How US Investment Banking Excesses Helped China’s State Sector

April 25th, 2010

When the banking crisis broke in September 2008, the global economy went into shock and nearly collapsed. The Chinese government was widely seen as being the most proactive in reacting to the crisis, injecting more than US$570 billion into the Chinese economy.

Because China’s four leading banks are all state-owned, all of this money quickly reached Chinese state-owned companies. This stood in stark contrast to the US, where the banks were bailed out, but the money did not make it to companies and individuals, largely because the banks sat on the cash received, mainly to cover their own capital losses, and in many cases, to pay out bonuses to management.

Only recently have the Obama administration and congress started tentative investigations into the investment banking practices which brought the world economy so close to the brink. Since the US economy is now largely based on FIRe (finance, insurance and real estate), and because the financial lobby is the most powerful and well-funded lobby in Washington DC, changes and reforms have been slow in coming. In spite of this, even in the early days of the investigation, there are signs that there was more to it than just investment bankers flogging poorly understood derivatives to unknowing corporate clients, there was deliberate fraud at the heart of it.

Today, the Chinese government and economy have come out of the crisis smelling like a rose. Certain indicators, such as auto sales in China, show China overtaking the US as global leader, and unlikely to relinquish it back to the US. Compared to the US and EU, China seems positively great, and the government has made all the right moves, investing in infrastructure and keeping Chinese consumers happy and spending. Optimists believe that now Chinese consumers and its middle class have stepped in and filled the gap left by the weakening of the US consumer.

Looking a little deeper though, while the Chinese government has succeeded in the short-term, their moves raise long-term questions. Here are some of the problems:

  • Most of the money found its way to Chinese state-owned enterprises (SOEs), many of which are in commodity imports and heavy manufacturing such as autos.
  • China’s economic development is following the US economic development of the 1950s; which is oil-based transport. Imports of coal and oil have dramatically increased in the past year in spite of government efforts to diversify to nuclear, wind and solar.
  • As the Chinese government funnels more money through its state-owned banks into SOEs, the party and the government ironically have less control over them. Recently, the Chinese government has used administrative measures, such as ordering 73 companies out of the real estate sector and, in some cases, dismissing executives on corruption charges, but these are not a long-term solution to a systemic problem.
  • More Chinese university graduates look for jobs in SOEs instead of the private sector, seeking job stability instead of looking for better job opportunities, or a chance to start their own business as in previous years.
  • For the most part, Chinese SOEs are over-staffed and inefficient. But because of the crisis, and the overall makeup of China’s economy, they seemed destined to take up a bigger part of China’s GDP.
  • China’s seemingly unquenchable demand for commodities and raw materials, is in large part, driven by a lack of faith in derivatives. This is directly related to Wall St. investment banking practices which ran wild and unchecked under the Bush administration.

The flip side is that China’s private sector is in its most precarious position since China’s reforms began in 1979. While it has always been difficult for small businesses without strong government connections to raise capital, the situation has become worse recently. Yasheng Huang, in his book Capitalism with Chinese Characteristics: Entrepreneurship and the State touched on many of these issues.

In the internet field, I have noticed, for example, that many of the entrepreneurs and innovators in the field are choosing to emigrate from China instead of starting their businesses in China. China has a thriving Internet sector, but the successes are those which already have venture capital funding, or have successfully gone public. For practical purposes, the early stage innovation part of the pipeline has gone dry.

It is hard to say if this is true for many sectors in China at this stage, but if there is one truth now, it’s that innovation and entrepreneurship are a vital part of every economy. In today’s China, innovation and entrepreneurship are too dependent on government connections for success. For this reason, these relationships are open to exploitation, corruption and abuse.

The Chinese government for its part has been very ambivalent about the private sector. Both the president and premier have made occasional statements about the importance of helping and protecting private enterprise businesses, but disappointingly, few of these statements have turned into tangible policies and measures. Since the Chinese government has been pressing other governments to recognize China’s market as a market economy, why don’t other governments press the Chinese government for clearer policies for China’s own private sector? Some of these questions may be:

  • Do Chinese private companies have equal and open access to raising capital as SOEs?
  • Are their products and services distributed and marketed equally in the domestic market?
  • If they are subject to any kind of unfair competition, then what channels do they have to appeal to?
  • If the answer to any of the above questions is no, then what policy commitments is the Chinese government prepared to make to remedy the situation?

