-

You’ve got to love the timing. With U.S. mired in a debt and spending crisis, with tax revenues stagnant and its government about to run out of borrowed money to spend, the Chinese government just announced that its fiscal revenues during the first half of 2011 rose by 29.6% compared to a year earlier. One country is a fiscal train-wreck, the other a fiscal gusher.

China’s tax revenues are surging for a host of reasons that set it apart from the US – the economy is booming, and in particular, businesses are thriving. According to the Chinese Ministry of Finance, profit taxes are growing especially quickly. Income and corporate tax rates are stable, at rates far lower than the US. China levies a nationwide VAT, while most of the US charges sales tax. Consumer spending is growing by over 20% in China, while it’s basically flat in the US.

To all these must be added another crucial difference: China is modernizing so quickly, that every year money pours in from new sources. China doesn’t need to raise tax rates to increase tax revenue. It just allows its citizens to get on with their lives.

Take auto sales. A decade ago, China produced and sold about two million cars. This year, it will sell about 20 million. China passed the US two years ago to become the world’s largest auto market. Since then, sales have grown by a further 40%.

Along with creating some of the world’s worst traffic congestion, all these new car sales do wonders for the country’s fiscal situation.  Start with the fact that every car sold in China has not just a 17% VAT built into its price, but a host of other taxes and levies. A consumption tax adds as much as 40% more to the sticker price depending on the size of the engine. Customs duties are also levied on imports.

These all add up fast. The government’s tax take from the sale of a single Mercedes-Benz can easily top Rmb325,000 (US$50,000). Last year alone, sales of Mercedes-Benz in China doubled. This year, Mercedes will sell about 180,000 cars in China. Total tax take: about USD$1 billion. Keep in mind that Mercedes-Benz has less than 1% of the Chinese market. BWM, Porsche and Lexus are also doing great in China. While they are all doing well, the Chinese government does even better. The government earns far more on the sale of every luxury car than the manufacturers do.

The sales and consumption taxes are just the start. Most news cars in China are sold to new drivers. That means, every year, there’s a significant net increase in the consumption of gasoline. Each liter of gasoline also carries a variety of different taxes – VAT, consumption tax, resource tax. Plus, almost every gas station and refiner in China is owned by companies majority-owned by the Chinese government. So, profits at the pump flow back to the government.

At the moment, the gasoline price in China is about Rmb7.5 per liter,  or Rmb30 ($4.60) per gallon. Figure the Chinese government is making about Rmb10 ($1.50) per gallon sold in tax. Each new car sold this year will likely contribute an additional $500-$600 in fuel taxes, or about Rmb100 billion in total. Again, a big chunk of that will be a net increase in fiscal revenues, since there are so many new drivers each year.

Think the same for sales of new apartments, air-conditioners, iPads and iPhones, plane and high-speed train tickets. Each one has all sorts of taxes built into its sales price, and then an annuity of future tax revenues from energy taxes, fees and assessments.

In the US, taxes and spending are so high, people grow more and more reluctant to spend. Huge budget deficits today, as Milton Friedman long ago established,  creates the expectation of tax increases tomorrow. Americans adjust their spending accordingly. Not so in China. Chinese keep spending and the government reaps the bounty.

As flush as the Chinese fisc now is, tax revenues represent only one part of the government’s huge cash hoard. To begin with, there is the over $3 trillion in official foreign exchange reserves. This money contributes little to no benefit to the economy as a whole, except bottling up pressure on the Renminbi to appreciate against the dollar. It’s basically money buried in the backyard.

The government also owns significant – often controlling — shares the country’s biggest and most profitable companies, including SinoPec, China Mobile, China Telecom.

Net profits at the 120 biggest centrally-controlled Chinese SOEs rose by 14.6% year-on-year during the first half of 2011, reaching Rmb457.17 billion yuan ($71 billion) . These 120 SOEs are meant to pay taxes and levies of almost twice that, Rmb850 billion, up 26.4% from 2010. No one quite knows how much of that money actually reaches the Chinese Treasury. But, of course,  the money is there, should it be needed – in a way the US Social Security “Trust Fund” most assuredly is not.

