On the rise of China

Again via Disqus, another comment I made on Fred's blog last week, this one in response to a comment by serial entrepreneur, civil engineer, retired U.S. Army officer, and current CEO of a bulletin board company¹, JLM:

Interesting you mention James Kynge. I've blogged about his "China Continental" thesis a few times (Most recently, in the footnote to this post, where I also linked to an FT editorial that had a more bearish take on China's economy). I hope Kynge is right that China is transitioning to an economy fueled by internal demand; that would be good for average Chinese and the rest of the world too.

I have a tough time envisioning China becoming a global military hegemon, for a couple of reasons. The first reason that comes to mind is that the post-war status quo of U.S. Naval hegemony in the Pacific has been pretty good for China and its more advanced neighbors, economically speaking. Why mess with a good thing?

The second reason is that it's a lot easier to project power globally when you are surrounded by oceans on two sides and friendly neighbors to the North and South. China is cursed by geography by comparison. Consider some of its neighbors: Japan, which mopped the floor with China in WWII; Vietnam, which fought China to a standstill, if memory serves, a few decades ago; Russia; Mongolia -- sparsely populated, but a country whose ancestors conquered China and most of the rest of the world; India, the world's most populous democracy (and a country China has fought a war or two with in the past, when India was weaker); Pakistan; Afghanistan. Add to that mix separatist Tibetans in China's southwest and separatist Muslims in China's northeast. I suspect the submarine-building (China still spends a pittance on military procurement, compared to us) is more about keeping the steel mills humming.

A more likely scenario -- and a more ominous one -- if current trends (i.e., certain self-destructive American policies) hold isn't China replacing the U.S. as a global superpower, but the world having no such superpower.

¹One that had an Altman Z"-score in the distress zone, last time I checked. I mentioned this to JLM via e-mail, and he said he penned (keyed?) an in-depth response, but it was eaten up by the aether and I never received it.

What would have been spectacular timing

A day late. Damn. Details later.

Update: Here are the details I didn't have time to write about earlier. Sorry about not writing this out earlier, but it takes me a while to write these posts, and I just didn't have the time to do that earlier today, so I posted that as a placeholder.

As I mentioned in a previous post, the biggest risk I see with Alloy Steel International (OTC BB: AYSI.OB) is, "a nasty exogenous event (e.g., a big fall-off in Chinese demand for industrial commodities¹)". For companies that have options traded on them, you can of course buy puts on the company to hedge your position. How, exactly, to do that in an optimal way is what the next subscription-based site, Portfolio Armor, is about (Portfolio Armor isn't live just yet, but that's its logo above²). Portfolio Armor's proprietary algorithm tells you exactly how many of which put options to buy to give you the level of protection you specify at the lowest cost.

Of course, Alloy Steel doesn't have any options traded on it, so there would be no way to use options to hedge against any purely idiosyncratic risk, but there are ways to hedge against the exogenous risk. I thought about this last night and figured that a way to do that would be to buy puts on a steel company with significant exposure to China. Then I figured, instead of using just any steel company with exposure to China, why not try to find a financially distressed one? I found just such a company using the screener on Short Screen. To give me a rough idea of how many of which of that company's puts to buy to hedge my AYSI position against the specific exogenous risk I mentioned above, I e-mailed my developers at around 8:30 am, asking them to run the algorithm on the steel company I found. When I got the answer from them later, I went to pull up the option and learned that the financially distressed steel company had announced a secondary offering at around 9am today, and on news of that dilution the stock dropped more than 20%, and the optimal put contract spiked more than 50%. Too bad I didn't think of this a day earlier.


¹That's the big question. We presented the positive view on China this post back in September, "China's new self-propelled economy", and the editors of the FT presented the scary view in this editorial last month, "The cost of China’s excess capacity". In a nutshell, the positive scenario: China's big stimulus this year has helped transition its economy to one fueled more by internal demand, in which case there should be continued growing demand for industrial commodities to build infrastructure in underdeveloped parts of China, manufacture first refrigerators for rural Chinese, etc. And the negative scenario: China's stimulus has been mainly hair of the dog, propping up an unsustainable status quo relying on massive trade surpluses that over-extended Western consumers can no longer support.

²Recall our discussion in this recent post of the initial challenges in coming up with this logo.

More Alloy Steel

Bought a few more shares of Alloy Steel International (OTC BB: AYSI.OB) at $2.18 today. I am curious what Q4 earnings number it will take to support the current price. My initial guess was 7 cents, but my small survey (n=4) on iHub resulted in average of 5.6 cents as the earnings number needed to support the current price. Maybe I'll try a similar survey on AYSI's Yahoo message board (if anyone reading this owns the stock, feel free to leave your guess in the comment thread -- remember though, this isn't your guess of what the earnings will be, but what they would need to be to support the current share price). The company had announced that it was running two mills at full blast after landing its huge supply deal with BHP, but that wasn't the case for the full quarter. The company's highest quarterly earnings were 6.8 cents in Q2 of 2008, and that was with one mill running at full capacity. That was with an earlier version of the company's product though.

