At the start of 2008, the two key numbers in China’s auto industry were 10 million and 1 million. With sales of both passenger cars and commercial vehicles (trucks and buses) growing at 20 percent or more in the first few months of the year, it seemed all but certain that China’s auto industry would produce at least 10 million vehicles in 2008. Likewise, vehicle exports have been nearly doubling every year for the past four—from a mere 78,000 units in 2004 to over 612,000 units in 2007—-so vehicle exports seemed a sure bet to cross the 1.0 million mark. 

With more than three quarters of the year gone, how is China doing against the 10 million vehicle benchmark? (Vehicle exports will be covered at a later date.) By the end of September, 4.3 million passenger cars and almost 3.0 million commercial vehicles have been sold. While both categories registered double digit, year on year increases in the first nine months —10.4 percent in the case of passenger cars and 13.4 percent in the case of commercial vehicles—growth rates have been losing steam all year, to the point where both categories registered year on year declines in September. With sales of approximately 750,000 vehicles in September (466,000 passenger cars and 284,000 buses and trucks), it appears unlikely that China will reach the magic 10 million number. 9.5 million vehicles seems more realistic.

The macro economy, of course, has been a big reason for the marked slowdown in vehicle sales in recent months. China’s GDP grew at a blistering 11.4 percent pace in 2007, causing the government to take measures late last year to cool an overheated economy. China did its job all too well. The Shanghai index is down more than 70 percent from its peak in 2007; property prices across the country have softened; and GDP growth has been declining on a monthly basis since the start of the year. For the first time in five years, China’s GDP growth rate is likely to fall below 10 percent in 2008. All of this happened before the financial crisis hit the global economy—and none of it is good for consumer confidence.

On top of a slowing economy, industry specific factors have also played a role in slowing vehicle sales growth. While fuel prices shot up for most of the world early in 2008, China did not raise gasoline and diesel prices until July. Therefore, auto sales in China were not affected by the higher cost of fuel in the first six months of the year because fuel prices had not changed since October, 2007. Only in July, August and September have Chinese consumers been faced with the higher costs of operating a vehicle. Moreover, with oil prices now in a free fall globally, the government has not only maintained its July pricing for the country as a whole, but it recently raised fuel prices in Beijing.  For the first time in memory, the price of gasoline at the pump is higher in China than it is in the United States.

With respect to commercial vehicles, China adopted stricter, Euro III emission standards as of July 1. This lead to a substantial pre-buy of heavy duty trucks as truckers scrambled to buy the lower priced Euro II trucks before June 30. Gangbuster truck sales in the first half of the year are now being followed by a marked slowdown in the second.

Ever since China joined the World Trade Organization in December, 2001, the country’s auto industry has been on a tear, with vehicle production and sales increasing by at least 20 to 50 percent per year. China has reached a point where it is now producing at least as many vehicles as the United States and Japan and is destined to become the largest market for vehicles in the world—by a wide margin.

As 2008 comes to a close, however, there are many questions as to what 2009 will bring for the industry. For example:

• What impact will a slower growing economy have on vehicle sales? Even before the financial crisis, many economists were predicting that China’s growth rate could drop to as low as 8 percent in 2009.
• How will the global financial crisis affect consumer confidence? Precipitous stock market declines all over the world; widely publicized government bailouts of banks and other financial institutions; and headlines calling this the worst economic crisis since the Great Depression are downright scary and do not inspire confidence. The natural tendency of consumers is to hold back on large purchases like autos when confidence is low.
• What will the ultimate impact of higher fuel prices be on vehicle sales? Higher fuel prices have only been in place for three months in China, so this remains a big question mark.

Despite these concerns, auto executives look with envy at the China market as vehicle sales plunge in developed markets and General Motors and Chrysler fight for their very survival. While the China auto industry cannot be expected to grow as fast over the next five years as it has over the past five, vehicle sales should nonetheless continue to grow at double digit rates. Vehicle ownership is still extremely low in China compared to all but the least developed countries in the world, and continued economic growth will require more and more trucks, buses and cars to move people and goods around the country.