-

Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The PE firms now considering the “delist-relist” transactions I wrote about last time (click here to read)  are jeopardizing not only their investors’ money, but the firm’s own survival.  The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to ever raise money from LPs again. In other words, PE firms that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE firms considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors. There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms active in China.

This investment approach, of looking for mispriced or distressed assets on the stock market,  is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US.  But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made.  How will LPs respond if a PE firm does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE firm is taking.

-

-

Hands down, it is the worst investment idea in the private equity industry today: to buy all shares of a Chinese company trading in the US stock market, take it private, and then try to re-list the company in China. Several such deals have already been hatched, including one by Bain Capital that’s now in the early stages, the planned buyout of NASDAQ-quoted Harbin Electric (with PE financing provided by Abax Capital) and a takeover completed by Chinese conglomerate Fosun.

From what I can gather, quite a few other PE firms are now actively looking at similar transactions. While the superficial appeal of such deals is clear, the risks are enormous, unmanageable and have the potential to mortally would any PE firm reckless enough to try.

A bad investment idea often starts from some simple math. In this case, it’s the fact there are several hundred Chinese companies quoted in the US on the OTCBB or AMEX with stunningly low valuations, often just three to four times their earnings.  That means an investor can buy all the traded shares at a low overall price, and then, in partnership with the controlling shareholders,  move the company to a more friendly stock market, where valuations of companies of a similar size trade at 20-30 times profits.

Sounds easy, doesn’t it? It’s anything but. Start with the fact that those low valuations in the US may not only be the result of unappreciative or uncomprehending American investors. Any Chinese company foolish enough to list on the OTCBB, or do any other sort of reverse merger, is probably suffering other less obvious afflictions. One certainty:  that the boss had little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing which, among its other curses, likely cost the Chinese company at least one million dollars to complete, including subsequent listing and compliance costs.

Why would any PE firm, investing as a fiduciary, want to go in business with a boss like this? An “undervalued asset” in the control of a guy misguided enough to go public on the OTCBB may not be in any way undervalued.

Next, the complexities of taking a company private in the US. There’s no fixed price. But, it’s not a simple matter of tendering for the shares at a price high enough to induce shareholders to sell. The legal burden, and so legal costs, are fearsome. Worse, lots can – and often will – go wrong, in ways that no PE firm can predict or control. The most obvious one here is that the PE firm, along with the Chinese company, get targeted by a class action lawsuit.

These are common enough in any kind of M&A deal in the US. When the deal involves a cash-rich PE firm and a Chinese company with questionable management abilities, it becomes a high likelihood event. Contingency law-firms will be salivating. They know the PE firm has the cash to pay a rich settlement, even if the Chinese company is a total dog. Legal fees to defend a class action lawsuit can run into tens of millions of dollars. Settling costs less, but targets you for other opportunistic lawsuits that keep the legal bills piling up.

The PE firm itself ends up spending more time in court in the US than investing in China. I doubt this is the preferred career path for the partners of these PE firms. Bain Capital may be able to scare off or fight off the tort lawyers. But, other PE firms, without Bain’s experience, capital and in-house lawyers in the US, will not be so fortunate. Instead, think lambs to slaughter.

Also waiting to explode, the possibility of an SEC investigation，or maybe jail time. Will the PE firm really be able to control the Chinese company’s boss from tipping off friends, who then begin insider trading? The whole process of “bringing private” requires the PE firm to conspire together, in secret, with the boss of the US-quoted Chinese company to tender for shares later at a premium to current price. That boss, almost certainly a Chinese citizen, can work out pretty quickly that even if he breaks SEC insider trading rules, by talking up the deal before it’s publicly disclosed, there’s no risk of him being extradited to the US. In other words, lucrative crime without punishment.

The PE firm’s partners, on the other hand, are not likely immune. Some will likely be US passport or Green Card holders. Or, as likely, they have raised money from US institutions. In either case, they will have a much harder time evading the long arm of US justice. Even if they do, the publicity will likely render them  “persona non grata” in the US, and so unable to raise additional funds there.

