In the chapter on China’s Two Markets in my book, Managing the Dragon, I describe how every product in China has two markets: a highly visible market that resembles those in the most developed economies in the world, and a second, much less visible one that is purely local and unique to China. While the world focuses on the first, much of China’s population deals on a daily basis with the latter.

This is true even in the case of capital. On the one hand, China’s commercial banks are now among the largest in the world and have become highly active, and visible, players in global financial markets. In the stock market, the ups and downs of the Shanghai Stock Exchange are reported on in the same breath as those of the exchanges in New York or London. At its peak last year, the valuation of China’s A share listed companies was a lofty 43.7 times earnings, more than double valuations on most stock markets around the world. Even with the 55 percent decline from last October’s peak prices, A share companies trade at 18.5 times earnings, slightly more than the price/earnings multiple for the S&P 500.

While China’s largest companies enjoy rich stock market valuations and can readily borrow money from banks at interest rates less than 8 percent, most private companies in China are forced to resort to a large and growing network of illegitimate, unregistered and unregulated private lenders that charge interest rates of 20 percent or more. This underground network constitutes China’s less visible, purely local market for capital. Though it has always existed in one form or another, China’s recent credit tightening measures are drying up bank financing that most private companies find it difficult to obtain even in the best of times.

Rampant entrepreneurialism in China and the 85 million private enterprises that Ted Fishman, author of China, Inc., estimates exist in the country, belie the fact that being an entrepreneur in China is no easy matter. Despite the enormous amount of capital that has flowed into the country over the past thirty years, and the vast amount of wealth that has been created during that period, obtaining capital to start or build a business in China is one of the biggest hurdles faced by budding entrepreneurs.

Bank loans, a traditional source of financing for new companies in other countries, have been largely reserved for state-owned enterprises in China, where the implicit guarantee of the state makes it unnecessary for loan officers to learn how to analyze a business plan. A survey by the Guangdong provincial government showed that small and medium sized enterprises in that province only got 2 billion yuan in bank loans in 2007, 2 percent of the total loans extended in the province.

Leasing and other institutionalized forms of secured lending are still in an embryonic stage of development in China. Even selling shares in the stock market, an option available to companies of all sizes in most other stock markets around the world, is not an option for private companies in China, no matter how promising their growth prospects. Which companies go public in China is determined by state regulators, not the investment bankers.

With traditional channels for obtaining capital closed to them, a purely local market for capital has developed as many private companies have been forced to go “underground” to obtain start-up or working capital. A recent story in China Daily Business described some of the aspects of this purely local market and the dilemma faced by entrepreneurs in the country.

When Yuan Xing needed 800,000 yuan to start his organic farm, he turned to private lenders in his hometown for financing at a 20 percent annual interest rate.

“I knew I could get a better rate from a bank,” said the 29-year-old fruit and vegetable producer. “I tried Bank of China and Industrial and Commercial Bank of China, but they didn’t even want to look at my business plan.”

“A lot of small firms come to us. Only the bigger enterprises go to the banks,” said an underground lender, who declined to be named. He has lent out 10 million yuan - he declined to say how he made that kind of money - at 30 percent annual interest rate.

“Interest is not an issue. They will go bankrupt if they don’t get our short-term loans,” he said. “Our money is available at short notice. We can deliver the cash within 24 hours, while a bank loan might take at least six months.”

Despite usurious interest rates, underground lending is becoming a big business in China. In a survey conducted by Beijing’s Central University of Finance & Economics, it was estimated that underground lending totaled 1.98 trillion yuan in 2007, equal to 28 percent of the amount lent by banks.

China is a study in contrasts and nowhere is this more apparent than in its capital markets. Countries like the United States have found that the biggest sources of new jobs are the small and medium sized enterprises, not the large Fortune 500 companies. One of China’s biggest problems is its lack of effective capital markets to distribute capital to those individuals and companies that can use it most effectively. One of China’s biggest opportunities is to develop capital markets that do.