A lot of unanswered questions, but the future in China autos continues to be very bright.

First it was Fannie Mae and Freddie Mac; then AIG; and then 14 of the country’s largest commercial banks. Every day it seems, more and more companies in the United States are becoming “state-owned enterprises,” a term I had always associated with the Chinese economy.

The next round of state ownership—or at least bailout—is likely to be in autos. Executives at General Motors and at Cerberus, the private equity firm that owns Chrysler, are feverishly working to merge the two companies, with Election Day as a deadline to leverage political support—and maximum capital commitments– from the government. Soon, the “Big Three” may even become the “Big One” as rumors abound regarding efforts to put all three companies together.

What’s driving these talks? Is it the efficiencies that might be gained in design, production and sales and marketing? Sadly not. It’s even more basic—money. Specifically, a larger share of the $25 billion in loans that the government has already set aside to help the shift to green cars. With Detroit’s prospects looking dimmer by the day, this may in the end become survival cash instead.

According to a recent editorial in the The Wall Street Journal, there may be one more thing at stake—political clout. Holman W. Jenkins, Jr., a member of the Wall Street Journal Editorial Board, wrote:

The talk is of synergies and cost-cutting, of tapping new lodes of cash to ride out the storm. Don’t believe it. These negotiations are about one thing: creating a political last stand of American auto making that a Democratic Congress and president won’t be able to resist bailing out.

How did the U.S. auto industry get to this point? The knee-jerk response is to blame it all on poor management, but Mr. Jenkins does not think so. In his words: “The human factor nets out over time.” Instead, his thesis is that, like banking, the auto industry has been around long enough to have taken on an enormous amount of baggage from government intervention. He calls this the “GM Effect,” which he describes in this way:

Why don’t the auto makers limit themselves to paying competitive wages and benefits in line with what workers could earn elsewhere? Because, in the 1930s, Congress passed the Wagner Act with the nearly explicit purpose of imposing a labor monopoly on Detroit to keep wages at higher-than-competitive levels.

Why doesn’t Detroit rationalize its musty brand lineups and dealer networks? Because, in the 1950s, legislatures across the country imposed franchising laws, including the federal “dealer day-in-court clause,” to make such rationalization prohibitively expensive.

Why don’t the auto giants do as Whirlpool and other manufacturers have done, and move their production to cheaper offshore locales? Because, in the 1970s, Congress enacted fuel economy rules to penalize homegrown auto makers if they don’t build the lion’s share of their cars in high-wage, UAW-staffed domestic factories.

Understandably, people in the United States are outraged by the huge government bailouts and the greed on Wall Street and self-serving actions of company managements that seem to have gotten the country into this mess. No doubt, managements have not acted responsibly, but there is plenty of blame to go around. In both banking and autos, you don’t have to look far to see the fine hand of government at work.

Interestingly, China is moving in the opposite direction as it privatizes and sells off ownership stakes in its state-owned enterprises. As it does, it should learn from the United States and make as clean a break as possible. Well-meaning regulations, which may not have been detrimental in pre-globalization days, can be lethal in today’s world where every company competes with every other company around the world, every day of the year.

One of the criticisms frequently leveled at China is that the government controls energy prices at below-market levels. In a world concerned with increasing carbon emissions, encouraging greater consumption with below-market pricing seems strangely out of synch—particularly by a country that is already the world’s second-largest energy user.

Of course, there are always two sides to any story, and China has its own reason for price controls—it’s merely been trying to protect the pocketbooks of the 900 million or so in its population who live in the countryside and have much lower incomes than their city cousins. One of the government’s biggest worries is the huge income disparity that exists in the country. For the majority of China’s population that continues to toil in a pre-industrial, agrarian economy, fuel is a particularly big item in the family budget. With the sharp increases in food prices in 2007 and 2008, the government was reluctant to add to the economic burden of rural families by also raising gasoline and diesel prices.