Such LP risk – that the PE firm will be so disgraced by the transaction with the US-quoted Chinese company that they’ll be unable in the future to raise funds in the US – is both large and uncontrollable. The potential returns for doing these “delist-relist” deals  aren’t anywhere close to commensurate with that risk. Leaving aside the likelihood of expensive lawsuits or SEC action, there is a fundamental flaw in these plans.

It is far from certain that these Chinese companies, once taken private, will be able to relist in China. Without this “exit”, the economics of the deal are, at best, weak. Yes, the Chinese company can promise the PE firm to buy back their shares if there is no successful IPO. But, that will hardly compensate them for the risks and likely costs.

Any proposed domestic IPO in China must gain the approval  of China’s CSRC. Even for strong companies, without the legacy of a failed US listing, have a low percentage chance of getting approval. No one knows the exact numbers, but it’s likely last year and this, over 2,000 companies applied for a domestic IPO in China. About 10%-15% of these will succeed. The slightest taint is usually enough to convince the CSRC to reject an application. The taint on these “taken private” Chinese companies will be more than slight. If there’s no certain China IPO, then the whole economic rationale of these “take private” deals is very suspect.  The Chinese company will be then be delisted in the US, and un-listable in China. This will give new meaning to the term “financial purgatory”, privatized Chinese companies without a prayer of ever having tradeable shares again.

Plus, even if they did manage to get CSRC approval, will Chinese retail investors really stampede to buy, at a huge markup, shares of a company that US investors disparaged? I doubt it. How about Hong Kong? It’s not likely their investors will be much more keen on this shopworn US merchandise. Plus, these days, most Chinese company looking for a Hong Kong IPO needs net profits of $50mn and up. These OTCBB and reverse merger victims will rarely, if ever, be that large, even after a few years of spending PE money to expand.

Against all these very real risks, the PE firms can point to what? That valuations are much lower for these OTCBB and reverse merger companies in the US than comparables in China. True. For good reason. The China-quoted comps don’t have bosses foolish or reckless enough to waste a million bucks to do a backdoor listing in the US, and then end up with shares that barely trade, even at a pathetic valuation. Who would you rather trust your money to?

-

For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

1. Valuation, p/e multiples
2. IPO approval process – cost and timing of planning an IPO
3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.

.

The impetus for writing the last blog post was reading this in a New York Times article on China:  “Most people in China can only dream of being able to afford an expensive phone. But millions of Chinese are developing a taste for luxury goods, and Apple products have joined Louis Vuitton bags as totems of wealth.”

The comment was vintage NYT reportage: managing to be both condescending and ill-informed. The reality is otherwise: personal wealth in China is widespread and growing quickly. While not yet at levels seen in Taiwan or Hong Kong, more people in China can afford “an expensive phone” than in the US. The New York Times, however, prefers more often to characterize China today much as it has for the last 30 years – as a largely poor country, with a few selfish and wealthy autocrats lording over a teeming mass of mistreated peasants subsisting on starvation wages.

Back when I was a reporter, I once heard someone describe another journalist as,  “Often wrong, but never in doubt”. The same, writ large, can be said of The New York Times Its primary activity is one of substantiation, not investigation. It seeks out, or partly imagines, stories that will support its rather simple, binary world view: Democrats good, conservatives bad; UN good, US military action bad; tolerance for its favored groups and causes, good; tolerance for the groups and causes it loathes, bad.

I don’t get my business news from The New York Times, a habit I first cultivated over 20 years ago when I went to work at Forbes. The times I do read business stories in the NYT they seem to be written by reporters with a disdain and distrust for business. I’ve met a few NYT business reporters over the years. If I had to sum up their basic belief system, it would be “property is theft”.

As far as China goes, the NYT’s reporting mainly has two dominant flavors: “we don’t like it”, or “we don’t understand it”. Human rights, pollution, Tibet and defective manufactured products figure prominently. China’s remarkable positive transformation, and the huge increases in personal, political and economic freedom, all get short shrift inside the pages of the NYT.