    • While the Chinese government and SOEs are powerful and cash-rich now, the real heroes of China’s reforms are China’s entrepreneurs and innovators, and the hard-working and industrious people. It’s time they got some recognition and fair treatment both inside and outside China.

It’s Worse Than You Imagined

March 8th, 2009

Warning: If you are easily frightened, upset and can get depressed, please do not read this article. The content is strong not in its language, but in its implications.

On Twitter I have acquired a reputation for my “Tweets of Doom”. For the most part, I do not consider myself to be a pessimist but a realist. My main area of interest in the unfolding financial crisis is how economics, history, demographics and politics come together and give us hints about future trends and show us where we are heading to.

Recently, I have read a fine article by Michael Lewis in the April Vanity Fair, Wall Street on the Tundra (also called “How Iceland Went Splat”), about how the crisis unfolded in Iceland, first transforming it from an economy based on fishing, to a country based on investment banking at the peak of the boom, then when the economy collapsed, back to fishing again.

Three paragraphs in particular stuck in my mind:

Back in 2001, as the Internet boom turned into a bust, M.I.T.’s Quarterly Journal of Economics published an intriguing paper called “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” The authors, Brad Barber and Terrance Odean, gained access to the trading activity in over 35,000 households, and used it to compare the habits of men and women. What they found, in a nutshell, is that men not only trade more often than women but do so from a false faith in their own financial judgment. Single men traded less sensibly than married men, and married men traded less sensibly than single women: the less the female presence, the less rational the approach to trading in the markets.

One of the distinctive traits about Iceland’s disaster, and Wall Street’s, is how little women had to do with it. Women worked in the banks, but not in the risktaking jobs. As far as I can tell, during Iceland’s boom, there was just one woman in a senior position inside an Icelandic bank. Her name is Kristin Petursdottir, and by 2005 she had risen to become deputy C.E.O. for Kaupthing in London. “The financial culture is very male-dominated,” she says. “The culture is quite extreme. It is a pool of sharks. Women just despise the culture.” Petursdottir still enjoyed finance. She just didn’t like the way Icelandic men did it, and so, in 2006, she quit her job. “People said I was crazy,” she says, but she wanted to create a financial-services business run entirely by women. To bring, as she puts it, “more feminine values to the world of finance.”

Today her firm is, among other things, one of the very few profitable financial businesses left in Iceland. After the stock exchange collapsed, the money flooded in. A few days before we met, for instance, she heard banging on the front door early one morning and opened it to discover a little old man. “I’m so fed up with this whole system,” he said. “I just want some women to take care of my money.”

This made me ask myself a question: Maybe it was not enough to look at how economics, history, demographics and politics come together in this unfolding crisis? Maybe I should also take a look at human psychology and the role it played in the financial services industry? Were there certain personality traits which made it to the top of the financial services industry, making individuals with these personality traits captains of industry?

Armed with this question, I went to Wikipedia and looked up the term psychopathy and found this definition:

The psychopath is defined by a psychological gratification in criminal, sexual, or aggressive impulses and the inability to learn from past mistakes. Individuals with this disorder gain satisfaction through their antisocial behavior and lack remorse for their actions.

Now some of the characteristic symptons are:

Factor1: Aggressive narcissism
Glibness/superficial charm
Grandiose sense of self-worth
Pathological lying
Cunning/manipulative
Lack of remorse or guilt
Shallow
Callous/lack of empathy
Failure to accept responsibility for own actions
Factor2: Socially deviant lifestyle
Need for stimulation/proneness to boredom
Parasitic lifestyle
Poor behavioral control
Promiscuous Sexual Behavior
Lack of realistic, long-term goals
Impulsivity
Irresponsibility
Juvenile delinquency
Early behavior problems
Revocation of conditional release
Traits not correlated with either factor
Many short-term marital relationships
Criminal versatility

This was getting interesting, so I went to a Time magazine article which listed the 25 people to blame for the financial crisis. The behavior of some of these individuals is, to say the least, very interesting.