My guess is that the company will release record earnings and trade higher on that news, which is why I picked up a little more here. If it disappoints on the quarter, but the longer-term thesis remains intact, I'll buy more on the drop. Barring a nasty exogenous event (e.g., a big fall-off in Chinese demand for industrial commodities1), I think I will do well adding at this price.

¹That's the big question. We presented the positive view on China this post back in September, "China's new self-propelled economy", and the editors of the FT presented the scary view in this editorial last month, "The cost of China’s excess capacity". In a nutshell, the positive scenario: China's big stimulus this year has helped transition its economy to one fueled more by internal demand, in which case there should be continued growing demand for industrial commodities to build infrastructure in underdeveloped parts of China, manufacture first refrigerators for rural Chinese, etc. And the negative scenario: China's stimulus has been mainly hair of the dog, propping up an unsustainable status quo relying on massive trade surpluses that over-extended Western consumers can no longer support.

Time for tariffs?

Calls from some quarters for tariffs on Chinese imports to the U.S. are nothing new, but this one in yesterday's Financial Times, from a former University of Chicago professor named Robert Aliber, caught my attention, "Tariffs can persuade Beijing to free the renminbi". Excerpt:

Americans have been patient - too patient - in accepting the loss of several million US manufacturing jobs because of China's determined pursuit of mindless mercantilist policies. The absurdity of the current situation is that China's currency protectionism has more of an impact on American manufacturing employment than US fiscal policy.

The US can help China make the necessary adjustments toward a reduction in imbalances by adopting a uniform tariff of 10 per cent on all Chinese imports, based on their values when they enter the US. Six months after the establishment of this tariff, the rate would increase by one percentage point a month until the Chinese trade surplus with the US declines to $5bn a month.

The precedent is clear. In August 1971 the US adopted a 10 per cent tariff on dutiable imports to induce Japan and several European countries to allow their currencies to float. The measure quickly accomplished its goal - the European countries stopped pegging their currencies immediately and the Japanese allowed the yen to float a week later. The tariff was eliminated after a few months.

[...]

It should not take long for the Chinese to learn that they are much more dependent on access to the US market than Americans are dependent on Chinese goods. Virtually all of the goods that the US imports from China could be sourced at home or in Indonesia, the Philippines or South Korea. China would find it difficult to find other foreign markets for the goods that it no longer sold in the US.

The Chinese might huff and puff about US protectionism and threaten that they will no longer finance the US trade deficit - but that chatter would be hollow because the single most important cause of that deficit is Chinese purchases of US securities. Such an initiative by the Obama administration would be much more significant as a jobs-creation measure than anything else it could adopt.

The Chinese authorities can hide behind the smokescreen of American protectionism to undertake the adjustments that some in the People's Bank of China must already recognise is inevitable. The experience of the early 1970s suggests that once the logjam has been broken and imbalances reduced, the Americans and the Chinese can focus on North Korea, Iran and other contentious issues.

SNL on President Obama's China visit

Hat tip: Kid Dynamite.

Alloy Steel expands into Indonesia

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Alloy Steel International (OTC BB: AYSI.OB) filed this 8-K today:

Quantum Leap for New Super Alloy

High demand for new Super Alloy Arcoplate products has prompted Alloy Steel International to expand their operations into Indonesia by the appointment of a company to carry out functions on its behalf and under its direction.

The first overseas engineering office, based in Jakarta, will house both marketing staff and engineering professionals.

The Indonesian capital was chosen as the hub of operations due to its proximity to the expanding South-east Asian market, the lower manufacturing costs and the availability of highly qualified technical staff.

Possible sites for the manufacturing facility are undergoing analysis regarding capital costs of construction and fit out.

The Arcoplate Super Alloy, released in July this year, can be manufactured thinner thus lighter and more durable than older white iron type products. A one inch Arcoplate Super Alloy plate can replace white iron products up to six inches thick. Successful laboratory tests and field trials have shown cost and energy savings by reducing friction, greater ease of handling, and less production shutdown time for plate replacements.

Mining clientele have indicated they will specify Arcoplate in their plant expansions, upgrades and in new mining and mineral processing applications worldwide. The new thicker sizes are in heavy demand worldwide.

The new Indonesian branch of Alloy Steel International will cater for clients extending their mining operations into Indonesia and will allow for further expansion into the Chinese, Indian and Mongolian markets.

Alloy Steel International Chairman, Mr Gene Kostecki, estimates that once the company has the facility to service the Indonesian market from a local base, demand for Arcoplate in Indonesia could exceed $10 million per annum.

There was some question on Alloy Steel's i-Hub message board about whether this is a licensing deal or not. I suspect it isn't, but I sent an e-mail to the CEO asking if he could clarify. If I hear back from him, I'll update this post accordingly.