For this reason, fuel prices were not increased in China until June 20 (the first time in more than eight months), despite the fact that the price of oil had soared to $140 per barrel by then. The 17 percent increase in gasoline prices generally surprised analysts who had expected China to wait to raise prices until after the Olympic Games. In retrospect, China knew that inflation was on the wane and that it had some leeway to put through fuel increases. (Inflation in China, as measured by its Consumer Price Index, reached a 12-year high of 8.7 percent in February, but then began declining and had already fallen to 7.1 percent in June. In September, it declined further to 4.6 percent.)

Even with the hefty increases, the price of Number 93 gasoline, the most-used fuel in the country, was only $3.18 per gallon, compared to over $4 per gallon at the pump in the United States.

That’s the history. In this context, it’s interesting to note what China has been doing given the precipitous decline in global oil prices in recent months. Since July, when oil prices peaked at $147 per barrel, prices have been cut in half and are now in the $70 to $80 range. In line with this decline, U.S. motorists are now finding it less expensive to fill up as gas prices have fallen to below the $3 mark in most parts of the country. Despite this sharp decline, however, the price in China for Number 93 gasoline remains at $3.18 per gallon. Contrary to the situation in June, Chinese consumers are now actually paying more per gallon than their counterparts in the United States.

What seems even more ironic was the announcement by the city of Beijing several weeks ago that it was actually raising gasoline prices. As a result of price increases put into effect by the Beijing government on October 7, Number 93 gasoline now costs 5.90 yuan per liter, or $3.27 per gallon. Gas stations in the nation’s capital may sell it for as much as 6.37 yuan per liter ($3.53 per gallon) after an adjustment of up to 8 percent allowed by government rules.

It seems that on January 1, China introduced a costlier fuel in Beijing to cut pollution before the August Olympic Games, and this latest price increase is meant to compensate for the higher cost of the cleaner-burning fuel. Beijing, the only Chinese city supplied with fuels meeting Euro IV emission standards, consumes about 10 million tons of gasoline and diesel per year, accounting for 2.7 percent of the nation’s total.

Given the monumental task China faces as it endeavors to industrialize in a greener way, these actions on the price front may seem like rather small steps. But, as anyone who has done business here knows, that’s the way China operates. Although the steps taken may be small, the direction is always clear. In the case of energy consumption and the environment, China is taking the steps that it can, consistent with its other constraints, to move the country in the direction of greater energy efficiency.

As a guest speaker at the prestigious SuperReturn Middle East 2008 Conference in Dubai this past Tuesday, I had a great opportunity to hear the latest thinking on the future of private equity (PE) in a post-Meltdown Monday world from the best in the business.

The annual conference brings together approximately 500 private equity professionals from firms and investors with a presence or interest in MENA. (The term MENA is an acronym for “Middle East and North Africa” and refers to the region that extends from Morocco in northwest Africa to Iran in southwest Asia, including all the Arab Middle East and North African countries except Turkey.) On the speaking roster were Henry Kravis, David Rubenstein and Steve Schwarzman, founders of KKR, Carlyle and Blackstone, respectively, as well as the principals from dozens of other leading global and regional firms.

Although the views of these professionals varied in the degree and intensity in which they were held, there was a general consensus around a number of points. The conference was off the record for the press, so in keeping with that spirit, I will not attribute any direct quotes to specific speakers.

Long Recovery: No one thought that the recovery from the current financial crisis would be quick. In fact, approximately 90 percent of the attendees thought that it would take three years or more for financial markets to recover to their 2007 highs. Of these, 38 percent thought it would take more than five years. Most felt that the United States and Europe, in particular, were in for long and nasty recessions.