Of course, there are many and better sources of information about China. The Wall Street Journal, for example, is consistently good. The NYT’s circulation is shrinking year-by-year, as is its influence. But, for a certain group of Americans, particularly on the left and in the more elite precincts of academia and the media, the NYT remains the primary source of information about the world.  So, its reporting about China has outsized consequences,  helping to shape (or deform) elite opinion in the US.

It will come as news to many of the NYT’s readers that China is on the whole a stable and contented nation. This is, arguably, the most important story of my lifetime, China’s return, after at least a 500-yeaar hiatus, to a place of central importance in the world, as a confident and prosperous nation. The New York Times too often seems the last to know.

.

Two years back, I met the boss and toured the factory of a Shenzhen-based company called TMK Power Industries. They make rechargeable nickel-metal hydride, or Ni-MH,  batteries, the kind used in a lot of household appliances like electric toothbrushes and razors, portable “Dustbuster” vacuum cleaners, and portable entertainment devices like MP3 players. 

At the time, it seemed to me a good business, not great. Lithium rechargeable batteries are where most of the excitement and investment is these days. But, TMK had built up a nice little pocket of the market for the lower-priced and lower-powered NI-MH variety. 

I just read his company went public earlier this year in the US, through a reverse merger and OTCBB listing. I wish this boss lots of luck. He’ll probably need it.

Things may all work out for TMK. But, at first glance, it looks like the company has spent the last two years committing a form of slow-motion suicide. 

Back when I met the company, we had a quick discussion about how they could raise money to expand. I went through the benefits of raising private equity capital, but it mainly fell on deaf ears. The boss let me know soon after that he’d decided to list his company in the US.

He made it seem like a transaction was imminent, since I know he was in need of equity capital. Two years elapsed, but he eventually got his US listing, on the OTCBB, with a ticket symbol of DFEL. 

Here is a chart of share price performance from date of listing in February. It’s a steep fall, but not an unusual trajectory for Chinese companies listed on the OTCBB. 

From the beginning, I guessed his idea was to do some kind of reverse merger and OTCBB transaction. I knew he was working then with a financial advisor in China whose forte was arranging these OTCBB deals. I never met this advisor, but knew him by reputation. He had previously worked with a company that later became a client of mine. 

The advisor had arranged an OTCBB deal for this client whose main features were to first raise $8 million from a US OTCBB stock broker as “expansion capital” for the client. The advisor made sure there wouldn’t be much expanding, except of his own bank account and that of the stock broker that planned to put up the $8mn. 

Here’s how the deal was meant to work: the advisor would keep 17% of the capital raised as his fee, or $1.35mn.  The plan was for the broker to then rush this company through an expensive “Form 10” OTCBB listing where at least another $1.5 mn of the original $8mn money would go to pay fees to advisors, the broker,  lawyers and others. The IPO would raise no money for the company, but instead all proceeds from share sale would go to the advisor and broker. The final piece was a huge grant of warrants to this advisor and the stock broker that would leave them in control of at least 15% of the post-IPO equity. 

If the plan had gone down, it’s possible that the advisor and broker would have made 2-3 times the money they put up, in about six months. The Chinese company, meanwhile, would be left to twist in the wind after the IPO. 

Fortunately for the company, this IPO deal never took place. Instead, I helped the company raise $10mn in private equity from a first class PE firm. The company used the money to build a new factory. It has gone from strength to strength. Its profits this year will likely hit $20mn, four times the level of three years ago when I first met them. They are looking at an IPO next year at an expected market cap of over $500mn, more than 10 times higher than when I raised them PE finance in 2008. 

TMK was not quite so lucky. I’m not sure if this advisor stayed around long enough to work on the IPO. His name is not mentioned in the prospectus. It does look like his kind of deal, though. 

TMK should be ruing the day they agreed to this IPO. The shares briefly hit a high of $2.75, then fell off a cliff. They are now down below $1.50. It’s hard to say the exact price, because the shares barely trade. There is no liquidity.

