culture. For example, Uptakers in China are probably the top 99.5% people who are familiar with US geography in this country.

That’s my humble takes on working in an offshore team of a global company in China. What’s your learning of working in China?

Again. welcome to Uptake to plan your next vacation! (Sorry, U.S. hotels and attractions only.)

Just read a nicely-written article with interesting statistics about China at The Independent (via Dan over at China Law Blog).

Though China’s market reforms and subsequent economic growth started 30 years ago, it has only been the recent decade where an appreciable amount of the masses are finally grasping just how profound it is. I say “grasping” because even so, the vast majority of them have yet to appreciate or truly understand just what China’s rise to global economic and political prominence will mean, burdened as they are–understandably–by their fears and ultimately their ignorance.

Here is a good excerpt (emphasis mine):

I am not sure we in the West fully grasp the magnitude of what is happening. Intellectually we can see it affecting us but emotionally it is hard to understand that we are moving towards a world where Western ideas, our ideas, will no longer hold sway. China has other ideas. Those will increasingly co-exist alongside ours in shaping global economic and political development….We will not find this comfortable. What we think will matter less and less. But we cannot do anything about it, and in any case, consider the alternative. Would we really want a China that was failing in economic terms, with all the misery that would cause? That would surely be far more dangerous and disruptive to the world than a continuation of China’s thrilling but terrifying success story. (more…)

Warning: long post about my recent obsession (no, not the other one) with RMB appreciation. My other posts here and here.

Today, I exchanged USD to RMB at the rate of 6.9835. A milestone. It seems like just yesterday that I was calculating the rate at 8:1. (4/12 Update: on 4/3 I also made a deposit into my new FDIC insured RMB Everbank account and the rate was 6.9544.  According to Xinhua the People’s Bank of China (PBOC) set the central parity rate at 6.992.)

Here’s some more links on the subject of RMB appreciation and why it will likely continue. Here’s my quick summary:

• Foreign direct investment and hot money continues to flow in. This more than offsets the reduced trade surplus that results in an appreciated RMB. Therefore, China’s “monetary trap” will continue with the likelihood of a one-off maxi revaluation more likely.
• With a higher RMB, importers are winners, exporters are losers. In general, Chinese people should feel more wealthy, with international travel, foreign real estate, and study abroad less expensive in RMB terms.
• With a 15.6% increase in value since the peg was dropped in July 2005, China’s economy has miraculously offset that increase by generating over 20% productivity growth rate, and overall profit margins increasing from 3% to 6.5%, according to JP Morgan.
• RMB appreciation is a key weapon against inflation. But it is not the only tool. And even with the accelerating appreciation we’ve seen, it appears that inflation has not cooled and now is 13% annualized based on Q1 data.
• In fact, the RMB hasn’t really even appreciated against a trade-weighted basket of currencies. It has only appreciated because the US dollar has depreciated. So expect accelerating appreciation and increasing likelihood of a shocking one-time revaluation.

Michael Pettis: Money Keeps Pouring In

Pettis notes that Foreign Direct Investment (FDI) has increased substantially:

According to the numbers released today, FDI for the first quarter was $27.4 billion – nearly 73% more than the $15.9 billion recorded last year over the same period. So although the trade surplus declined by $4.7 billion, it was more than matched by the $11.5 billion increase in FDI

His argument is simple: even if RMB appreciation cools the trade surplus as one would expect, RMB appreciation is causing more FDI and “hot money inflows” to take the place. This further increases government USD reserves, and further accelerates what he calls “the monetary trap” that will lead inevitably to a large, maxi-revaluation of 15-20% to dramatically change investor expectations:

We are now caught in the most mechanical and frustrating part of the monetary trap in which China has been caught during the past five years. The trade surplus was the original driver of China’s out-of-control money growth, but by now the growth seems to have taken a life of its own as money piles into the country seeking to take advantage of the nearly-inevitable run-up in the value of the currency. Hu Xiaolan, the head of SAFE, said that SAFE and the Ministry of Commerce are going to investigate whether FDI has become a channel for hot money inflows. Hmmm, I wonder.

Pettis’ conclusion: a one-time maxi-revaluation of 15-20% is on its way.

ChinaStakes: April 10 report on the RMB exchange rate

ChinaStakes reports that on April 10 the RMB exchange rate to the USD dropped to 6.9920 and that RMB appreciation was “beginning to transform China from a labor power to a capital power.” This represents a 4.06% increase during Q1 2008.

What is amazing is that the RMB dollar peg of 8.28:1 was lifted July 2005, and that the total appreciation to date is 15.6%. So almost one-third of the appreciation has happened in just the last 3 months. If this isn’t accelerating RMB appreciation I don’t know what is!

Who are the winners as the RMB appreciates?

