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How do you invest in a country such as China that's making up the law as it goes along?
03/23/2010 2:52 pm EST
I’m not talking about Google’s (GOOG) decision to stop self-censoring its China search engine and retreat to Hong Kong in the hope, delusional I suspect, that the Chinese government will let Google Hong Kong operate outside the censorship rules.
And I’m not talking about the spying bribery trials of four Rio Tinto (RTP) executives and employees that have resulted, so far as anyone can tell since today the proceedings were moved to a closed court, in guilty pleas from some defendants on bribery charges but denials of the commercial spying charges. Speculation, and that’s all it is at this point, is that, given a recent deal between Rio Tinto and Chinalco (ACH), there’s some kind of deal that would let the Australian defendants off with a lesser sentence (although who wants to spend any time in any prison, especially a Chinese prison) in exchange for testimony that would implicate Chinese steel company executives in bribery charges.
Those two cases—Google and Rio Tinto—should be enough to make an investor wonder how anybody can make money in a country where the government gets to make up the law as it goes. But the implications of those cases are nothing in comparison to the ramifications of a much lower profile case, the takeover of privately owned Shenzhen Airlines by government-controlled Air China (AIRYY.PK).
In 2005 a private company, Huirun, beat out Air China in a bidding war and bought about 65% of Shenzhen Airlines. (Air China wound up as the second largest shareholder with a 25% stake.) That effectively turned Shenzhen Airlines from a state-owned company into a privately owned company.
But the Chinese airline industry has been undergoing rapid consolidation since 2008 with state-controlled companies buying up smaller, often privately-owned companies. In 2009, for example, state-controlled China Eastern Airlines (CEA) bought up Shanghai Airlines.
Many of these deals haven’t been exactly voluntary, I’d say. In 2009, for example, Lan Shili, the owner of East Star Airlines, disappeared in the middle of merger talks with Air China. Before his disappearance Lan had set a price of $88 million for his company. After his disappearance, East Star wound up going into bankruptcy. Air China bought the company out of bankruptcy for just $3.4 million in December.
Something similar has happened to Shenzhen Airlines. Here’s the story as laid out by the Financial Timkes.
In December, Li Zeyuan, the head of Huirun, was placed under investigation for “economic crimes.” Two weeks ago, the top Huirun executive at Shenzhen Airlines, Li Kun, was named in the same investigation.
That has left management of Shenzhen in the hands of Air China executives (Air China owns 25% of the airline, remember.)
And what do you know but yesterday Air China announced that it would take over Shenzhen Airlines by paying $100 million to raise its 25% stake to 51%. Air China is likely to expand that position further since Huirun itself has now filed for bankruptcy.
It’s pretty clear that China, which once had decided that it was okay for privately-owned companies to operate airlines, has decided to renationalize its airline industry around the three big state-controlled companies, Air China, China Eastern, and China Southern (ZNH).
So what do you do if you’re an investor that wants to own a piece of the world’s fastest growing economy?
There’s the cynical approach. You can go with the big guys and buy into the companies like Air China that are favored by Beijing. Assuming you can figure out who’s in favor and who’s not. In some cases I think it’s pretty easy. It’s no coincidence, for example, that former Air China head Li Jiaxiang is now in charge of the General Administration of Civil Aviation of China, the government body that regulates the airline industry in the country. So you buy shares of Air China because you believe that this company has the government connections to rule the airline industry in China.
And there’s the stay out of the big sectors the government cares about. It’s pretty safe to think that Beijing things steel, railroad equipment and construction, Internet and telecom equipment, and solar and wind power gear, just to name a few industries, are strategic sectors. It’s unlikely that China’s government would let a private company dominate any strategic sector. Privately owned successes in those industries face the fate of China’s privately owned airlines.
But dairy producers, cosmetics retailers, noodle companies, certainly you can invest in those without worrying that Beijing will decide that they represent strategic industries that need to be under government control. Especially if you buy companies in these sectors while they’re still relatively small.
That’s true enough—and safe enough—as long as you believe that what’s going on is simply a government making sure that its strategic sectors stay in government hands.
But some China watchers, such as Minxin Pei, think that what we’re actually witnessing is politically connected individuals using the government to make them rich. If that’s what’s going on, then staying out of strategic sectors won’t be enough. (I review Minxin Pei’s book China’s Trapped Transition in June 2009. Read that post here http://jubakpicks.com/2009/06/29/books-on-china/ )
Me? I’d go with the second strategy and just add government-sponsored theft to one of my list of the risks that come with investing in China. That does raise the bar at bit, I'll admit, for deciding what's worth buying in China and what's not.
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