As the phrase goes, the shares “trade by appointment”. This is a common feature of OTCBB listed companies. Also typical for OTCBB companies, the bid-ask spread is also very wide: $1.10 bid, and $1.30 asked. 

Looking at the company’s underlying performance, however, there is some good news. Revenues have about doubled in last two years to around $50mn. In most recent quarter, revenues rose 50% over the previous quarter. That kind of growth should be a boost to the share price. Instead, it’s been one long slide. One obvious reason: while revenues have been booming, profits have collapsed. Net margin shrunk from 13% in final quarter of 2009 to 0.2% in first quarter of 2010. 

How could this happen? The main culprit seems to be the fact that General and Administrative costs rose six-fold in the quarter from $269,000 to over $1.8mn. There’s no mention of the company hiring Jack Welch as its new CEO, at a salary of $6mn a year. So, it’s hard to fathom why G&A costs hit such a high level. I certainly wouldn’t be very pleased if I were a shareholder. 

TMK filed its first 10Q quarterly report late. That’s not just a bad signal. It’s also yet another unneeded expense. The company likely had to pay a lawyer to file the NT-10Q to the SEC to report it would not file on time. When the 10Q did finally appear, it also sucked money out of the company for lawyers and accountants. 

TMK did not have an IPO, as such. Instead, there was a private placement to raise $6.9mn, and in parallel a sale of over 6 million of the company’s shares by a variety of existing shareholders. The broker who raised the money is called Hudson Securities, an outfit I’ve never heard of. TMK paid Hudson $545,000 in fees for the private placement, and also issued to Hudson for free a packet of shares, and a large chunk of warrants.

Hudson was among the shareholders looking to sell, according to the registration statement filed when the company completed its reverse merger in February. It’s hard to know precisely, but it seems a fair guess that TMK paid out to Hudson in cash and kind over $1mn on this deal. 

The reverse merger itself, not including cost of acquiring the shell, cost another $112,000 in fees. At the end of its most recent quarter, the company had all of $289,000 in the bank. 

These reverse merger and OTCBB deals involving Chinese companies happen all the time. Over the last four years, there’s been an average of about six such deals a month.

This is the first time – and with luck it will be the only time – I actually met a company before they went through the process. Most of these reverse merger deals leave the companies worse off. Not so brokers and advisors. 

Given the dismal record of these deals, the phrase 美国反向收购 or “US reverse merger” , should be the most feared in the Chinese financial lexicon. Sadly, that’s not the case.

I don’t know the direction of the dollar-renmibi exchange rate. But, I do know most of the American press, led by the New York Times and Washington Post, got snowed by the announcement last weekend that China would introduce new “flexibility” in its exchange rate.

The immediate media reaction – and that of the Obama administration – was one of hosannas and smug approval. The tone of most coverage was along the lines, “the Chinese have finally seen the error in their mercantilist ways and will now allow their currency to appreciate strongly against the dollar, leading to a new golden age of manufacturing employment in the US.”

A week has gone by and the renminbi has appreciated by exactly 0.5%.  So, a $100 item made in China that previously cost Rmb682 will now cost an importer Rmb685, or $100.50. Factory managers in the US may be waiting for awhile yet before the flood of orders arrives from China.  The President’s union buddies will also not soon see much of an uptick in their membership rolls.

For those without short-term memory impairment, this is, of course, the second time in two months that US press and the Obama administration loudly predicted the imminent upward revaluation of the renminbi. In April, a flurry of reporting, loudest and strongest from the New York Times,  announced the Chinese government was at last ready to accede to US demands and let the renminbi rise.

That time, the press articles were timed to coincide with a visit by the US Secretary of Treasury, Timothy Geithner, to Beijing. He was there, if the Administration and its media allies were to be believed, to talk tough and get the Chinese to fall in line with American wishes. Discernible results? Zero.

This time around, the reporting coincides with the G-20 Summit meeting in Toronto, where we are told, President Obama will use his intelligence and oratorical brilliance to persuade Chinese leader Hu Jintao to do his part for the sagging US economy. Likely results? We’ll see, but the signs are that China will continue to make policy decisions with its own interests to the fore.