Update: Alloy Steel International's CEO Gene Kostecki responded via e-mail saying that this was not a licensing deal. He said the company was avoiding those out of concerns about protecting its intellectual property, which he said was the company's highest priority. He said that this expansion would enable AYSI to take advantage of Indonesia's lower labor costs and proximity to markets in China and India. If I get his permission to do so, I will quote his e-mail verbatim here, but those were the key points.

Second Update: I have his permission, so here's his e-mail:

Dear David:

We are all very excited with our expansion program into South East Asia as it will give the company a great stepping stone into the entire ASEAN Market which is one of the fastest growing economies in the world.

The new government in Indonesia is fast tracking all economic development and investment in Indonesia. With Indonesia’s low labour costs and proximity to China and India it will place the company in a very competitive position to capitalize on Asian markets in this part of the world without sacrificing quality and margins, yet still being price competitive against low end products that portray themselves as wear plate.

David, we do not see the need to enter into any licensing agreements with any third party as this could potentially compromise our position in protecting our intellectual property rights in this part of the world. Protecting our intellectual property rights is the company's top priority.

Sincerely,

Gene Kostecki

Questions for the CEO of Alloy Steel International?

On the off chance any of you have a question for the Hank Reardon of wear plates, leave it in the comment thread below. Mr. Kostecki has apparently indicated through an intermediary a willingness to chat with me.

China's New, Self-Propelled Economy

A few months ago, we mentioned James Kynge's 'China Continental' thesis. In that post, we excerpted an essay Kynge had written in the Financial Times explicating his thesis for China's continuing growth in the wake of declining exports. This was the excerpt we quoted from Kynge's essay:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China’s case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world’s fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to “China Continental” – the transition of the world’s most populous country into an increasingly self-propelling economic force.

A couple of items that appeared earlier this week in the Financial Times suggest that Kynge's thesis may have been correct. This item from Monday's Lex column, "China's Stimulus" is one, and Martin Wolf's column from Monday's FT, "Wheel of fortune turns as China outdoes west", is another. Here are a couple of brief excerpts from both.

Lex:

There is no precise breakdown of stimulus spending by geography. But $366bn falls under the heading of infrastructure and post-quake recovery; another $113bn under public housing and rural development. Only a small slice – $54bn to stimulate “technological innovation” – seems to explicitly favour developed regions. Output in 12 western provinces grew an average 8 per cent in the first half – a whole percentage point better than 11 provinces in the east.

This structural shift was evident in first-half figures from ICBC, China’s largest commercial lender. Its year-on-year percentage increase in operating income in the Yangtze and Pearl river deltas fell, but rose in central and western regions. In short, China would rather finance roads in Chengdu than sweatshops in Guangdong. Many private, export-led companies in coastal areas, lacking collateral in the form of land or government relationships, are still struggling for funds. Trade data on Friday showed exports and imports falling for the 10th month, year-on-year. Weak external demand is not the only cause; this is an unabashed internalisation of growth.

Martin Wolf:

China has emerged as the most significant winner from the financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so?

Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy.

[...]

Three immediate questions arise. How has China responded to the crisis? Is its resurgent growth sustainable? How far will its recovery help the world economy?

The answer to the first question is: astonishingly. According to data reported at the end of last week, industrial output expanded 12.3 per cent in the 12 months to August, up from a 10.8 per cent increase in July. This is the fastest growth for a year.

[...]

Is this growth surge sustainable? In a word, yes. Inevitably, the torrid growth of bank credit and money is spilling over into asset prices, particularly equities. But there is little danger of excessive inflation in an economy with an appreciating currency, fully embedded in a world economy still threatened more by deflation than by inflation, at least in the near term. Moreover, the government is solvent. As premier Wen Jiabao noted in Dalian, "we . . . kept budget deficit and government debt at around 3 per cent and 20 per cent of the GDP respectively". Should bad loans increase, China is well able to recapitalise its financial system.

This is good news, of course, for companies selling raw materials to China, for vendors to those companies (e.g., Alloy Steel International), and, more broadly, for countries such as Australia and Brazil that export significant amounts of raw materials to China.

Alloy Steel's 10-Q

The company (OTC BB: AYSI.OB) swung to a loss of ($437,951) on sales of $1,307,160 in the quarter ending June 30^th, but the 10-Q includes this news:

The Company has recently been advised of its successful tender for a significant contract with BHP Billiton Ltd, with the first order release being received by the Company to the value of approximately $3,200,000 subsequent to the reporting date.

Alloy Steel was also the subject of this longer, recent post.

News from Alloy Steel

The company (OTC BB: AYSI.OB) filed this 8-K earlier today:

Mill Commissioning

The company advises that the new ARCOPLATE manufacturing plant specifically designed to produce extra thick (up to 20/11mm) and super alloy wear plate has been commissioned and has commenced production.

