The China real estate collapse leads to a hard landing scenario is getting scary, but I think it’s mostly a problem for hard pressed local governments

And as long as we’re on the subject of hard landings…

The Financial Times reports that Guangzhou, China’s third largest city, has cancelled or scaled back land auctions four times last month.

If you’re worried that Beijing’s moves to slow growth in order to control inflation may have gone too far, this isn’t good news.

One scenario for a hard landing that takes growth in 2012 way below the current consensus projections of 8% or so has a collapse in the real estate sector stalling the economy and leading to a huge retrenchment by banks and local governments. Land sales account for about 40% of local government revenue in China. Local governments use the money to finance large infrastructure projects. No land sales, no revenue, no infrastructure spending. Falling land prices would be a big bad deal for banks, which typically have accepted land as collateral for loans to local governments.

In the first nine months of 2012 the Guangzhou government collected just $2.2 billion in revenue from land sales. That is just a bit below the target of $7.8 billion for 2011. The government raised $7.1 billion from land sales in 2010.

Last week, the government of Guangdong province—Guangzhou is the provincial capital—estimated that the debt owned by its city and county governments at the end of 2010 was $117 billion. Nationwide, Beijing estimates that local debt at the end of 2010 was $1.7 trillion.

Beijing could fix this problem, short of a financial crisis, with structural reform to the way that China collects taxes. Most locally collected taxes—such as the VAT (value-added tax)—go straight into the treasury in Beijing. Last year more than 60% of the taxes collected by Guangzhou went to Beijing.

But rather than handing local tax revenue back to local governments, Beijing has decided that the solution is to let local governments sell bonds. In November Guangzhou sold about $1 billion in bonds as part of a pilot project that has let a few cities issue debt for the first time since 1994.

More debt. That’s the fix?

So much depends on China. And the ability of its economy to escape a hard landing that crushes growth.

This may be the biggest immediate legacy of the euro debt crisis. With the EuroZone projected to grow by just 0.7%–or less– next year and the U.S. economy projected to chug along at 2% growth or less, China will be the make or break story for a huge number of companies in 2012.

Investors are used to this by now for the shares of companies like Freeport McMoRan Copper & Gold (FCX) or Vale (VALE) or Peabody Energy (BTU). Worries that growth in China might be slowing drives down shares of the companies that supply the commodities that feed China’s manufacturing machine slump. Growth looks stronger than expected, on the other hand, and these shares climb.

But China’s influence has been growing and it now extends well outside the commodity and materials sectors to stocks that don’t immediately seem to have a China connection. The China risk in many of these stocks isn’t well recognized by investors. And I’d argue that’s likely to be especially dangerous over the next six months or so because of the way that many of these stocks are increasingly dependent on China for growth.

I call this the Tiffany & Co. (TIF) problem. On November 29, before the New York market opened, the high-end luxury retailer announced third quarter earnings for the fiscal year that ends on January 31 that beat Wall Street estimates by 10 cents a share. But the stock plunged 11.2% from the November 28 close to the November 29 open when the company announced disappointing guidance for the fourth quarter and for the full fiscal year.

Global net sales would climb by a percentage in the high teens for the full year, Tiffany told investors and analysts, but would increase by just a low-teens percentage in the fourth quarter. That’s disappointing after a 20% increase in worldwide sales in the first half of the year. Which, of course, explains the sell off.

But what interests me is the regional composition of the company’s sales guidance. In the fourth quarter Tiffany’s expects sales to slow in the U.S. Northeast and in Europe. For the full year that doesn’t have a big effect on projections for sales growth in Europe and the United States. In its full year guidance Tiffany kept sales growth projections unchanged at 20% for Europe and in the high teens for the United States.

The only region where Tiffany is projecting an increase in sales from its last guidance is the Asia- Pacific. In that region, dominated by China’s economy (especially since Tiffany breaks out Japan as a separate region), the company has raised its projections for growth to 35% for the year from earlier guidance of 30%.

Think about that for a minute or two. Read more

Take a deep breath and let’s decide not to talk about the Greek debt crisis, the Italian debt crisis, or the euro debt crisis. Let’s instead think long-term, say, eight or nine months down the road. (Yes, that’s long term in this volatile market.) Greece will have defaulted or it won’t. (I bet on default.) Italy will have finally replaced its government and restored some confidence in its finances. EuroZone leaders will be buried in negotiations to amend the treaties that govern the monetary union.

And what will be top of the mind for investors?

Growth. And where to find it in a world where economic growth is very scarce. Rather than building portfolios with a goal of avoiding a potential blow up in Greece, Italy, or the European banking sector in general, investors will be trying to build portfolios that wring the last drop of growth out of what will be a very slow growth world.

Shall we get a head start? (Please think of this as an update and fine-tuning of my October 11 “My road map for the next nine months http://jubakpicks.com/2011/10/11/my-road-map-for-the-next-nine-months/ )

Okay, begin with the macro economic picture. Read more

The last few days—more specifically Thursday October 6 and Friday October 7—have shown investors how markets are likely to work in at least the first half of 2012.

You do need to apply a little stock market history to flesh out the past few days and turn it into a road map for the next nine months or so, but I think the outlines are there.

I’ve written recently about the likelihood that sometime in 2012 the emerging stock markets of China, Brazil and the rest of the gang—dragging the commodity economies of Australia, Canada and the rest of that global group with them—will decouple from the slow growth developed economies. At some time around the middle of 2012 it will become clear enough to investors that China, to take the core case, isn’t headed for a hard landing, and that growth of 8.2% to 8.5% is indeed the likely bottom for this cycle that global cash flows will move toward economies showing that kind of growth and out of developed stock markets where growth is stuck near 1% to 2%. At that point emerging stock markets will reverse the underperformance of November 2010 to now and begin to outperform their developed country counterparts.