There is much both wrong and economically illiterate about all this US pressure to revalue the renminbi. Start with the fact the Chinese currency is not significantly undervalued. Yes, it is tied to the dollar. So are many other currencies with which the US trades, including Mexico, Taiwan, Russia, Singapore, Thailand, Saudi Arabia. The renminbi’s formal peg with the dollar ended in July 2005. It is true that the renminbi, if it were fully convertible and freely floating, would likely appreciate against the dollar. But, by enough to really make an impact on US manufacturing employment? Hardly.

The biggest benefit to China of letting the renminbi rise against the dollar would be to lower the renminbi cost of China’s huge imports of oil, iron ore and other core dollar-denominated raw materials. Weighing against this would be falling margins at many of China’s exporters, which would ultimately have an impact on manufacturing employment.

Creating and maintaining jobs is a paramount concern for a country whose labor force grows by millions every year, and where there is no “social safety net” as in the US.  Fact: every year, six million more Chinese join the migrant labor force, according to recent report by China’s National Population and Family Planning Commission.

It’s a mistake shared by many Americans that at the current exchange rate, China is some kind of low-cost paradise for people with dollars. I live here. Prices here are not low. In fact, most things in China, with exception of fresh vegetables and public transportation, are either on par with US prices or higher.

Most fruit is generally more expensive here, even at the proletarian outdoor market where I do a lot of my shopping. Same goes for beef, chicken and most everything else you fill up a supermarket cart with. Gas, automobiles, computers, TVs, brand-name products are all higher in China than in the US.

I’m writing this in my local Starbucks in Shenzhen. And while this is hardly a perfect bellwether, the cheapest cup of regular brewed coffee here costs Rmb 15, or $2.20. A cappuccino? Rmb 25, or $3.65.  The place is jammed, as it always is, from noon to midnight. Not a seat in the house. Starbucks has over 350 stores in China and growing fast.

Not that long ago, the renminbi was pegged at 8.2 to the dollar. Has this 17% appreciation done anything to impact the decline of manufacturing employment in the US, a decline that began over 30 years ago? No. Will another 17% appreciation of the dollar reverse this trend? I very much doubt it.  Instead, what will likely happen is prices for many products in the US will rise sharply, since so much of what America likes buying is made here.  This will lead to higher unemployment, lower growth and hit hardest the poorer Americans President Obama claims to champion.

Make no mistake: if Chinese prices rise, this will not create huge new opportunities either for US manufacturers to reconquer the domestic market or allow lower wage countries like Bangladesh, Nigeria, India, the Dominican Republic or Peru to increase dramatically their exports to the US. Those countries can’t now, nor will they ever in my view, manufacture products to match the quality at the same price of those made in China, even if the cost of Chinese made products rises 15%-20% or more.

True, an economics professor’s models would argue otherwise, and President Obama is surrounded by economics professors. The models are plain wrong. Some textile imports from places other than China will rise. Not much else.

So, the real world result of the “strong renminbi” policy: greater economic hardship in the US.  But, won’t ordinary Chinese benefit from lower import prices? Perhaps a little, but not in any way that will create the desired outcome of much higher manufacturing employment and exports in the US. Maybe the Washington state apples and cherries in my supermarket will become a little cheaper, and become only twice as expensive as they are in the US. Again, not overly likely.

China’s current currency policy has its benefits and drawbacks. The benefit is mainly greater predictability for exporters, which has been somewhat helpful during the economic crisis of the last two years in China’s largest export markets of the US and Europe. Even with the stable exchange rate, a lot of exporters in China went bankrupt over this period, because of a collapse in orders from the US and Europe.

The biggest drawback of current exchange rate policy: $3 trillion in foreign exchange reserves accumulated to soak up all the dollars still pouring into the country. This money is not being put to any direct productive use to improve China’s economy. A higher renminbi will not alter that calculus much, if at all.