Then I went back to the article and read more about the traits of psychopathic behavior. Where appropriate, I have added emphasis. They are:

In practice, mental health professionals rarely treat psychopathic personality disorders as they are considered untreatable and no interventions have proved to be effective.[18] In England and Wales the diagnosis of dissocial personality disorder is grounds for detention in secure psychiatric hospitals under the Mental Health Act if they have committed serious crimes, but since such individuals are disruptive for other patients and not responsive to treatment this alternative to prison is not often used.[19]
Because an individual’s scores may have important consequences for his or her future, the potential for harm if the test is used or administered incorrectly is considerable. The test should only be considered valid if administered by a suitably qualified and experienced clinician under controlled conditions. [20][21]
Hare wants the Diagnostic and Statistical Manual of Mental Disorders to list psychopathy as a unique disorder, saying psychopathy has no precise equivalent[20] in either the DSM-IV-TR, where it is most strongly correlated with the diagnosis of antisocial personality disorder, or the ICD-10, which has a partly similar condition called dissocial personality disorder. Both organisations view the terms as synonymous. But only a minority of what Hare and his followers would diagnose as psychopaths who are in institutions are violent offenders.[22][23] The manipulative skills of some of the others are valued for providing audacious leadership.[24] It is argued psychopathy is adaptive in a highly competitive environment, because it gets results for both the individual and the corporations[25][26][27] or, often small political sects they represent.[28] However, these individuals will often cause long-term harm, both to their co-workers and the organization as a whole, due to their manipulative, deceitful, abusive, and often fraudulent behaviour.[29]
Hare describes people he calls psychopaths as “intraspecies predators[30][31] who use charm, manipulation, intimidation, sex and violence[32][33][34] to control others and to satisfy their own selfish needs. Lacking in conscience and empathy, they take what they want and do as they please, violating social norms and expectations without guilt or remorse”.[21] “What is missing, in other words, are the very qualities that allow a human being to live in social harmony.”[35]

This was getting very interesting. I would encourage you to search through Google or your search engine of choice and make your own observation whether these individual/s showed any psychopathic personality characteristics.

Basically, what the American financial services industry created an industry where individuals with psychopathic traits could rise to the top to positions of power, making decisions about billions of dollars in investments and assets.

Intelligent psychopaths exist in every society, and many become actors, politicians and lawyers. The genius of the American system was that it put them in charge of large sums of money.

But this is only the beginning. In the name of industry deregulation, they were given, by the US government the power to create financial instruments. In plain English, they were given the power, through leveraging, to make money out of thin air, out of nothing.

Over the past twenty years, using their talents and creativity, they have leveraged approximately every single US dollar 35-40 times, inventing CDOs, CDSs and other financial instruments in the process, all of which were interlocked. As if that were not enough, some of these personalities co-opted the whole financial media, earning their trust and selling their investment ideas directly to the American people over leading TV stations and print media. At no time did any of the financial media say “Wait a moment. These guys are shysters and are cheating and lying to the American people.” Instead, the media went along and played the game with them, becoming actors in the play when they should have questioned what was going on.

The lines between advertisers, corporations and media became completely blurred, and dissenting voices were simply not heard. It became a vortex which benefited all the players, who hyped the same worldview about finance.

What was missing in the whole equation? In one word, trust. The quants had created formulas such as the Gaussian copula formula to provide a rough measure of risk, but banks had become completely separated from their clients through a complex ecosystem which also included mortgage brokers, who originated loans, even for individuals who did not have work and had no chance of being able to make the monthly payments for the homes they bought.

The house of cards began to collapse in 2007 with the subprime credit crisis, and is continuing to unwind. At this stage, we do not know where it will all end.

What is even more interesting is that the personalities and personality traits which got us into the mess are still there, negotiating with US Secretary of Treasury Geithner in the belief that they should receive money from the government for their bad assets, which they believe will recover some value after the economy bottoms out. Others believe that these assets have no value, and the sooner the government recognizes this fact, the sooner recovery can begin.

American society had become one where competition and competitiveness were rewarded without regard to the implications for the society as a whole. The society was always looking for the next big thing, the instant hit without caring about the cost. Now it is paying the price for a screwed up values system. Now we know that there are no quick fixes, and none of the choices are good.

In the meantime, we are helpless in this world they have created for us.

If you haven’t poured yourself one already, maybe it’s time for a whiskey. A strong whiskey. Neat.