The new mill is the only one in the world capable of producing a bi-metallic fused super alloy wear plate in a thickness of application of up to 20 mm (just over ¾ of an inch) in a single continuous casting operation.

The conventional method used to produce a hard surface overlay is by a welding method which can only achieve a weld surface which at best is ¼ inch or 6mm thick in a single pass and is flawed with major quality technical limitations.

The new AYSI new technology has overcome all the known technical difficulties and is capable of fusing 20mm or super wear resistant alloy onto a ½ inch or 12mm steel backing plate.

This is a significant technological breakthrough which should see this plate be specified consistently in new mining projects and become the norm for replacements in upgrades for existing mining operations.

Mr. G Kostecki C. E. O. of the company is very encouraged with the strong interest being shown by all the major producers who have seen the test samples and the technical reports and predicts a large future demand for the product.

Mr. Kostecki was responsible for the technical innovation and development of the new process and alloy formulation.

These reports have been carried out by independent laboratories.

Whether any of the demand predicted above will be apparent in the 10-Q Alloy Steel is going to file next week remains to be seen, but this is good news. More generally, the surge in Chinese steel production and the recovery of iron ore prices has been good news for Alloy Steel's mining company customers (how sustainable Chinese demand will be remains to be seen).

I picked up a few more shares of Alloy Steel at .325 on Tuesday, when the stock dipped about 20% on no news. Still keeping most of my powder dry for investing in another asset class though.

Incidentally, a couple of weeks ago, I mentioned Alloy Steel in a comment thread on Fred Wilson's blog, in response to a comment by Mark Cuban about how he'd be more interested in investing in a Rearden Steel¹ than the next social media start-up. That was a brain cramp on my part: Even if Cuban could buy all of Alloy Steel, it wouldn't be a big enough investment to be worth his time. Plus, Cuban (wisely) likes to invest where he has an information advantage², so unless he has connections in the wear plate or mining industries, he probably wouldn't seriously consider investing in this sort of company.

¹An allusion to Hank Readen's company in Atlas Shrugged.

²Writer, entrepreneur, and angel investor Tim Ferriss seconded Cuban's point in a post last fall. Ferriss wrote that he feels more comfortable investing in tech companies where he has some inside knowledge and connections than swimming with the sharks in the stock market.

BRIC Versus CRIB

In an op/ed in yesterday's Financial Times, Michael Hudson, an economics professor at the University of Missouri, ventriloquized the thoughts of foreign opponents of the United States, while warning of ominous consequences from the summit in Russia this week of the BRIC countries (Brazil, Russia, India, and China) ("Washington Cannot Call all the Shots"):

Many foreigners see the US as a lawless nation. How else to characterise a country that holds out a set of laws for others – on war, debt repayment and the treatment of prisoners – but ignores them itself?

[...]

It is no mystery to other countries how the US remains above the law. Foreigners see a financial system backed by American military bases encircling the globe. The IMF, World Bank, World Trade Organisation and other Washington surrogates are seen as vestiges of a lost American empire no longer able to rule by economic strength, left only with military domination. They see this hegemony cannot continue without adequate revenues and are attempting to hasten the bankruptcy of the US financial-military world order.

[...]

US officials wanted to attend Yekaterinburg as observers. They were told no. It is a word that Americans will hear much more in the future.

Mark Chandler, Global Currency Strategist at Brown Brothers Harriman, had a slightly different take on this summit recently ("Bric or Crib?"):

Brazil, Russia, India and China, now collectively known as the BRICs, will hold a summit in Russia on June 16th. Besides the Goldman Sachs invented moniker, these countries have very little in common except for the fact that they believe, to seemingly varying degrees of intensity, that they deserve greater influence in the conduct of world affairs than they currently have. And given the enormity of US power, as hard-core realists, they know any increase in their power and influence will come at the expense of America’s.

[...]

One of the most important reasons why the BRICs do not have the economic clout that they would like is frankly they don’t deserve it. Goldman-Sachs had a story (and more) to sell with its BRICs concept, but those same letters spell a real word, CRIB. The point is that the countries, outside of China, are not among the largest.

According to Bloomberg data, at the end of last year, China was the fourth largest economy ($3.2 trillion), behind the US, Japan, and Germany. This of course takes the Chinese data at face value, and given the often large gaps between energy production and reported GDP growth, as well as the amazing consistency of the pace of growth, many often cast a suspicious eye on Chinese data.

With a GDP of $1.3 trillion in 2008, Brazil was the 10th largest economy, though it is roughly half the size of France, which is the 6th largest economy. Russia and India were neck-and-neck for 11th and 12th places with each having produced about $1.2 trillion of goods and services last year. Spain’s economy is nearly 20% bigger than Russia’s and India’s, and it is the 8th largest economy. Together the BRICs account for a little more than 12% of the world’s GDP, and China alone accounts for half of that.