Traditional PE Business Models Won’t Work: The days of using financial engineering (high leverage, “covenant light” debt and arbitraging higher exit multiples) to generate returns are gone. With the consolidation of the banking industry globally, there are fewer lenders today than there were yesterday, and the ones that are still standing have opportunities to buy existing debt in good companies at substantial discounts to their face values. While cost cutting can improve profitability, companies cannot cost-cut their way to prosperity. Therefore, the premium is on growth as the way to generate acceptable private equity returns in the future.

Minority Interests and Buffet: Traditionally, PE firms have taken control positions in companies and have generally shunned minority investments. In this turbulent financial world with debt financing scarce, the head of a major global PE firm expressed the view that minority interests and “buy and hold” strategies might become more prevalent, specifically citing Warren Buffet’s recent strategic investments in General Electric and Goldman Sachs as examples of what the future might hold. Following on this point, the moderator remarked that when Warren Buffet was asked to explain his strategy for determining when and under what circumstances to sell a company, he responded by saying: “I don’t know. I’ve never sold one.”

Emerging Markets versus Developed Markets: As readers of MTD know, the term “emerging markets” was coined by my friend, Antoine Van Agtmael in the early 1980s. It now refers to about 200 countries—essentially all of the countries in the world outside the United States, Canada, Western Europe, Japan and Australia. A head of one of the major global firms thought that the term “emerging markets” had outlived its usefulness because it was now so broad. For example, lumping the countries of China and Chad into one category is not terribly meaningful. In the words of this individual, the term “developed markets” should be changed to “submerging markets.” More than anything, that remark characterized the views of the conference.

Places to Avoid Investing: Europe and commercial real estate, anywhere.

Highest Future Returns: Approximately 60 percent of the participants thought that the best returns over the next five years would come from the Asia and India region. While the current credit crisis would lead to recessions in many countries, most felt that it would merely slow the growth rates in China and India. In this context, the current crisis might actually be a blessing in disguise for China by providing an opportunity to cool down the overheating of the economy experienced in 2007.

Even before the current financial crisis, the center of gravity in the global economy was shifting from the one billion people who live in the developed markets of the world, to the 5.8 billion people who live everywhere else. Over the past three or four years, money has flowed to the large, rapidly-developing economies of the world like China and India, as well as the resource-rich countries such as Russia, Brazil, Indonesia and Australia. By exacerbating recessionary cycles in the United States and Europe, the current credit crisis will only serve to hasten this shift.

In addition to myself, there were several other representatives from China. I was most impressed with Hao Wu, a partner in Centenium-Pinetree China Private Equity. Centenium targets fast-growing, middle-market companies in China with equity values ranging between $20 million and $200 million. Centenium likes domestic, consumer-oriented companies; knowledge intensive companies and companies in the alternative energy sector, including clean energy, energy-efficient technology and environmental technology. Centenium’s investment strategy is to identify excellent companies and help them to grow, not only through capital injection, but also by connecting them with the contacts and resources necessary to build them into leading global companies.

Although interest on the part of global PE firms in China has been strong, they prefer large control deals and have gotten used to the outsized returns they have been able to earn historically on highly-leveraged buyouts in the United States and Europe. As a result, the deals in China which tend to be significantly smaller, are generally unleveraged and where obtaining majority ownership is problematic have been of less interest. With the cataclysmic financial events of the past two weeks, it appears that unleveraged, “growth capital” deals, such as those espoused by Hao Wu and his firm, will be the trend of the future.

With the U.S. stock markets closed on Monday for Columbus Day, the fate of yet one more venerable Wall Street firm hangs in the balance over a long weekend.

This time it’s Morgan Stanley, a firm that traces its roots to 1871, when J. Pierpont Morgan founded J.P Morgan & Co. – The House of Morgan, as it was commonly called — played a key role in financing the steel mills, railroads and other companies that helped industrialize the United States at the turn of the 20th century. With the passage of the Glass-Steagall Act in 1935, commercial banks were no longer permitted to engage in investment banking activities. Accordingly, J.P. Morgan & Co. spun-off its investment banking business, and the modern day Morgan Stanley was born.