• companies that import raw materials, e.g. crude iron and ore
• companies that import high tech items, e.g. planes and capital machinery
• people who plan international travel or study abroad. (Min, Stanford is getting more and more affordable by the day!)
• people and companies who want to buy foreign real estate
• RMB denominated assets, such as China’s real estate and stock markets

Guardian.co.uk: China exporters feel pinch of rising yuan, costs

Who are the losers as the RMB appreciates?

Answer: export oriented Small and Medium Businesses.

The Guardian covers this:

Deutsche Bank analysts Jun Ma and Wenjie Lu project that 20% of “Up to 20 percent of low-end exporters could go belly-up this year as the harsher operating environment dissolves profits and demand slows in major markets such as the United States and Europe,” they said. “China’s export sector faces multiple shocks simultaneously this year. Many of these are unintended, but the magnitude of these shocks combined is stronger than we had expected,” they wrote in a recent report.

Small and Medium Businesses (SMB or SMEs) who are export oriented are the clear losers. In addition to having thin margins and competition, they are less familiar with hedging options, such as forwards contracts and options markets.

ChristineLu.com: Frank Gong, JP Morgan, at Harvard China Review Conference.

Christine Lu spoke at and blogged about the Harvard China Review Conference. She highlighed a video of Frank Gong, Managing director and China’s Chief Economist with JP Morgan Securities in Hong Kong. He framed the recent 5 year period as an incredible period of achievement in China that has allowed the government to allow the RMB to appreciate vs. the US dollar.

Here’s my summary of his points:

• The stereotype is that China is a “profitless growth story”
• During the last 5 years, that has not been the case.
• Return on Equity (ROE) in corporate sector has increased from 7 to 17%.
• Profit margins have also been rising
• Three years ago, export sector had only 3% profit margin.
• People believed that if the RMB appreciated by 3%, the export market would just go bust.
• When the peg was lifted, the first year saw only 2.1% revaluation.
• However, three years later, the RMB appreciated more than 15% vs. dollar.
• In 2008, the annualized rate of RMB appreciation is 15%, based on Q1 numbers.
• So what happened to export sector? Did they go bust?
• No. In fact, their profit margin is now 6.5% vs. 3.0% in the past.
• The export sector did not die, but became stronger with a stronger currency. They moved up the value chain and became more efficient.
• Same process has been shown with other developing countries like Japan
• For example, Japan was at 400 Yen to USD and now is 100 Y to USD.
• Even with this revaluation of the Yen, Japanese business has remained competitive.
• The same process happening to the chinese economy as companies are moving up to higher value-added work.
• What has powered this growth is 20% productivity growth rate during lats 5-7 years, the highest in the world.
• Labor cost has been rising over last 5 years. Wage growth up 10-12 %
• Oil and commodity prices also rising.
• In the face of all these changes, productivity growth has more than made up for this.

Michael Pettis: Inflation consensus inching higher

Inflation is still high in China, even with the increase in RMB. March appears to have a 8.3% year on year inflation rate. This means 13% annualized influation in Q1 2008, vs 9.2% annualized inflation rate in Q4.

Speaking of appreciation, today Zhu Baoliang, chief economist at the State Information Center, a think tank under the NRDC (China’s powerful planning agency), wrote an article in China Securities Journal, the official securities newspaper, saying that China had to speed up the rate of appreciation. He said this was needed to combat inflation. Interestingly enough the same newspaper had a front-page commentary arguing that China needed more than just currency appreciation to control inflation.

China Securities Journal is not the formal voice of government policy, but it does have the reputation of reflecting official opinion, so I assume that it must also be reflecting the ongoing debate about how aggressively the currency must be managed to deal with inflation. What does Mr. Zhu mean about a faster rate of appreciation? Since the RMB is already appreciating fairly quickly, I suppose it might be code for a one-off revaluation.

Fighting inflation is clearly a key reason why the monetary authorities need to keep driving the RMB up.

Brad Setser of RGE Monitor: Could a stronger RMB help limit food inflation in China?

Brad’s answer is yes: a stronger RMB could make food imports profitable, and that would cause domestic producers to lower prices.

Brad Setser: A RMB that isn’t appreciating cannot be killing you

Setser critiques a New York Times article entitled Seeing the Sights of Industrial China: 2 Factories, 2 Future. The article first profiles the Shanghai Jinjue Fashion Company and makes the point that low cost exporters are facing pressure because of the rising RMB. It then profiles ReneSola, a solar panel silicon wafer manufacturer. Chinese exporters believe they need to move up the value chain to survive in the face of increasing costs and RMB appreciation. ReneSola did just that and as a result claims that RMB increases resulted in “trivial” money lost.

Brad makes a simple point: the RMB is appreciating against the dollar, but is going down against the euro and yen. “It is basically flat against a trade-weighted currency basket.” And the RMB is down 4% versus the euro in Q1, according to the Wall Street Journal quoted in Setser’s post.