James Kynge's Thesis: "China Continental"; John Authers's Follow Up

James Kynge laid out his thesis for China's continuing growth in the wake of declining exports in a recent Financial Times column, "China Continental". Excerpt:

China is going continental. Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China’s case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world’s fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to “China Continental” – the transition of the world’s most populous country into an increasingly self-propelling economic force.

Kynge lists a few different specific metrics to back up his case, including increases in China's retail sales and domestic cargo traffic, and survey results on consumer spending intentions, before addressing China skeptics in his conclusion:

Sceptics argue that China’s performance this year has come through huge but ultimately unsustainable government intervention. Such spending, they say, will boost growth for a time but achieve little but industrial overcapacity in the longer run. These arguments are not without merit, but they miss a newer, more interesting prospect; that Chinese growth is increasingly self-generating and continentally driven.

Recent moves in the commodity markets support Kynge's thesis, as John Authers noted in his Financial Times column today ("China's health gives rise to fresh growth theory"):

Industrial commodities, that benefit most from economic growth, have surged, with lead and copper up more than 50 per cent in three months. Gold, an inflation hedge, has barely gained.

Authers went on to summarize the debate about China's economy (both sides of which have been fleshed out by Kynge and Zeihan, respectively):

As a whole, even before yesterday's strong headline to the US jobless report, world markets were plainly working on the assumption that China has saved the world from Depression. Is the market right to do so?

There are two camps. The optimistic side, laid out by James Kynge in the Financial Times last week, is "China Continental"; like the US in the late 19th century, China can turn itself into a great economic power, by building links to its interior and unleashing its buying power.

The pessimistic side suggests China has poured money into the public sector, and will merely form excess capacity. The huge demand for industrial metals may be artificial.

Electricity generation is down year-on-year. Supply managers surveys show new export orders are barely expanding. So maybe China is caricaturing the US in the 1930s, and paying some people to dig holes and others to fill them in.

If so, the gains could soon be in for another ugly recoupling. Either way, nothing just now is more important than the health of the Chinese economy.

Geography as Destiny? Zeihan on China

Below is an excerpt from the China-related part of Peter Zeihan's column The Geography of Recession.

China's core is the farmland of the Yellow River basin in the north of the country, a river that is not readily navigable and is remarkably flood prone. Simply avoiding periodic starvation requires a high level of state planning and coordination. (Wrestling a large river is not the easiest thing one can do.) Additionally, the southern half of the country has a subtropical climate, riddling it with diseases that the southerners are resistant to but the northerners are not. This compromises the north's political control of the south.

Central control is also threatened by China's maritime geography. China boasts two other rivers, but they do not link to each other or the Yellow naturally. And China's best ports are at the mouths of these two rivers: Shanghai at the mouth of the Yangtze and Hong Kong/Macau/Guangzhou at the mouth of the Pearl. The Yellow boasts no significant ocean port. The end result is that other regional centers can and do develop economic means independent of Beijing.

With geography complicating northern rule and supporting southern economic independence, Beijing's age-old problem has been trying to keep China in one piece. Beijing has to underwrite massive (and expensive) development programs to stitch the country together with a common infrastructure, the most visible of which is the Grand Canal that links the Yellow and Yangtze rivers. The cost of such linkages instantly guarantees that while China may have a shot at being unified, it will always be capital-poor.

Beijing also has to provide its autonomy-minded regions with an economic incentive to remain part of Greater China, and "simple" infrastructure will not cut it. Modern China has turned to a state-centered finance model for this. Under the model, all of the scarce capital that is available is funneled to the state, which divvies it out via a handful of large state banks. These state banks then grant loans to various firms and local governments at below the cost of raising the capital. This provides a powerful economic stimulus that achieves maximum employment and growth — think of what you could do with a near-endless supply of loans at below 0 percent interest — but comes at the cost of encouraging projects that are loss-making, as no one is ever called to account for failures. (They can just get a new loan.) The resultant growth is rapid, but it is also unsustainable. It is no wonder, then, that the central government has chosen to keep its $2 trillion of currency reserves in dollar-based assets; the rate of return is greater, the value holds over a long period, and Beijing doesn't have to worry about the United States seceding.

Because the domestic market is considerably limited by the poor-capital nature of the country, most producers choose to tap export markets to generate income. In times of plenty this works fairly well, but when Chinese goods are not needed, the entire Chinese system can seize up. Lack of exports reduces capital availability, which constrains loan availability. This in turn not only damages the ability of firms to employ China's legions of citizens, but it also removes the primary reason the disparate Chinese regions pay homage to Beijing. China's geography hardwires in a series of economic challenges that weaken the coherence of the state and make China dependent upon uninterrupted access to foreign markets to maintain state unity. As a result, China has not been a unified entity for the vast majority of its history, but instead a cauldron of competing regions that cleave along many different fault lines: coastal versus interior, Han versus minority, north versus south.