Despite its long and prosperous history, Morgan Stanley has been under attack over these past several months. Like Bear Stearns, Lehman Brothers, Merrill Lynch and AIG before it, Morgan Stanley’s highly-leveraged balance sheet, coupled with the collapse of its stock price, has raised questions about the adequacy of its capital base.

Last month, the firm seemed to address these concerns when it announced a deal whereby the Mitsubishi UFJ Financial Group of Japan agreed to inject $9.0 billion of capital for a 21 percent stake in the company. Since the deal was announced, however, Morgan Stanley’s shares have dropped by 60 percent. The 22 percent drop in its share price last Friday now values the entire company at only $10 billion, leading many to question whether the Mitsubishi deal will get done on its original terms, if at all. Everyone will be waiting to see what happens when the market opens on Tuesday.

The Morgan Stanley episode brings with it a sense of déjà vu for me personally. Just over 20 years ago, I was biting my nails in the midst of a stock market crash, wondering whether I could pull off a deal that would bring much needed capital into my firm, Paine Webber. The amounts were considerably smaller, but other than that, the circumstances were surprisingly identical.

As a result of the tremendous development of the Japanese economy in the 1980s, many U.S. investment banks began establishing strategic alliances with Japanese insurance companies, securities firms or commercial banks as a way of augmenting their capital and developing investment banking relationships in Asia. In June 1987, Paine Webber decided to try and strike a deal with Yasuda Life, a Japanese insurance company. The idea was for Yasuda to invest $300 million into Paine Webber, and for the two companies to work together to develop cross-border investment banking business. Don Marron, Paine Webber’s Chairman, asked me to lead the negotiations.

At first, it all went pretty smoothly. A team from Yasuda Life spent a week at Paine Webber in June, gathering information about the firm and performing due diligence. After the Yasuda team returned to Japan, Don Marron and I were invited to make a reciprocal visit to Japan. Over the course of the summer, we hammered out the key terms of the deal: a convertible preferred stock with a 4 percent dividend rate and a conversion price of $35. Since Paine Webbers’s stock was trading in the $25 to $27 range, both Don Marron and I were quite pleased with what I had negotiated. We all agreed that the Yasuda team would fly to New York in October so that we could document and close the deal.

I always say that in China, there are only two rules: “Everything is possible,” and “Nothing is easy.” Even outside China, though, nothing worthwhile is ever easy, as I soon found out.

As the JAL flight from Tokyo carrying the team from Yasuda Life began its descent into JFK Airport on the afternoon of October 19, 1987, it wasn’t the only thing in New York that was rapidly losing altitude. The Dow Jones Industrial Average was in a free fall, plummeting more than 500 points on what became known as “Black Monday,” a stunning 23 percent drop in market value and the biggest one-day decline since 1929 to that point.

Ironically, my day that Monday in October had started out on a pretty upbeat note. On the previous Friday, the market had dropped 100 points–not all that surprising, given the amount it had risen in the previous six months. Over the weekend, a reporter for The New York Times called and wanted to know what I thought. I had completely forgotten about our conversation until I picked up a copy of the Times on Monday morning, only to see my picture on the first page, right alongside those of David Rockefeller and Ross Perot, two industrial titans at the time.

When the opening bell sounded, the market began its precipitous decline almost immediately. All of a sudden, every firm on Wall Street, no matter how solid its finances, was worrying about “counterparty risk.”

Every day, firms on Wall Street do billions in dollars of trades with each other, and it was feared that if any one of those firms failed it could set off a chain reaction that could potentially bring down the country’s entire financial system. (Morgan Stanley, for example, is rumored to have a large exposure to Lehman Brothers.) It is this concern that has lead the U.S. Treasury, the Federal Reserve and the U.S. government to conclude that they had no choice but to structure bailout packages for companies they deemed “too big to fail.”