I’m troubled in many ways by the direction of American international financial policy. The Obama Administration finds it far easier to scapegoat China’s exchange rate than put their focus on the deepest source of American economic malaise: runaway spending and budget deficits in Washington, with the inevitability of large tax increases to follow.

It’s not likely to happen, but here’s what I’d most like to see is the next time the US media starts braying for a higher renminbi. Chinese newspapers respond with articles, quoting unnamed Chinese government officials,  pleading with the Obama Administration to cut spending, deficits and taxes, and so put more money in the pockets of American consumers. They will certainly choose to spend some of this cash on Chinese-made products and so help boost employment, wages and living standards across China.

As panaceas go, this one would be a lot more effective and all-around helpful than anything the American government and its media allies are peddling.

Since 2005, 380 Chinese companies have executed reverse mergers in the US. They did so, in almost all cases, as a first step towards getting listed on a major US exchange, most often the NASDAQ. Yet, as of today, according to a recent article in Dow Jones Investment Banker, only 15% of those Chinese companies successfully “uplisted” to NASDAQ. That’s a failure rate of 85%. 

That’s a rather stunning indictment of the advisers and bankers who promote, organize and profit from these transactions. The Chinese companies are left, overwhelmingly, far worse off than when they started. Their shares are stuck trading on the OTCBB or Pink Sheets, with no liquidity,  steep annual listing and compliance fees, often pathetically low valuations,  and no hope of ever raising additional capital. 

The advisors, on the other hand, are coining it. At a guess, Chinese companies have paid out to advisors, accountants, lawyers and Investor Relations firms roughly $700 million in fees for these US reverse mergers. As a way to lower America’s balance of payments deficit with China, this one is about the most despicable. 

You would think that anyone selling a high-priced service with an 85% failure rate would have a hard time finding customers. Sadly, that isn’t the case. This is an industry that quite literally thrives on failure. The US firms specializing in reverse mergers are a constant, conspicuous presence as sponsors at corporate finance conferences around China, touting their services to Chinese companies.

I was at one this past week in Shenzhen, with over 1,000 participants, and a session on reverse mergers sponsored by one of the more prominent US brokerage houses that does these deals. The pitch is always the same: “we can get your company listed on NASDAQ”. 

I have no doubt these firms know that 85% of the reverse mergers could be classified as expensive failures, because the companies never migrate to NASDAQ.  Equally, I have no doubt they never disclose this fact to the Chinese companies they are soliciting. I know a few “laoban” (Chinese for “company boss”)  who’ve been pitched by the US reverse merger firms. They are told a reverse merger is all but a  “sure thing”. I’ve seen one US reverse merger firm’s Powerpoint presentation for Chinese clients that contained doctored numbers on performance of firms it brought public on OTCBB.  

Accurate disclosure is the single most important component of financial market regulation. Yet, as far as I’ve been able to determine, the financial firms pushing reverse mergers offer clients little to no disclosure of their own. No other IPO process has such a high rate of failure, with such a high price tag attached. 

Of course, the Chinese companies are often also culpable. They fail to do adequate due diligence on their own. Chinese bosses are often too fixated on getting a quick IPO, rather than waiting two to three years, at a minimum, to IPO in China. There’s little Chinese-language material available on the dangers of reverse mergers. These kinds of reverse mergers cannot be done on China’s own stock exchanges. Overall knowledge about the US capital markets is limited. 

These are the points cited by the reverse merger firms to justify what they’re doing. But, these justifications ring false. Just because someone wants a vacation house in Florida doesn’t make it OK to sell them swampland in the Everglades. 

The reverse mergers cost China dear. Good Chinese SME are often bled to death. That hurts China’s overall economy. China’s government probably can’t outlaw the process, since it’s subject to US, not Chinese, securities laws. But, I’d like to see the Chinese Securities Regulatory Commission (中国证监会), China’s version of the SEC, publish empirical data about US reverse mergers, SPACs, OTCBB listings. 

There is not much that can be done for the 325 Chinese companies that have already completed a US reverse merger and failed to get uplisted to NASDAQ. They will continue to waste millions of dollars a year in fees just to remain listed on the OTCBB or Pink Sheets, with no realistic prospect of ever moving to the NASDAQ market.