China's survival technique for the current recession is simple. Because exports, which account for roughly half of China's economic activity, have sunk by half, Beijing is throwing the equivalent of the financial kitchen sink at the problem. China has force-fed more loans through the banks in the first four months of 2009 than it did in the entirety of 2008. The long-term result could well bury China beneath a mountain of bad loans — a similar strategy resulted in Japan's 1991 crash, from which Tokyo has yet to recover. But for now it is holding the country together. The bottom line remains, however: China's recovery is completely dependent upon external demand for its production, and the most it can do on its own is tread water.

James Kynge of the Financial Times has an entirely different take on China's near-term economic prospects. We'll save Kynge's thesis for the next post, to keep this one from getting too long.

The image above comes from Zeihan's column.

Geography as Destiny?

John Mauldin's latest "Outside the Box" piece is a column by Peter Zeihan of Stratfor, The Geography of Recession. In a time when many of us are thinking about the challenges the U.S. faces, Zeihan reminds us of some of our geographic blessings, and contrasts American geography with that of some other powers. Below are a couple of excerpts.

The most important aspect of the United States is not simply its sheer size, but the size of its usable land. Russia and China may both be similar-sized in absolute terms, but the vast majority of Russian and Chinese land is useless for agriculture, habitation or development. In contrast, courtesy of the Midwest, the United States boasts the world's largest contiguous mass of arable land — and that mass does not include the hardly inconsequential chunks of usable territory on both the West and East coasts.

Second is the American maritime transport system. The Mississippi River, linked as it is to the Red, Missouri, Ohio and Tennessee rivers, comprises the largest interconnected network of navigable rivers in the world. In the San Francisco Bay, Chesapeake Bay and Long Island Sound/New York Bay, the United States has three of the world's largest and best natural harbors. The series of barrier islands a few miles off the shores of Texas and the East Coast form a water-based highway — an Intercoastal Waterway — that shields American coastal shipping from all but the worst that the elements can throw at ships and ports.

The real beauty is that the two overlap with near perfect symmetry. The Intercoastal Waterway and most of the bays link up with agricultural regions and their own local river systems (such as the series of rivers that descend from the Appalachians to the East Coast), while the Greater Mississippi river network is the circulatory system of the Midwest. Even without the addition of canals, it is possible for ships to reach nearly any part of the Midwest from nearly any part of the Gulf or East coasts. The result is not just a massive ability to grow a massive amount of crops — and not just the ability to easily and cheaply move the crops to local, regional and global markets — but also the ability to use that same transport network for any other economic purpose without having to worry about food supplies.

The implications of such a confluence are deep and sustained. Where most countries need to scrape together capital to build roads and rail to establish the very foundation of an economy, transport capability, geography granted the United States a near-perfect system at no cost. That frees up U.S. capital for other pursuits and almost condemns the United States to be capital-rich. Any additional infrastructure the United States constructs is icing on the cake.

[...]

The United States has exited each decade since post-Civil War Reconstruction more powerful than it was when it entered it. While there are many forces in the modern world that threaten various aspects of U.S. economic standing, there is not one that actually threatens the U.S. base geographic advantages.

Is the United States in recession? Of course. Will it be forever? Of course not. So long as U.S. geographic advantages remain intact, it takes no small amount of paranoia and pessimism to envision anything but long-term economic expansion for such a chunk of territory.

Zeihan doesn't mention the impact of demography in his column, but, in the most extreme example, it's worth remembering that what is now the U.S. had all of the same geographic advantages but wasn't an economic power before European settlement.

Zeihan's comments on China's geography are worth excerpting too, but to keep this post from getting too long I'll do so in a separate post.

The image above comes from Zeihan's column.

China's Economic Transition

China's exports were down 22.6% year-over-year in April, continuing a six month negative trend. That's the obvious cloud in China's economic forecast, but in an article in yesterday's Financial Times ("Chinese tap an inner dynamic to drive growth"), James Kynge highlighted the silver lining:

Just as the US during the 19th century underwent a transition from export-oriented growth to a greater reliance on inner dynamism, so China is looking inwards for the engine to drive its economy.

In China's case it is still early days, but evidence suggests the conventional view of an export-dependent, river delta-driven economy no longer matches the reality. The argument here is not that trade has somehow become unimportant to China, but rather that the energy generating the world's fastest economic growth rate this year is increasingly coming from within.

A series of indicators reveals the shift to "China Continental" - the transition of the world's most populous country into an increasingly self-propelling economic force. There are caveats, of course, but first the evidence.

Retail sales have held up much better in China this year than in other big economies, growing at a real 15.9 per cent in March year-on-year. But more important than the overall trend is the composition of the retail spending.

The most robust consumer spending figures are coming from inland and lower-tier cities rather than from the traditional growth powerhouses clustered around the Yangtze and Pearl river deltas.

Kynge also notes another sign of this transition, "that domestically bound cargo traffic through ports is increasing year-on-year, while foreign trade volumes are slumping".