What Happens To E-Commerce When Credit Cards Don’t Work?

October 9th, 2008

During the past several years in China, I have spent a good deal of my time explaining to Americans that e-commerce solutions do not have to depend on credit cards. In many parts of the world, such as Germany and Japan, and in China, e-commerce is about building payment gateways to different banks using debit cards or other devices which connect directly to bank accounts.

This was how Paypal started in the US. It is also how Alipay, Yeepay and other solutions work in China. Tencent, a company with a market cap of US$80B, based in Shenzhen uses a subscription payment system which also deducts payments directly from users’ accounts.

As the global Ponzi scheme which started as the subprime credit crisis continues to unwind, defaults on credit cards in the US will shoot up.

In the near future, credit will be given out much more sparingly. American society will very quickly change from a credit-based society to a cash-based society for most transactions. But there will be plenty of honest people who will need to buy, and sometimes they will want to buy online. If they don’t have access to credit and credit cards, how will they buy?

When you think about it in these terms, many of the payment solutions developed in China look more interesting, not just for China, but adapted to suit the needs of Americans who no longer have credit. Most likely these won’t be Chinese companies, but American e-commerce firms who want to develop something suited for Americans and the American market.

So which American company would come out with a non-credit card based payment solution? My guess is that it would be the leading e-commerce company, Amazon. I’d bet they are working on it right now.

Chinese Government’s CSRC To Fund Managers: No Bad News

July 29th, 2008

The Chinese government’s watchdog for equities, the CSRC (China Securities Regulatory Commission) has issued an edict to local fund managers that they are not to issue any pessimistic reports about equities during the Olympics in Beijing.

My question is “Why bother?”

The Shanghai market has been down 50% in the first half of the year, and what started out as a subprime mortgage problem in the US has now morphed into a banking problem with more US banks at risk.

In the meantime, Pony Ma, CEO of Tencent has joined in the chorus with Alibaba’s Jack Ma to talk about hard times ahead. The Chinese government has signaled that the rise of the yuan against the dollar will slow down, with a very public discussion in the People’s Daily. The signs of economic deceleration are everywhere.

When there is so much public discussion about upcoming economic challenges in the Chinese and western media, what good could possibly come from telling local fund managers not to say anything bad which might upset the Chinese equities markets? While many western observers of China see this as a sign of an authoritarian regime, for many Chinese, it looks more like desperation. Instead of allaying fears, it makes those who are still in the market fear the worst, and think that the government is trying to suppress even worse news, which in turn will fuel the rumor mill and make the market even more volatile.

In short, this looks more like a desperation move than a well-thought policy move. Instead of helping the market, it’s likely to make things worse.

This is what happens when politics interfere in the markets.

Risk Is In The Eyes of the Beholder Part II

January 28th, 2008

Chris Masse’s excellent MidasOracle.org, which focuses mainly on prediction markets, has a posting called Journalism Failures – Big Time.

The Midas Oracle article links to an article by Risk magazine nominating Societe Generale as the equity derivatives house of the year.

(You better check out the link soon before the magazine’s management takes it down.)

In case you haven’t heard, Societe Generale has been having some problems lately. We’re talking about US$7B losses because of a rogue trader, which even with the dollar falling, is not chump change.

I couldn’t invent this kind of shit even if I wanted to, and I’m a pretty creative guy.

Now if this is the kind of advice the western risk experts dish out, kind of makes you wonder, doesn’t it?

I’d say that the Chinese way of the CEO making all the risky calls himself according to his or his mistress’s mood at the moment is more reliable, and maybe, even more scientific…

The emperor has no clothes.

Chinese Face, Chinese Heart Part I

January 24th, 2008

Zhengtu gaming title

One of the frequent questions I run into in China is how western Internet companies coming into China should position themselves for growth in China.

Should they try to be western, or should they try in the shortest possible time, try to become Chinese, hiring Chinese for their local staff and management? Under what circumstances is it best to be western, and under what circumstances is it best to be Chinese? And what if a company has been in Taiwan, Hong Kong and/or the US; how should they position themselves for future growth in the Chinese market?