Given the very real concerns about whether Paine Webber had enough liquidity, my job negotiating the terms of a $300 million equity investment by Yasuda Life took on a new sense of urgency. With Paine Webber’s stock price cut in half on Monday alone, the terms I’d agreed with the lead negotiator for Yasuda were going to have to change. When we met on Tuesday, we didn’t even discuss the price issue, however. My first job was to convince everyone from Yasuda that Paine Webber was still a viable company. At that point our stock was trading at $13, and I was hoping that it would bounce back once the dust settled. By the end of the week, it was pretty clear that this wasn’t much more than a dream on my part.

In the end, considering what Wall Street had just been through and where our stock was trading, we did quite well. We reset the conversion price at $28, raised the dividend a bit, and went ahead and closed the deal. After Black Monday, there was no more important symbol that Paine Webber had staying power. If Morgan Stanley can pull off its deal with Mitsubishi UFJ, the impact will be no less important.

Never Invest in Something You Don’t Understand

Consider this: Lehman Brothers at its peak was worth $47 billion. One year later, it filed for bankruptcy and its stock market value was slashed to $138 million. At the top of its game, Bear Stearns was valued at $200 billion. When the dust finally settled, J.P. Morgan’s initial $2 per share bid valued the company at only $236 million. Similarly, AIG’s stock market value dropped from $188 billion to approximately $10 billion in one year.

With these three firms alone, over $400 billion of shareholder value was wiped out faster than you can say “meltdown.” That does not include the loss of value that was experienced at Merrill Lynch, Wachovia, Washington Mutual, Fannie Mae, Freddie Mac, Goldman Sachs, Morgan Stanley and countless other banks and Wall Street firms as the credit crisis unfolded. The stunning loss of value over these past several weeks totals well into the trillions of dollars. No wonder Wall Street’s reaction to the $700 billion bailout package has been lukewarm. No one believes it’s enough to solve the problem.

How could this happen? How could such large amounts of money be made–and then lost—over such a short period of time? The answer is simple. Wall Street got well ahead of itself and became much too complicated for its own good. Believe it or not, even the heads of the large Wall Street firms did not understand their firms’ exposure to risk. After all, why would Dick Fuld, the head of Lehman Brothers who started as an intern at the company 42 years ago, knowingly put Lehman in a position where it could become worthless overnight? The answer is that he wouldn’t, unless he just didn’t understand the exposure that Lehman had taken on with the securities its bankers had created. Combined with large amounts of debt, the trading of these complicated securities generated huge profits—and bonuses– when the markets went the right way, but huge losses when they didn’t. In dealing with such complicated securities, Wall Street forgot one of the cardinal rules of investing: “Never invest in something you don’t understand.”
The precursor to the meltdown on Wall Street and a warning that was not heeded was the failure of Long Term Capital Management (LTCM) in 1998. If there was ever a hedge fund designed in heaven, it was LTCM. Based in Greenwich, Connecticut, LTCM’s founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Among other accomplishments, Scholes and Merton developed, along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM’s roster also included John Meriwether, a former vice chairman of Salomon Brothers and successful bond trader as its guiding light; David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System; Harvard University professors Eric Rosenfeld and William Lasker; and a group of smart arbitrage analysts from Salomon Brothers, a leading bond trading firm.

The idea behind LTCM was….. to look for arbitrage opportunities in markets using computers, massive databases and the insights of top-level theorists. These opportunities arose when markets deviated from normal patterns and was likely to re-adjust to the normal patterns. By creating hedged portfolios the risks could be reduced to low levels. According to the model developed by Merton, the risk could be reduced to zero, but in practice some of the crucial assumptions of Merton’s model did not hold so the risk of the hedged portfolios was not really zero, as subsequent events proved.

Myron Scholes stated the objective of LTCM in a striking image. He said LTCM would function like a giant vacuum cleaner sucking up nickels that everyone else had overlooked.