The photo above, of a Wal-Mart in Chongqing, comes from the USDA's Foreign Agricultural Service. Chongqing is one of the lower tier cities Kynge referred to in his article.

Alloy Steel's 10-Q

Alloy Steel International (OTC BB: AYSI.OB) filed its 10-Q today (summary; full filing). Another break-even quarter: $39,000 of net income on $1,479,774 of sales. As I mentioned in a recent post ("Run Silent, Run Deep"), I had expected a loss this quarter, so I'm (mildly) pleasantly surprised the company was able to break even during what might turn out to have been the worst quarter of the current global recession. Judging from the price action today though, others had higher expectations. Management offered this comment on the quarter and the company's prospects going forward:

The decrease in sales for the period is representative of the general downturn being experienced in the world economy. The number of orders received by the Company have declined as demand for our product reduced as various mining companies announced that new mining projects were being delayed and/or existing mining projects were being wound back until demand for commodities increased. The Company has submitted tenders for the supply of Arcoplate where possible and is confident that these will be successful with orders likely to be received in the next three to six months. The Company has continued to promote its product in the market place as a superior option for maintenance, as well as seeking entry into other markets which were previously limited by the Company’s ability to meet the demand existing prior to the economic downturn. The Company is confident of being able to present its product well in these new markets, and anticipates additional orders will be generated from these new locations.

Updated Altman Z-Score for Alloy Steel

In a previous post ("Using the Altman Z-Score to Calculate the Risk of a Company Going Bankrupt"), we described the Altman Z-Score model for manufacturing companies:

The Altman Z-Score is a model developed in 1968 by NYU Finance professor Edward Altman (pictured above) to predict the likelihood of a company going bankrupt within the next two years. According to Investopedia,

[R]eal world application of the Z-Score successfully predicted 72% of corporate bankruptcies two years prior to these companies filing for Chapter 7"

In creating the Z-Score model, Professor Altman studied an initial sample of 66 firms, half of which had gone bankrupt, and looked for the balance sheet and income statement ratios that had the most predictive value. Dr. Altman settled on these five ratios¹:

T₁ = Working Capital / Total Assets
T₂ = Retained Earnings / Total Assets
T₃ = Earnings Before Interest and Taxes / Total Assets
T₄ = Market Value of Equity / Total Liabilities
T₅ = Sales/ Total Assets

He then assigned weightings to them based on their predictive values to create his model:

Z Score Bankruptcy Model:

Z = 1.2T₁ + 1.4T₂ + 3.3T₃ + .6T₄ + .999T₅

Based on this model, a Z-score below 1.8 means bankruptcy is likely within two years; a Z-score between 1.8 and 2.99 is a gray area; and a Z-score above 2.99 means there is little likelihood of bankruptcy within the next two years.

In that post, we noted that the Altman Z-Score for Alloy Steel at the time was 4.89. I re-ran the calculation today using the updated numbers and got an Altman Z-Score of 4.19. Unsurprisingly, it's lower than last time, given the drop off in sales and earnings, but still well above the 2.99 level, above which the model predicts little likelihood of bankruptcy within the next two years.

Run Silent, Run Deep

That is, of course, the title of one of the classic submarine movies¹, but it's also a fitting description of the current investor relations tack of Alloy Steel International (OTC BB: AYSI.OB): as the company's stock price has dived, the company has refrained from releasing any information since its last 10-Q. Over the last few weeks, I tried contacting the company's CEO (who has designated himself the investor relations contact) via the company's website and then via his company e-mail address. After no luck, I trying calling him. Alloy Steel's receptionist in Malaga mentioned he was traveling overseas and, assuming he hadn't had a chance to check his company e-mail address, gave me his personal e-mail address and suggested I try him there. Again, no response. This week, after calling the company's headquarters again and learning that the CEO was again traveling overseas, I sent him the following message:

I understand from Melanie in your Malaga office that you are traveling overseas again. Given your heavy travel schedule and extensive responsibilities, I imagine you must have little time to answer questions from investors. Nevertheless, you have designated yourself as the investor relations contact for your company. Have you considered delegating this role to someone who might have the time to respond to an occasional investor e-mail or phone call?

And received the following response:

Dear Dave.
As a result of the market volatility and the short sellers that have been short selling our stock the board has decided to only release information through the normal reporting channels there will be no separate reports to any investor who we have no record of in our share register.

Kind Regards.
Gene Kostecki
CEO Alloy Steel Int.

Sent via BlackBerry® from Vodafone

This response didn't inspire a lot of confidence in the company's current situation. I can understand the reluctance to communicate with an individual shareholder on Reg FD grounds, but if Mr. Kostecki believes that the market's opinion of his company's prospects is unjustly negative, the best way to counter that would be to release information through "normal reporting channels" proving it wrong. For example, if the company picked up a major order recently, or an order in a new market, it could announce that via an 8-K (as it has done in the past). Since Alloy Steel hasn't released any such updates this year, it's rational for market participants to assume that it has no good news to report.