Their positions are made more complicated because it is now hard to find good management people they can trust locally in China; as an organization becomes larger the camaraderie and culture which forms in the management team becomes increasingly important. Over time, this builds into trust, especially if they need to deal with problems and challenges which need to be overcome on a daily basis. This comes face to face with another China reality: it simply is not easy to find people you can trust in China. Backgrounds can be fudged, headhunters want to push their candidates; the list goes on and on.

Internet businesses are especially complicated; most founders come from technology backgrounds, even today, and they have very little understanding of marketing, company positioning, and yes, national and corporate culture. Many still have dreams of serving the world from one virtual data center in Redmond, Mountain View, Beijing, Hong Kong or elsewhere, and letting more junior management deal with the soft and fuzzy stuff like “culture” and “marketing”. Even relying on ethnic Chinese management from Taiwan or Hong Kong has not really worked, as China is littered with Internet startup failures led by Taiwan and Hong Kong management teams who really did not understand the dynamics of the market in China. There have been many western executives who have said “How was I supposed to know that they didn’t understand China; they told me that they were from Hong Kong/Taiwan?”

For anyone from established business service sectors, such as banking, these ideas seem silly, even foolish. And they are. A simple reality of the Internet is that it is going to come under more national jurisdictions and regulations as it becomes a more important part of peoples’ lives. Just as it is inconceivable that banking would not be government regulated (unless you count the ongoing subprime mortgage crisis as a failure of the government’s regulatory system), it is becoming inconceivable that the Chinese, US or other governments would not want to have a say in how the Internet is run.

These established sectors know only too well how important it is to somehow find a way to live with government regulatory bodies. In China, successful new startups have almost always come from new areas which the Chinese government has not figured out regulations about and does not yet know how to regulate.

The perfect example is the online gaming industry. This industry was basically an import from South Korea, and took root in China because gaming consoles are technically illegal. (Sony PS2 and 3, Nintendo Wii and xBox360 are all freely sold; that law is seldom enforced, and all of the games sold are cracked versions.) The Chinese government’s rationale for that law was because way back in the nineties, the Chinese government saw PCs as a valuable educational tool, but considered gaming consoles to be expensive frivolous tools for kids to waste their time. At a time when the Chinese had much less buying power than they do today, it seemed like a good idea to ban gaming consoles.

This created an opportunity for Shanda, which was the first company to launch online games (almost all from South Korea) in the Chinese market. This idea caught fire with many younger Chinese and spawned the Internet cafe industry, where many younger Chinese choose to spend/waste their time and has also popularized QQ, the ultimate social networking application if there ever was one, and which for many Chinese, is the Internet.

This industry has swiftly matured, and with success has come regulation. Online gaming companies have tried to adapt, some have adapted (or tried to adapt) by moving into the online game publishing business from online game distribution. The transition from online game distribution to online game publishing has been a rocky road for companies like Shanda. The company has in the past acquired studios and titles, but many of the creative pros have left post-acquisition. A new wave of game publishers with strong titles have come up, led by Perfect World and the highly-contentious Giant Interactive.

On the regulatory and marketing fronts, the online game publishing company has become a victim of its own success: the huge amount of revenue it generates has created something the government and other regulators call a “social problem”, and it has fallen into a rut on the creative side, adding more titles in what are basically the same genre with very little to differentiate each other. The result: titles with diminishing shelf lives and ROI. People who are not addicted to games (i.e. people who have lives) have an increasingly bad view of the industry and game titles.

Unless you have some way to break out of your core audience, which is exactly what Nintendo did with the Wii. The greatest contribution of the Wii is that it has forced people to take a second look at gaming, as something other than just frivolous entertainment which wastes a lot of time and is anti-social for people who do not play games. (Heavy game players would argue that game players are social; they are just online.)

So the Nintendo Wii is halfway there; it has offered a new paradigm for games and gaming.

Now, if gaming is going to really succeed, it will have to get non-gamers to think that they are not playing a game. Then we are talking breakout.

And the game publishers (creative people) will have to learn how to get along and work with the marketing pros, and will have to understand that there is much more to marketing than press releases, press conferences, paying off the media to pick up their stories, planting stories and fake planted conversations on Chinese BBSes, etc.

To really go big, they will rely on a new class of professional and and a new kind of strike force.

We’re not there yet, and we’re not moving fast enough. But there is a way.

I believe in the value of history, but I also believe that there are times when we have to stop referencing the past for what we do in the future.

This is one of those times.