April 22,2008

A-share Alchemy Exposes the Bubble of "Made in China"

By Ma Wenluo

The recent and continuing decline of China’s A-share market, so far by almost 50%, from 6124 points half a year ago to the current 3100 points, has not only saddled investors with huge losses, but also exposed holes in China’s industrial sector. Manufacturers who had nicely padded their profit reports with rich returns from securities investments in 2006 and 2007 have now seen share prices plunge through the floor, taking their profits with them. The situation cannot but remind analysts of the lead up to Japan’s bubble economy in 1980s.


Listed companies accounting for 90% of total market value disclosed in their 2007 annual reports a 40% year on year increase in net profit. But by April 18th, of the 308 companies that have released quarterly performance reports, 88 of them predict a loss or profit reduction. Along with price hikes for raw materials, RMB appreciation, industry business cycles and seasonal factors, securities investment losses are a major reason. 

Foshan Electrical and Lighting Co., Ltd. (FELCO), a leading manufacturer of lighting products known to many as the "Lighting Champion" in China, recently declared that, due to fluctuation in the securities market, the company’s short-term stock investment gains and fair value in the first quarter totaled a loss of 100 million yuan. In the same period last year the company reported a gain of 100 million yuan. Although the company’s production and operations run smoothly, this will still lead to a loss of 75 million yuan.

In 2007, due to investment gains, FELCO’s gross profit had increased by 56%, much higher than the operating income growth, which stood at 19%. The company’s investment gains grew by 351% over the previous year to about 330 million yuan, contributing about 60% to the company’s net profit. The 32.73 million shares of the Bank of Communications held by the company gained 600% book profit, and the six funds the company invested in also saw a 200% growth by the end of the year.  

China’s stock index grew by 100% in 2007. Companies in low profit industries raised loans to invest in the securities and real estate markets. Gains from the stock market were much higher than those from the manufacturing industry, an extreme temptation for FELCO, a leading enterprise in its industry.

And not only for FELCO.  Guangdong Fenghua Advanced Technology (Holding) Co., Ltd., listed on the Shenzhen Exchange, is a high-tech company engaged in production of new chip components, electronic materials, integrated circuits and other basic electronic information products. The average profit margin for the electronic component industry in 2007 was a mere 2.1%. However, Fenghua also invested tidy sums in securities. In the first quarter of 2007 the growth of the company’s short-term stock investment returns and fair value hit 50,505,000 yuan, almost equal to its net profit of 52,773,000 yuan. Recently, though, it predicted in the first quarter of 2008 a loss of 73,000,000 yuan. The advanced technology company had become a failed securities speculator. 

In 2007 the average profit ratio for the Chinese textile and clothing industry was 3.6%. Youngor Group Co., Ltd., a leading clothing manufacturer, holds shares of 10 listed companies, including CITIC Securities, Haitong Securities, and the Bank of Ningbo, which contributed 68% of its profit in 2007. During recent years, the company’s income from real estate was much higher than that of its core business. In 2007 its income from real estate alone totaled 4 billion yuan, a growth of 100% over the previous year, while in 2006 its total income was 6 billion yuan. In early 2008 Youngor invested 1.8 billion yuan of short-term financing bills in the real estate industry. But its effort to switch industries may be suspended or halted by the slumping stock market, which has greatly reduced the fair value of the stocks held by the company, and the languishing real estate market. 

The current behavior of Chinese enterprises reminds people of the situation in Japan 20 years ago, when the Nikkei Index rocketed 400% within five years. The Chinese stock market grew from 998 points in June, 2005, to 6124 points in October, 2006, over 500% in less than two years, greatly tempting Chinese companies to ignore their main businesses and focus on securities investment.

Similarly, in Japan in the late 1980s a excess liquidity due to the appreciation of its currency also drove too much money into the stock and real estate markets. Japanese companies saw profits go through the roof. At the time they called it "alchemy," the transformation of base metals into gold. Then came the collapse of the bubbles. The huge extent of loans to the "sogo shosha," vast diversified conglomerates with close relationships to banks, gone bad with the fall of the stock and real estate markets was a direct cause for Japan’s "lost decade" in the 1990s. Alchemy became anti-alchemy.

Comparisons between Japan in the 80s and 21st century China are limited, but the similarities are instructive. Currently in China, low profit margins due to fierce competition push companies to look for profit outside their core concerns and into areas outside their expertise, areas where the profits look great but where the risks go unrecognized.  The fantastic profits and growth of "made in China" stand now revealed as much of a bubble as the markets they were based on. Time for "made in China" to get back to its real work.

Alchemy, the transforming of lead into gold, was always an illusion.  But anti-alchemy, the useless wasting of great wealth, has always been only too real.

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