Down and Out in Wenzhou
Smead Capital Management
By Bill Smead
June 19, 2012
Dear Fellow Investors:
In early 2006, I wrote a piece called “Down and Out in Bloomfield Hills”. Our argument back then was that the economy of the rest of the US could look and act the way the economy of Bloomfield Hills, Michigan was acting even before the nationwide residential real estate market had fallen apart. The auto industry’s decline had caused wealthier residents to practice austerity and frugality, which looked very similar to the behavior of the generations most affected by the 1930’s depression. In effect, Bloomfield Hills was foreshadowing what would happen in the rest of the US. Here is how Jeffrey Laslow of the Wall Street Journal wrote it in 2006:
are up and charitable giving is down. A local country club has a
waiting list—for members who want to quit. The market for expensive
homes is so slow that Michael Robbins, a divorce attorney here, says
one of his clients is still living with his ex--three months after their
divorce was final.
With the Michigan economy battered by the ailing auto industry, the ripples are being felt across the state—even here in one of the nation’s wealthiest communities. At a time when there’s a growing gap between the rich and the poor, Bloomfield Hills offers a clear reminder that the wealthy often can’t escape from the severe problems of a local economy. And that, in turn, is putting pressure on a wider swath of less-wealthy residents who depend on the rich for business.
theory proved to be true. The problems selling homes and the urge to
reduce debt and live inside our means swept across the US during the
Recession” of 2007-2009. Bloomfield Hills was prophetic and told us a
great deal about how to get ahead of the curve.
triggered our walk down this painful memory lane was an article by
Bloomberg News writer, Jun Luo, at Bloomberg’s website on June 12th,
2012 titled, “Angry Bagmaker Shows China Slowdown Worst in Wenzhou”. In
the article, Mr. Luo describes the struggles of an export-based economy
of 9 million people which appears to have hit the wall. He does it
through the eyes of business owners, a cab driver
and Chen Xijun, a director of the city’s Chamber of Commerce:
Xiangsong has 18 days to pay a 2 million yuan ($314,000) bank debt or
his suitcase company in eastern China will go bankrupt. He’s close
to tears as he realizes his last hope, a government-backed office,
is totally useless: If I had any collateral, why the hell would I come
here?” he yells at an official in Wenzhou’s state-run loan service,
set up to help small businesses after rising bankruptcies and suicides
prompted Premier Wen Jiabao to visit in October and pledge support.
more than 400,000 businesses make everything from shoes in dusty side
streets to synthetic leather in dilapidated factories, much of it
financed by unregulated lenders that spread during China’s record
2009-10 credit boom. The decline of so-called shadow banking
in the city, triggered by Wen’s move to rein in a national property
bubble, has left Wenzhou bearing the brunt of the country’s economic
plans for a more targeted stimulus than the 4 trillion yuan package
unveiled in 2008 ($586 billion at the time) mean Wenzhou may see little
reprieve. Wen’s administration in March picked the city, five hours by
train south of Shanghai, for a trial program designed to boost capital
for private companies, an effort that’s failed to quell locals’ gloom.
previous years, it was difficult,” Chen Xijun, a director at the city’s
Chamber of Commerce, said in a June 6 interview in the city. “This
year it’s completely dark. We have no sense of direction where the
economy is heading.”
like in the US in 2006, the Chinese government officials and the
worldwide media need to believe that what is going on in Wenzhou is not
first domino in a series of dominos which fall over the next two years.
The Chinese economy and its “miracle” of the last 30 years were
originally driven by the competitive advantage of cheap labor. The cheap
labor advantage China had over other worldwide
manufacturing countries became connected with over one billion
intelligent and hard-working people. These people wanted a better life
for themselves and either found it in their own business or working for
someone who owned one. Millions of them moved from
other, more rural areas of China to some of the more than 50
multi-million person mega-cities like Wenzhou.
keep up with all the growth, a great deal of infrastructure was built
and China became a major producer of coal and steel. The ability to own
your own home started about 25 years ago and the booming economy
consistently outperformed the expectations of even the most optimistic
fans of China. This led to blistering appreciation in home prices. Most
studies indicate that it takes about 12 times the
average household income to buy the average home in China versus the
peak of 8 times at the end of Japan’s real estate bubble in 1990 and 6
times income at the height of the American version of “Flip this House”
in 2005. Bloomberg News reported June 18, 2012
the current situation on the ground in China:
home values fell in a record 54 of 70 cities tracked by the government
in May as developers cut prices to boost sales amid housing curbs.
eastern city of Wenzhou led declines with a 14 percent slump in values
from a year earlier, while Beijing and Shanghai recorded losses of as
much as 1.6 percent, according to
data released by the statistics bureau today.
is a city of entrepreneurial small to medium-size businesses which rely
on the export market. Its financing came from the extensive “shadow
banking system”. When the central government tightened credit in 2011
and came down hard on the shadow banking system, Wenzhou got hit the
hardest. Here’s how Luo explains:
small businesses sought finance to expand, the city of 9 million became
one of the nation’s biggest centers for shadow banks, unregulated
that demanded 21.6 percent on loans in April, compared with 7.6 percent
from commercial banks, according to central bank figures.