Judging from the CEO's e-mail above, the break-even numbers it reported last quarter, and its high inventory levels over the last two quarters, my guess is that it will post a loss for the quarter that ended on March 31^st.

I was going to end this post on a positive note, by including a link to Goldman Sachs chief economist Jim O'Neil's column in the Financial Times Thursday, in which he mentioned he had revised upward his growth estimates for China's economy this year and next. If O'Neil's estimates come to pass, that would be good news going forward for mining companies, and, by extension, for Alloy Steel. Unfortunately, after 20 minutes of trying, I was unable to find a link to O'Neil's column using the Financial Times website's search feature.

¹The all time champ of submarine movies is Das Boot, in my opinion.

The Latest Warning from China about the U.S. Dollar and Debt

From an op/ed column by Professor Yu Qiao of the School of Public Policy and Management, Tsinghua University, Beijing, in the Financial Times this week ("Asia is the victim if the bond bubble bursts"):

Most of Mr Obama’s stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America’s over-consumption problem and delay sustainable recovery. On top of this, the unprecedented fiscal stimulus, with the Federal Reserve’s move to inject money into credit markets, contains self-destructive seeds. The US risks ending the dollar’s role as the reserve currency, especially considering there is already $10,000bn (€7,535bn, £7,009bn) in US Treasury debt, and much more in liabilities from the costs of social security, healthcare and financial institution bail-outs.

The provision of stable, reliable and viable dollars may be subordinated to short-term US interests, posing a risk to global monetary stability. In the long term, America may seek to resolve its economic mess by devaluing the dollar at best and a default at worst. This is depicted in a Chinese proverb: “Drinking poisonous liquid to quench thirst”.

Professor Yu proposes an interesting alternative in his op/ed: essentially, for China and other Asian holders of our debt to work with the U.S. government to convert some of these holdings into preferred minority stakes in equities and infrastructure projects, since "equity claims on sound corporations and infrastructure projects are at less risk from a currency default".

A Historical Perspective on China and Japan

Interesting letter to the editor in Wednesday's Financial Times:

Japan has been in the cold before, by the same rationale

Published: March 4 2009 02:00 | Last updated: March 4 2009 02:00

From Prof Arthur Waldron.

Sir, Japan’s allies have left it in the cold before (“A diplomatic feint that looks set to leave Japan in the cold”, Philip Stephens February 27), most notably after the Washington Conference of 1921-22, which saw the security treaty with Britain, fundamental to Japan, discarded, with a fine-sounding set of multilateral guarantees as substitute. The rationale then, as now, was the need to yield before the inevitable rise of China.

What happened? China entered an unexpected period of turbulence that threatened Japanese interests. Tokyo drifted for a while trying to work within the multilateral framework, but when it proved useless found a new compass in dictatorship at home and pre-emptive attack abroad, against China and eventually the US.

History does not repeat itself but it has lessons. One is never to sell short Japan, least of all as a power. Another is that all long positions on China should be carefully hedged.

Arthur Waldron,
Bryn Mawr, PA, US
Lauder Professor of International Relations,
University of Pennsylvania

The image above, of one of the Kongo Rikishi guardian statues at the Kofukuji temple in Nara, Japan, was pilfered from a Geocities site of what appears to be (judging by the flag) an Argentinian karate club.

Profiting from the Credit Crisis

Back in August, we mentioned two groups of entrepreneurs that were profiting from the credit crisis ("Profiting from the Credit Crunch/Real Estate Bust"). Yesterday, the Financial Times published an article about another such entrepreneur: Barry Silbert, the founder of SecondMarket. According to the article ("SecondMarket enters new territory"), Silbert started SecondMarket in 2004 to provide a marketplace for trading restricted securities; in the first quarter of 2009, Silbert plans to create an online marketplace for illiquid mortgage-backed securities and CDOs. From the article:

Inspired by books about Amazon.com, Ebay and Goldman Sachs, Mr Silbert says the SecondMarket platform will, for example, allow valuation experts, research providers and others to offer their services and get ranked by users.

"We are incorporating the best of current technology," says Mr Silbert. "We are inspired by the ideas behind the wisdom of crowds, and want to be inclusive rather than exclusive."

SecondMarket is a broker-dealer, getting paid a transaction fee on deals that get done, but not taking any positions itself. With many Wall Street players strapped for cash, no other serious venture aimed at targeting illiquid markets has emerged.

This story about SecondMarket reminds me about the old cliché (apparently untrue, according to this essay by U Penn Chinese professor Victor Mair) that the Chinese word for "opportunity" is comprised of characters meaning "danger" and "opportunity". The characters shown above, from Professor Mair's essay, are the ones that comprise the Chinese word for "crisis", "wēi" and "jī". For Professor Mair's explanation of why "wēi" can be translated as "danger" but "jī" shouldn't be translated as "opportunity", see his essay.