For these companies, the US reverse merger is the capital markets’ version of 凌迟, or “death by a thousand slices”.

From his perch at the Washington Post,  John Pomfret is one of the better-known American journalists writing about China. He is also, coincidentally, one of my oldest and closest friends. I quibble with him often about his take on China, particularly now that I’m living here and he isn’t. He moved back to the US five years ago, and wrote a well received book about China called “Chinese Lessons”.  Quite a lot of it was written in my dining room in LA. 

For a change, I actually agree with the main thrust of one of John’s articles on China. It’s an opinion piece, co-written with his colleague Steve Mufson, published recently in the Post. It’s title: “There’s a new Red Scare. But is China really so scary?” Read it here.

The key insight is that America, in the midst of a deep and long recession,  is undergoing one of its periodic bouts of self-laceration. The widespread anxiety that America is in decline is exacerbated by a sense that China is now better, smarter, faster in many important ways. A lot of this is plain silliness, as John’s article points out. 

America’s problems are home-grown. China’s rise over the last 30 years is overwhelmingly positive, for its own citizens first and foremost, but also for the rest of the world, US included. 

There’s a lot for an American to admire, even envy, about China. Two examples: even while remaking most aspects of its society, the family has retained its primacy in Chinese life, as a source of stability, happiness, and purpose. China also remains the most “kid friendly” country I know, measured by the care and affection lavished on the young Chinese, particularly infants and preschoolers. 

Americans, in the main,  have always had a special fondness for China, regardless of the state of the political relationship between the leaders of the two countries. But, that fondness doesn’t stop many of them from perpetuating simplistic notions about the place. Once, China was seem as hopelessly backward and poverty-stricken. Now, it’s seen as a novice superpower, outmuscling the US across the globe. 

John’s article cites a quote from Sun Tzu, “If ignorant both of your enemy and yourself, you are certain to be in peril.”

Is China’s reaction to last week’s announced US arms sale to Taiwan really all that more strident than in the past? Should America be worried? To read some of the recent American news reporting, citing the usual ragbag of US-based “China experts”, you might conclude so.

http://www.washingtonpost.com/wp-dyn/content/article/2010/01/30/AR2010013002443.html
http://www.nytimes.com/2010/02/01/world/asia/01china.html?scp=1&sq=helene%20cooper&st=cse

I don’t buy it. China is not set, contrary to such reports, firmly on a course to antagonize America. It is, however, a great power with legitimate national interests to assert and protect. Sometimes those will clash with America’s national interests. But, the bilateral relationship also has a root system of common goals and shared admiration. 

I also don’t buy the line by American “China experts” about rising Chinese “triumphalism” , due to continued strength of Chinese economy. China’s economy has been outgrowing the US by eight to ten percentage points just about every year for the last 30 years. Same was true in 2009. The only difference: China grew by 8% while the US economy shrunk by over 5%. A similar net result as in the past, but one that highlighted a dramatic lessening of China’s economic dependence on the US. 

Do Chinese officials realize they now can maintain high economic growth without single-minded focus on exports to US, but look to domestic market instead? Yes. But, as you’ve also read, from Premier Wen Jiabao on down, there’s frequent public declarations on all the many problems and inefficiencies in China’s economy. 

Yes, China is getting stronger every year in every respect. But, is the tone now on arms sales to Taiwan really all that different? I don’t see it, and wonder how much others here see it, or whether it’s just the usual conventional US wisdom on China, a cousin of the “China expert” analysis that Chinese economic growth is a fraud, only resulting from cooked gdp numbers. 

China is mainly busy being China, just as America, most of the time is also mainly busy being America.  Both are continental powers with huge populations and vast domestic markets. Both also have a long history of being more inward- than outward-looking, quite patriotic, even occasionally xenophobic.

They often view the world with a similar sense of aloof distrust. There will always be points of friction between the US and China. But, time is gradually wearing down those points of friction, not sharpening them, as much of the US press would have us believe.