But what about the long nine months or so (and maybe longer) until that certainty and outperformance arrive? What happens then?

This is where the action of the last few days and the lessons of stock market history can suggest the likely details. Read more

Can the wreck of a single high-speed train change the course of China’s economy and politics? I wouldn’t bet against it

The collision of two high-speed trains in China on July 23 that left at least 39 people dead is quickly becoming a symbol for many Chinese of all that’s wrong with China’s government and economy—even if Beijing has cracked down on any public discussion of the event. The government’s central propaganda department has decreed that the theme of all reporting should be “in the face of great tragedy there is love.”

If you want to understand the tensions in Chinese system of government and development that might put a knot in the straight line projections of China’s future, spend a minute studying the way that this event is rippling out across China.

On July 23 a high-speed train on the newly opened Beijing-Shanghai line crashed into the rear of another high-speed train that had stopped after losing power. The first four cars of the moving train fell off a bridge and the last two cars of the stopped train derailed. At least 39 people died and 190 were injured.

Ripple 1: Nobody believes the government’s explanation that the wreck was a result of lightening hitting the first train and knocking out power. Experts on the signaling system used on China’s high-speed rail lines say that the second train would have received a stop signal even if lightening had knocked out power to the first train. Experts such as Sun Zhang of the Urban Mass Transit Railway Research Institute told Caixin that at least three or four redundant safety mechanisms kick in if a train stalls.

Ripple 2: Everyone believes that the government investigation will be a whitewash designed to make the problem go away as quickly as possible.  Less than 24-hours after the wreck, rumors were flying across the Internet that government construction crews had moved in to bury wrecked train carriages near the track. A widely viewed online video—maybe–shows bodies falling out of those train cars. A photograph taken on July 25 at the wreck site shows that the cars had not been buried. But almost nobody posting on the Internet believes the government’s explanation that the cars were merely being moved—and not actually buried—so that workers could get access to the rest of the wreck site.

Ripple 3: Everyone believes that the government will find scapegoats but that those truly responsible won’t really be punished. Could Beijing have handled this any worse so far? I don’t see how. The government has removed three railway officials from their jobs—Long Jing (head of the Shanghai Railway Bureau), Li Jia (head of the Shanghai Railway Bureau committee of the Communist Party), and He Shengli (deputy chief of the bureau.) This might have been effective except that to replace Long Jing Beijing appointed An Lusheng. He was demoted in 2008 after China’s biggest rail disaster when two trains collided in Shandong province killing 71. He was back in his old job within two years and now has been brought in as the solution to this disaster.

Ripple 4: You can cut the cynicism with a spoon: Somebody got rich and somebody else died. What’s new? In February Liu Zhijun, China’s railway minister, was removed from his job because he was the subject of an investigation into corruption. In March a government audit showed that about $30 million had been embezzled from the Beijing-to-Shanghai portion of the high-speed rail network. (The July 23 wreck took place on exactly this segment of the system.) And the common belief is these are almost certainly just the tip of a mountain of profits that went to contractors who cut corners on projects or padded costs and to land developers who got sweet deals on real estate near the new high-speed train stations. A lot of Chinese believe that it’s who you know, who your relatives are, and how much clout you (or your parents) have in the party that determine who gets rich in today’s China. This wreck feeds into those beliefs.

Ripple 5: China the innovator took a big hit. Before the wreck China and Japan were engaged in a heated “discussion” over who owned the patents to high-speed rail technology. In June China filed 21 international patents for its high-speed rail technology claiming that it had taken earlier high-speed rail technology from foreign partners and “adopted it, digested it, absorbed it and innovated based on it, transforming a 250-kilmeter per hour train into a 350-kilmeter per hour train” in the words of He Huawu, chief engineer of China’s Ministry of Railways. The rejoinder from Japanese and German makers of high-speed trains was that it looked to them like China hadn’t achieved higher speeds by innovating but by cutting corners on safety. That argument looks a lot stronger after the wreck when so many pundits are comparing the zero passenger-death record in the 47-year history of Japan’s high-speed Shinkansen system to the record of China’s four-year old high-speed rail system. Forget about just putting a damper on Chinese exports of its high-speed rail equipment. This wreck casts doubt on China’s strategy of moving up the technology value chain.

Ripple 6:  More bad debt. China’s Ministry of Railways showed just 15 million yuan in profits for 2010 on revenue of 686 billion yuan. Cash flow from operations came to 157 billion yuan compared to 150 billion in interest due and redemption of maturing debt. And 2010 was a better year than 2011 when debt repayment plus interest is projected to hit 250 billion yuan with cash flow from operations at 200 billion yuan. Those figures are all from before the wreck, of course, and they’ll undoubtedly get worse in coming months as some passengers shun the high-speed trains. But at least the ministry can borrow from the government. That’s not true for the real estate developers who have staked billions of yuan on projects linked to new high-speed rail stations. If those stations are canceled or delayed as part of the government’s rethink of the country’s high-speed rail system, or if traffic through those stations is lower than expected, then developers will book big losses. That’s a big deal for a sector that’s already over-extended and worried about a falling supply of new loans.

Ripple seven: The wreck feeds into a very important current debate among China’s leaders about where to set the speed limits of sustainable growth. Before the wreck, China’s leaders, most prominently Premier Wen Jiabao, spoke of the need to balance growth with slower inflation, with better education and healthcare, and with rising incomes for lower paid migrant workers. The argument was abstract when built on statistics or vague when built on people’s feel for the quality of their own lives. But now the country has a readymade and all too vivid symbol of what happens when an economy tries to go too fast—it comes off the tracks.

Don’t underestimate the power of an image to change the debate in China.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/