I recently met with a finance professor from a major U.S. business school who happens to be a native of China. Reflecting on the two weeks he had already spent getting re-acquainted with his home country, his first comment to me was telling: “This place has bubble written all over it.”

You don’t have to be a finance professor to come to the same conclusion. Signs are everywhere—from an inflated stock market, to growing inflation to ever increasing apartment prices. The questions are: Does China have a hard or soft landing, and what does it feel like? What happens after the Olympics?

I have to keep reminding myself that I have already been through a relatively hard landing in China. In 1994, China’s economy was overheated and inflation peaked at 24.1 percent. Zhu Rongji, China’s then-economic czar, had a simple solution. He immediately clamped down on credit, dramatically slowing the growth in China’s economy.

In 1992, 1993 and 1994, China’s Gross Domestic Product (GDP) grew by 14.2 percent, 14 percent and 13.1 percent, respectively. From this blistering pace, GDP growth slowed to 10 percent by 1996, and fell to a low of 7.6 percent in 1999. Although these growth rates still seem high by global standards, many economists at the time questioned whether they were overstated, with the Chinese government attempting to put a good face on a sluggish economy. In fact, analysts began to track measures such as the growth in electricity demand as proxies for economic growth. These metrics suggested slower growth than advertised by Beijing and appeared to be more reliable indicators as to the overall health of the economy.

The China economy of 2008 is a great deal larger and infinitely more complicated than the one that existed in 1994. It is therefore doubtful that simply restricting credit would ever work today, although this hasn’t stopped China’s government from trying. The general efforts by China to slow down its economy have not brought it to a screeching halt, but there are growing signs that we are on the other side of the high growth cycle.

A good benchmark is the Shanghai stock market, which has essentially done a round trip over this past year. At the beginning of 2007, the Shanghai Composite Index was just above 3,000. By mid-year, it had nearly doubled to 6,000. Last week, it slumped to 3,411, its lowest level since April 9, 2007. The Shanghai Index has fallen 35 percent this year, making it one of the worst performers among Asian markets.

PetroChina, the poster child for the China stock market, made its debut in Shanghai in early November and nearly tripled in price to 43.96 yuan in its first day of trading, giving it a market cap of over $1 trillion. Last week, it fell to 16.99 yuan, barely above its IPO price of 16.70 yuan.

Other signs are less dramatic but nonetheless apparent. Baoshan Iron reported last week that 2007 net profit fell by 2.8 percent on higher ore prices, suggesting a weaker market where higher raw material prices cannot be automatically passed along to customers. Inflation continues to be an issue, increasing to 8.7 percent in February, after a 7.1 percent rise in January, marking its fastest pace in nearly 12 years. Partially to offset higher food prices, China’s main source of inflation, the yuan has been allowed to increase sharply against the dollar, thereby reducing the cost of imported grain.

“I think the People’s Bank of China is worried that food inflation could turn into headlines inflation. Wages are increasing quite strongly….and for this reason they have to control excess liquidity more tightly,” said Sebastien Barbe, an economist at Calyon Credit Agricole CIB.

All of this suggests an economy which will begin to slow, if it has not already. What the rest of 2008 brings, and whether the inevitable emotional letdown after the Olympics has an economic impact, is anyone’s guess. However, it is certain that Beijing is pulling a number of levers to cool an overheated economy and bring it down to a more sustainable level of long-term growth.

The 17th National Congress, which has resulted in several personnel changes at the very top of China’s Government, will inevitably have significant ramifications on the business landscape in China. The main headline has been that General Secretary Hu Jintao has strengthened his position slightly, but fell far short of obtaining the dominance that many expected him to secure at this point. Along the same lines, many are pointing out that ultimate power is no longer being held by a single individual as several coalitions now compete to influence how the country is led.

On the business front, much remains unclear, but here are some key issues being discussed:

First, with Hu in a stronger position, following the retirement of several Jiang loyalists from the top posts, it could be predicted that he is in a stronger position to take bold measures on the exchange rate–letting it appreciate faster. Evidence that this might occur is backed up by the fact that the central bank governor, Zhou Xiaochuan was granted a place in the central committee for the upcoming five years, despite initial rumors to the contrary.