At first, LTCM’s models worked according to plan. Between 1994 and 1998, LTCM produced returns on investment of 40 percent or more per annum. But then, its enormously leveraged gamble with various forms of arbitrage involving more than $1 trillion dollars went bad. In August of 1998, Russia defaulted on its debt and the financial markets came unraveled. Historical trading patterns and relationships failed to hold, and LTCM which had bet on those regular patterns nearly went bankrupt, losing $1.9 billion in one month. Prompted by deep concerns about LTCM’s thousands of derivative contracts, the Federal Reserve Bank of New York got involved to avoid a panic by banks and investors worldwide, and organized a $3.65 billion loan fund from a group of banks and Wall Street firms. LTCM was eventually liquidated in 2000.

Although they seemed large at the time, the amounts of money involved with LTCM pale by comparison to those being bandied about today. But, the principles are the same. In the case of LTCM, a group of very smart people using sophisticated computer models believed they had developed a foolproof system for “vacuuming up nickels” that everyone else had left behind, as Myron Scholes explained. Confident in their assessment of the risks involved, they then leveraged their equity capital 30 times to create total buying power of $100 billion. When used to purchase derivatives and other financial contracts that were also inherently leveraged, $1 trillion was controlled by a mere sliver of equity. When Russia’s default caused the markets to behave in ways not predicted by LTCM’s models, the result was financial collapse.

Lured by the profits made by the LTCMs of the world, and also confident that they knew how to manage risk, Lehman Brothers, Bear Stearns and other investment banking firms became nothing but big hedge funds in recent years, overleveraged and bulging with complicated securities that no one understood. If two Nobel prize-winning economists and several Harvard professors can’t get it right, what chances do lesser mortals have?

China’s capital markets currently consist of two stock exchanges; loans by its commercial banks, most of which are state-owned; and a growing pool of venture capital and private-equity funds. Derivative securities and other exotic financial instruments are not yet part of the landscape, but eventually they will come into play. Despite their potential for harm when used improperly, derivatives and other synthetic securities can be important trading instruments that increase market efficiency. The inherent unpredictability of markets and the volatility of these securities, however, make them potentially dangerous when combined with excessive amounts of leverage.

In the aftermath of the 1929 stock market crash and the Great Depression, the Glass-Steagall Act of 1933 separated the commercial banking function from investment banking. The ability to take deposits was limited to commercial banks, and in order to protect depositors, the commercial banks became subject to regulation and strict oversight with respect to capital adequacy. As an additional measure to protect depositors, the Federal Deposit Insurance Corporation (FDIC) was created. Because investment banks were prohibited from taking deposits, they went unregulated.

When hedge funds came into vogue in the 1990s, they didn’t fit the description of a commercial bank and like investment banks, they too fell outside existing regulations. Quite simply, financial legislation in the United States dates back to the 1930s and has never been updated to deal with the new forms of financial institutions and capital market conditions as they exist today. Left to their own devices, the investment banks used their freedom from regulation to supercharge profitability by leveraging their capital bases 30 times or more, degrees of leverage that would be unthinkable for a commercial bank. At a minimum, the failure of the United States to regulate the new breed of financial firms is one of the root causes of the current credit crisis.

The lessons for China are obvious. As its capital markets develop, it must put in place regulations that do not impede their development, but which prevent financial players from taking on amounts of risk that can potentially destabilize the entire system. Each in their turn, LTCM, Bear Stearns, Freddie Mac, Fannie Mae and AIG became “too big to fail,” forcing the government to become involved in their bailouts. Very telling is the fact that both Goldman Sachs and Morgan Stanley have now become commercial bank holding companies, subjecting themselves to increased regulation and stricter capital ratios. In the aftermath of the current financial crisis, the United States capital markets will revert to simpler times. China’s traditional caution and “step by step” approach to development should serve it well in avoiding the pitfalls of excessive complication and leverage in its capital markets.