had the worst non-performing loan ratio among the 21 cities tracked by
Shenzhen Development Bank Co. (000001) last quarter. About 60 business
owners fled the city in the first two months of the year to avoid
paying their debts, China Business News reported. The exodus has
continued, said Zhou.
is Zhou Dewen, head of the Wenzhou Small and Medium-size Enterprise
Association. He describes what is going on the ground in the “shadow
private lending system was built on trust, and now that trust is gone,”
said Zhou. He estimates there is about 1 trillion yuan of idle
private capital in the city because “nobody is willing to lend to
are offering 40 percent discounts, cab drivers sit idle and laborers
are headed to other cities to find work in other metropolises. It is
that the shadow banking system made $600 billion worth of loans each
year in 2009-10 in a $6 trillion Chinese economy. More importantly, it
fed capital to the most entrepreneurial businesses and provided
attractive interest rates to those in search of capital
in a country where stocks have done very poorly since their peak in
2008 and deposit rates at banks have been below the rate of inflation
Smead Capital Management (SCM), we believe the next Chinese population
areas to get hit hard are the coal mining and steel manufacturing
On October 19th of 2010, David Barboza of the New York Times
wrote about the city of Ordos and the Ghost City of Kangbashi, which
was built next to it for about one billion dollars. Back then, Ordos was
booming. Here is how Mr. Barboza described
things back then:
Source: The New York Times
By many measures, this resource-rich city in northern China is a fabulous success.
has huge reserves of coal and natural gas, a fast-growing economy and a
property market so sizzling hot that virtually every house put up for
sale here is immediately snapped up.
There is just one thing largely missing in the city’s extravagant new central district: people.
proper has 1.5 million residents. But the tomorrow land version of
Ordos — built from scratch on a huge plot of empty land 15 miles south
of the old city — is all but deserted.
boulevards are unimpeded by traffic in the new district, called
Kangbashi New Area. Office buildings stand vacant. Pedestrians are in
supply. And weeds are beginning to sprout up in luxury villa
developments that are devoid of residents.
pretty lonely here,” says a woman named Li Li, the marketing manager of
an elegant restaurant in Kangbashi’s mostly vacant Lido Hotel. “Most
of the people who come to our restaurant are government officials and
their guests. There aren’t any common residents around here.”
we know now that we didn’t know in October of 2010 is that the price of
coal and the price of natural gas would have plummeted to their
depressed price. Therefore, the economic base of Ordos proper is
significantly undercut and it is very likely that cities like it, which
had a virtuous circle of prosperity, are hitting the wall. Think of it
like this. Phoenix was booming as retirees flocked
to the nice weather. Homes rose in value and the economy boomed. As the
economy boomed, locals bought houses. As houses soared in value,
investors got rabid. Ultimately, prices and nefarious loans brought the
last buyers at the top in 2005-06. The real estate
boomed because the economy boomed and the economy boomed because the
real estate boomed. We at SCM call this a virtuous circle.
economy boomed and China real estate boomed. The government force fed
stimulus into its economy in 2008-2011 to avoid the kind of recession
that the US went through from 2007-09. The stimulus was heavy on
infrastructure or “fixed asset investments”. These real estate
developments use massive amounts of heavy industrial equipment, capital
and enormous amounts of commodity inputs. As the input prices
for coal and steel rose, those areas where they are produced boomed
just like Phoenix had in 2005.
see Wenzhou and export-oriented cities like it entering a deep economic
slump. Ordos and heavy industrial/mining centers like it can’t be too
far behind. BBC News visited Ordos for a follow up report on March 17th, 2012. Here is how they described what they found:
Ordos: The biggest ghost town in China
By Peter Day Ordos, Inner Mongolia, China
Inner Mongolia a new city stands largely empty. This city, Ordos,
suggests that the great Chinese building boom, which did so much to fuel
the country's astonishing economic growth, is over. Is a bubble about
huge statue of the mighty warrior Genghis Khan presides over Genghis
Khan Plaza in Ordos New Town. The square is vast, fading into the snowy
mist on a recent Sunday morning.
Genghis Khan Plaza is flanked by huge and imposing buildings.
giant horses from the steppes rise on their hind legs in the centre of
the Plaza, statues which dwarf the great Khan himself.
Only one element is missing from this vast ensemble - people.
are only two or three of us in this immense townscape. Because this is
Ordos, a place that has been called the largest ghost town in China.
Most of the new town buildings are empty or unfinished. The rampant
apartment blocks are full of unsold flats. If you want to find a place
where China's huge housing bubble has already burst, then Ordos is the
place to come.
our opinion, when manufacturing slows to a crawl and natural resource
mining and heavy industrial activity hit the wall, get ready for at
a deep recession, if not a depression. The bear market in commodities
could be just getting started and those who have “suckled on China’s
bounteous teat” could be ready for their own economic decline. The
Chinese economy runs the risk of being “Down and Out”
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. All of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date stated in this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
(c) Smead Capital Management