On the other hand, this Congress has demonstrated that coalitions (i.e. Jiang Zenmin’s Shanghai clique, versus Hu’s clique) are becoming more powerful, and that the government is being ruled more by coalitions. This would indicate that bold moves on monetary policy will be more difficult to implement in the coming term.

As such, it is difficult to analyze with any degree of certainty what will happen with the Yuan’s exchange rate.

Either way, it seems that inflation will likely remain a major issue. With China’s deficit at 1% of GDP, and the economy continuing to grow, it seems likely that fiscal spending will increase over the coming years. The government is awash with cash, and Hu has pledged to help the rural sector in the name of harmonious development. His major initiative to date was the abolishment of the income tax on peasants. Although this was a major milestone for China, he will need to do much more in order to truly deliver on his commitment to China’s peasants and he has indicated that he will (healthcare, social security, and education spending are other areas spending would likely increase). With upward pressure globally on commodities, promised environmental regulation pushing up the costs of business and government cash flooding into the countryside, one would have to be concerned that inflation will continue to rise.

As a final note, one government relations expert that I spoke with noted that all the recent talk about coalition politics in the upper reaches of the Chinese government is focusing too intently on the power play between the Shanghai clique and the Hu clique, but is neglecting the Taizi Dang which refers to the children of former communist bigwigs who now hold commanding positions. This group includes Liu Qisan, Bo Xilai, and Xi Jinpin. Xi Jinpin is actually in the ideal position of straddling that group and the Shanghai clique. In one sense, this puts him in a very strong position to muscle his way to the top, despite apparently not being favored by Hu himself.

U.S. private equity firms are discovering that capital markets in China are more like the U.S. capital markets of the 1970s than those to which they are accustomed today. In the U.S, acquiring majority stakes in companies of all sizes has been limited only by one’s imagination—and the willingness of capital markets to provide financial lubricant in the form of cheap debt financing.

Until the recent credit tightening brought on by the sub-prime mortgage crisis, lots of cheap credit with little in the way of restrictions has given private equity firms a virtual blank check to hunt for corporate elephants. Despite the temporary lull in lending activity, it is likely that those days will return once the current backlog of deals clears.

China is a completely different story, however. Carlyle, a Washington D.C.-based private equity firm with plenty of political clout provided by an army of former administration officials, tried to buy an 80 percent plus stake in Xugang, one of China’s major construction equipment companies, only to find its bid rejected by Beijing. Over the past several years, China’s central government has become increasingly concerned that too many of its leading companies are coming under the control of foreign investors and firms. Acquiring majority ownership of a company of any reasonable size in China is very difficult as a result, and it may already be too late to have any hope of doing so in the future. The last time I checked, Beijing has not yet approved even a minority investment in Xugang by Carlyle.

No doubt learning from Carlyle’s experience, other large private equity firms are setting their sights lower and appear content to take minority positions in Chinese companies. In September, Blackstone announced that it would invest up to $600 million for a 20 percent stake in China National Bluestar Corp., a specialty chemical subsidiary of China National Chemical Corp., a leading international diversified chemical company.  This represents Blackstone’s first ever investment in China.

The Bluestar investment comes just months after China’s new state agency decided to invest $3.0 billion for just under 10 percent of Blackstone’s newly listed shares. The investment by China is one of the first of what is expected to be more financially oriented investments as China seeks to increase returns on its foreign currency reserves. At the time, many observers predicted that Blackstone’s investment program in China would be helped by its new relationship with China.

In another first, KKR announced that it would acquire a minority interest in Tianrui Group Cement Co., a Chinese cement maker for $115 million.