With fuel prices higher than ever, energy policy has become one of the key issues in the U.S. presidential campaign. Although it has taken a backseat lately to the economy as the country struggles to deal with the meltdown on Wall Street, everyone realizes that new solutions — and alternatives to the current sources of energy supply — are needed to meet America’s needs over the long term. So much so that John McCain, the Republican presidential candidate, proposed that a $300 million prize be given for new technology that would be 30% cheaper than current batteries for passenger cars and have “the size, capacity, cost and power to leapfrog the commercially available plug-in hybrids or electric cars.”

Well, the U.S. won’t have to spend that money after all and can apply it instead to the economic bailout package. Warren Buffet has beaten everyone to the punch by investing $230 million in what he considers to be the most promising battery technology in the world. Who’s the lucky winner? A whiz kid from Silicon Valley? An automotive engineer from Detroit? Or perhaps an engineer trained at Toyota, the company that pioneered the development of hybrid technology? Remarkably, it’s none of the above. The prize goes to a Chinese company that is a relatively recent entry to the battery business, and an even more recent entry to the automotive industry.

Warren Buffet announced Monday that he had agreed to pay 1.8 billion Hong Kong Dollars (about $230 million) for a 9.89 percent stake in BYD, a Chinese battery manufacturer that plans to sell electric cars in the United States by 2010.  Established in 1995 and based in Shenzhen, BYD is one of the world’s largest makers of rechargeable batteries for cellphones and other uses. The company’s fast-growing auto-making unit, which it only established in 2005, makes compact and subcompact cars for the Chinese market and now accounts for nearly a third of the company’s revenue. In the first half of 2008, BYD sold 72,357 gasoline cars in China, a 94 percent increase from the year before. The company plans to offer its first fully electric-powered car to Chinese customers in June 2009.

Buffet’s investment was made through MidAmerican Energy Holdings Company, an 87.4 percent-owned subsidiary of Berkshire Hathaway that is a global provider of energy services. David Sokol, the chairman of MidAmerican, said that the company wanted to address climate change and considered electric cars as a way to do so. “This is a technology that can really be a game changer if we’re serious about reducing” emissions of carbon dioxide, the main gas associated with manmade global warming, Mr. Sokol said.

In my recent interview with Sina.com, I stressed that the development of new products and new technologies would be the future trend in China. As the China market grows larger and develops its own unique set of requirements, products and technologies that have been developed elsewhere for another set of consumers may or may not have applications in China. Of all the countries in the world, for example, China has the greatest vested interest in developing vehicles that are more affordable, more fuel efficient and more environmentally friendly. The China economy needs to grow larger so that it can provide the opportunity for a better life to the 900 million Chinese who still live in the countryside. The more China grows, however, the greater the need for transportation. The more buses, trucks and cars on China’s roads, the greater the demand for fuel and the greater the stress on the environment. If China can’t provide more transportation, its economy can’t grow. It’s that simple. For China, therefore, developing vehicles and other forms of transportation that are more affordable, more fuel efficient and more environmentally friendly is a matter of economic life and death.

In this context, it should not be too surprising that the next advances in automotive technology come from China. Warren Buffet’s investment in BYD is yet one more sign that Chinese companies are moving upward technologically and gaining world class status. The executives at MidAmerican believe that BYD is at the cutting edge of battery technology and were impressed by BYD’s ability to produce electric cars that can be 80 percent recharged in 15 minutes and have a range of almost 190 miles on a single charge. GM’s Chevrolet Volt, by way of comparison, has a battery range of just 40 miles on a full charge.

In addition to their belief that plug-in electric cars are well-suited for the U.S. market because the country already has the infrastructure to recharge almost anywhere, Berkshire Hathaway and Mid American want to tap into China’s vast engineering talent. Investing in BYD, which has 11,000 engineers and technicians among its 130,000 employees, provides a way of doing so.