Beyond the fact that they represent minority stakes, the investments by Blackstone and KKR are very different than those typically made by these firms in the United States and Europe, reflecting their strong desire to find some way to invest in the China market. First off, a few board seats may come with a minority interest, but not the management control which both Blackstone and KKR would insist upon in the United States. Secondly, the investments are unleveraged and are being made with all equity. In the United States, a company’s shares are purchased with a relatively small amount of equity plus a large amount of debt that is based solely on the borrowing power of the company itself. In the United States, buying a company is like buying a house with some savings and a mortgage. In China, it is like buying an apartment with all savings and no mortgage.

The fact of the matter is that, unlike the U.S. capital markets with its diversity of financial instruments, China’s capital markets are undeveloped and consist primarily of short term working capital loans from Chinese banks. That is why KKR had to call upon JP Morgan and the International Finance Corp., two foreign based financial institutions, to provide an additional $335 million of USD and RMB long term financing to Tianrui to help finance its growth and expansion needs.

With the continued growth of the China market and the strong market positions which Bluestar and Tianrui undoubtedly have, these investments are likely to do just fine. The point is that both Blackstone and KKR have decided to depart from well honed investment strategies developed in their home markets to adapt to actual conditions on the ground in China. In the U.S, they do leveraged buyouts where they have management control. In China, they are providing growth equity to industrial companies where they don’t—two very different investment strategies.

I recently read the following post from Bespoke Investment Group’s “Think B.I.G.” site, which puts forth the following train of thought:

• A: Last week the Hang Seng index was very volatile (moving at least 1% every day) and ended the week at a gain.
• B: In the past, when the index was very volatile and ended at a gain, it usually carried that gain into the next week and month.
• The implicit conclusion C: it’s a good time to invest in the Hang Seng.

Now, I don’t purport to be an expert on investing, but I do know enough about logical reasoning to know that a lose correlation like the one between point A and point B does not warrant a rational investor’s attention. The myriad of causes that led to the index doing well for 3 weeks after seesawing intensely in December 1993, does nothing for me in 2007. I don’t even know why an article like that would be written.

The article caught my attention, because it reminds me of the faulty reasoning that is gripping Mainland Chinese investors these days. With the market soaring, Chinese investors continue to line up with little more than a gambling spirit backing their investment strategies. When evaluating how to take advantage of the enticing gains available in China, the following advice from the Everyday Finance Blog would be worth listening to:

Based on valuation and revenue growth, China is still considered to be THE value market of the BRIC four by many prominent investors and economists. However, before long, Vietnam, Columbia, and others could start to draw some of the speculative emerging market funds seeking 50%+ returns per year.

Given the massive runup in share prices in recent weeks, it would be prudent to take some money off the table. However, pulling out altogether could result in missing the investment opportunity of a lifetime. A good approach would be to continue to leave the speculative portion of your portfolio in SOLID Chinese stocks. This would include companies with some history, proven earnings, and you should be able to articulate what this company does.

Joe Kennedy, in 1929, is oft-quoted to having said that when his shoeshine boy started giving him stock tips, he knew it was time to get out of the market. I always thought this quote was hilarious, but mostly because I told my father to buy Microsoft stock when I was ten years old. At that time, he asked me: “Do you know what overvalued means?” To which I obviously replied no, and he laughed and gave me a pat on the head - and didn’t buy. That was 14 years ago now.

In Beijing University, there is a xiaochi right before you get to the CCER (China Center for Economic Research) building. I used to get dumplings from this place in the mornings. When you walk in, there are concrete floors, a vat of boiled eggs, and not enough space to walk with two people side-by-side. However, starting 6 months ago, the little lady running the shop bought a computer. I would walk into her shop at 8:30 am, order some dumplings, and she would send her cook to boil them up for me out front while she would sit there, at her computer in the back of the shop, staring at daily trading prices and volumes of whatever stock she happened to be looking at. It took a week before she told me she owned about 500 shares of Vanke - or approximately, at the time, 10,000 RMB worth. It was also the only stock she owned.

This is a huge gamble on her part. 10,000 RMB is not small change for a store whose average products sell for 25 cents, and have a profit margin even slimmer than that. She did not “advise” me, per se, to buy Vanke, but she did say that she thought it was a good company, and that she wasn’t afraid of the Chinese stock market crashing because China is getting more developed, not less. The government would not let the market crash.

Upon reflection, although the government probably does not have the absolute financial power to simply “not let” its markets crash, it certainly has been upgrading the markets. On February 1st of this year, the limits to the amount of foreign currency a Chinese national could buy rose from $20,000 to $50,000 a year. Even more recently, the $50,000 foreign currency purchase restriction has been lifted even further. This means that Chinese are allowed to buy more foreign currency on a yearly basis, allowing them greater investment opportunities abroad - one method of cooling the local markets. Chinese nationals are now allowed to openly buy stocks traded in the Hong Kong Stock Exchange, giving Hong Kong a surge in its index value. As China becomes more and more open, the market shifts have been playing the same tune as the government in general - that of growth, growth, growth.

There may be a bubble. Dumpling providers have now installed computers in their shops and are trading online. However, unlike the Internet bubble, there are actual businesses in this one, businesses that make money and provide jobs and pay taxes, and don’t have CEO’s golden parachuting their way into the Carribean after selling their customerless websites.

China’s Vanke has tripled in price this year. As of August 22nd, it was selling at 34 RMB per share.

China Business Services Blog had a recent post highlighting the ongoing debate between the US and China over currency manipulation.  The post concisely concluded that, “the debate on the RMB and the US trade deficit with China will continue in Washington, in the Strategic Economic Dialogue, and in the media. And China will continue with its gradualist approach.” 

Having observed the way that the Chinese government has dealt with similar issues in the past, I agree that they are not going to bow to pressure and that they will continue with the approach that they feel is the best for their own country.  What the  post fails to mention though, is what will happen as the 2008 elections loom and the RMB manipulation and trade imbalance issues becomes increasingly politicized (see this great post from Imagethief for a telling example of how other China related concerns are becoming election issues).  It seems reasonable to anticipate that the public will demand that candidates take a very firm stance on this issue and that could result in more significant, bolder action on the part of the US, whether it be through the WTO or directly in the form of economic sanctions.  It’s difficult to disagree with the fact that China isn’t going to change their gradualism policy as long as the US response is dialogues and potential action, but how will China respond if and when concrete action becomes imminent?

In an article published in the June 5 Wall Street Journal, Jason Leow highlights Citigroup’s current strategy to focus on asset management for China’s growing class of “super-rich.” The article focuses on several key drivers behind this strategy putting emphasis especially on the scale of how many extremely wealthy people there are in China and how this number is growing rapidly. There is another piece to Citigroup’s and other international bank’s decision to focus on this sector though, and it is related to a convergence of expansion limitations and product differentiation.

The foreign banks are desperate to take advantage of recent deregulation and establish a foothold in the country, but there are still a variety of hurdles and regulations that they must negotiate to establish operations in a new city – some foreign banks estimate that they can expand into a maximum of three new Chinese cities per year. China’s big four banks (Bank of China, China Construction Bank, ICBC and Agricultural Bank of China) have over 73,000 branches around the country (compared to 252 branches for the 73 foreign banks in China) and as such there is no chance that foreign banks will be able to compete with domestic banks for geographic coverage.

Boston Consulting Group released a report earlier this year stating that .4% of the China’s people hold 60% of China’s wealth (approximately USD 820 billion in assets) and the vast majority of these elite are located along China’s eastern seaboard — notably Beijing, Shanghai, Guangdong, Jiangsu and Zhejiang. Additionally, the foreign banks have product offerings that are tailored for the ultra wealthy, proven internationally and take advantage of investment strategies that are not offered by domestic institutions. So, a bank like Citigroup (or HSBC, or Bank of East Asia, or Standard Chartered Bank) focuses on the ultra wealthy because it not only serves to alleviate the pressure on geographic expansion but also enables them to best differentiate themselves from the domestic banks in a highly competitive, regulated industry.

China’s stock market has been among the best performing in the world over the past several years. The Shanghai Composite Index has quadrupled since mid 2005, attracting attention from around the world and raising the questions: “Why is this happening? Can it last? Is this a bubble? How do I get in?

While China’s stock markets are well covered in the media, our website would not be complete without at least some commentary on the subject. As with most issues relating to China, it is easy to get caught up in the details and to make the issue extremely complicated. Understanding China’s stock market is no different. However, I’ve found that the simplest explanations are often the best, and that’s what I will try to do in giving our spin on this subject.

As everyone knows, prices of stocks, like the prices of most anything, are a function of supply and demand. The higher the demand and the more limited the supply, the higher the price, and vice versa. The first step in understanding China’s stock market, therefore is to answer the most basic question “Where is all the demand for shares coming from?” The answer lies in China’s savings rate, which at approximately 50%, is one of the highest, if not the highest, in the world.

“Where does this huge amount of savings go?”Because of restrictions on taking money outside China (the renminbi is not “convertible”), Chinese citizens actually have a limited range of investment options. A great deal of savings are put into bank deposits, even though interest rates are low at about 3%. Bank deposits are considered safe, because everyone knows that the government stands behind the state-owned banks. Over the last five years, more and more Chinese are investing in real estate, buying apartments for their own use, and even buying additional units to rent to others. That is one of the reasons why you see so many cranes inChina. The only other place that the Chinese have to invest their savings is in China’s stock market, and that begins to explain the reason for the huge demand for shares of Chinese companies.

According to the latest figures from the China Securities Depository & Clearing Corp. more than 400,000 new accounts were opened at brokerages on May 29, 2007, taking the total to 100.7 million, an incredible number. That’s one account for every twelve people in China! JP Morgan once said that he could tell when the market was at its peak when he began to get stock tips from the shoe shine boy. That meant that everyone that could buy shares was already in the market, and is a bit of what is going on in China.

Demand is one side of the equation, the supply of shares in which to invest is the other. What is the supply of shares? More to come.

As China’s trade surplus with the United States, and its stockpile of foreign currency reserves, have mounted, the US has all but told the Chinese to stop buying US Treasury securities. By pressuring the Chinese to significantly revalue its currency, a move which would at the same time significantly reduce the value of the low yielding, US Treasury securities which China owns, the US has put China in a position where it has had no choice but to decouple the renminbi from the US dollar, and diversify. That it did in July 2005, when it began to peg the yuan against a basket of currencies, not just the dollar.

The second step, which has also been implicitly encouraged by Washington, is for China to increase the yield on its portfolio of foreign currency denominated investments, by expanding its investment horizon beyond low yielding US Treasury securities. In early 2007, China announced that it would take a portion of its $1.2 trillion of foreign currency reserves—some estimate between $200 billion to $300 billion—-and place it into a fund, modeled after the GIC of Singapore, which would seek higher returning investments. Since that announcement, the investment world has been waiting to see which investments the new fund, which is yet to be formed, will target.

On May 19, part of the answer came when China announced that it would invest $3 billion of its foreign currency reserves with Blackstone, taking an almost 10% equity ownership interest in the large US private equity firm. Apart from gaining a higher return on its reserves, this is an ingenious way for China to obtain significant equity interests in some of America’s and Europe’s leading companies. Chastened by the public outcry when one of its oil companies made an unsuccessful bid for Unocal, and perhaps remembering the resistance which Japan encountered in the late 1980’s when it had the audacity to purchase such American treasures as the Pebble Beach Golf Club and Rockefeller Center, China has found a clever way to invest in US assets, under the radar so to speak.

China’s announcement is yet another indication that the global economy is moving into unchartered waters and taking globalization to a level which could have been hardly imagined at the beginning of this century. Japan had a run in the 1980’s, and arrived at a similar point as China in 1990, only to have its economy stall in the 1990’s. Nothing in the tea leaves suggests that China’s economy will stall as Japan’s did twenty years earlier.

The level of exports flowing out of China in recent years has been difficult enough for many to accept. It may be that China’s biggest export in the coming years will, in fact, be its capital, not its manufactured goods. That may be an even more difficult pill to swallow.