Global Issues

Arabian Nights & Chinese Dreams July 2009

H
istorians will debate when the credit crisis officially began, but in our view, it just
celebrated its second anniversary. On June 22, 2007, Bear Stearns announced the
insolvency of two of its collateralized debt obligation funds. When Morgan Stanley
and other creditors seized the CDOs and tried to auction them, only 12 cents were retrieved
on the dollar. The rest, as they say, is history…
Two years in, while it may be premature to say that the worst is behind United States banks
(ominously, commercial real estate and private credit debt are performing at the levels that
we saw in housing last summer) markets have begun to fathom the extent of possible losses.
The same cannot be said with respect to the impact of the credit crisis and recession upon the
rest of the world.
In countries and regions whose economies and institutions are more opaque than America’s
relatively transparent financial system, a subtle but steady stream of news items is indicating
that significant troubles were hidden – and can no longer remain under wraps. Bank losses on
‘non-performing’ assets in Central and Eastern Europe are of particular concern, and have
received a great deal of ink in the European press (if perhaps less in the U.S.); banking failures
in the Middle East are a less catalogued but equally concerning development; slower than
expected economic growth in China is signaling that a global recovery will be weak. These
factors have the potential to further disturb relative currency values, depress earnings, and
lead to serious counter-party problems in the financial sector. They indicate that even as the
flow of awful news coming out of the United States seems to have at least decelerated, the
global economy is not out of the woods just yet.

Persian Gulf Deleveraging

As was noted previously in these pages, a terrific real estate bubble developed in the Persian
Gulf during the 2000s (“Dubai,” September 2006). Dubai was a microcosm of the mania: The
world’s tallest tower and biggest shopping mall were built there, along with archipelagos in
the shape of palm trees and planet Earth. While property prices swelled as oil hit $150/barrel
during the summer of 2008 (even as global real estate prices were rapidly falling everywhere
else in the world), valuations had plummeted more than 40% by early November and are in
free-fall at present.
Losses on similar real estate holdings are the main cause of the insolvencies of a series of
Gulf-based investment groups and holding companies. The first shoe to drop was the Ahmad
Hamad Algosaibi & Brothers Co., a conglomerate tied to the Saudi royal family whose
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holdings include Saudi Chevron Phillips, BP Solar Arabia, the Saudi Arabian American
Montreal, PQ Express licensee, the local Pepsi bottler, and a trading company that represents, among oth-
H 3 G 2W8 ers, Sumimoto, Jeumont, and ShawCor. In late May, rumblings began to the effect that the
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Algosaibi group would not be able to make a $1 billion dollar payment to various creditors,
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F: (514) 393-3453 including BNP Paribas and WestBank LB. Since then, the sum in default has been raised to
www.interinvest.com $9.2 billion.

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Another Saudi conglomerate closely linked to Algosaibi called the Sa’ad Group announced
on June 1 that it could not meet obligations on two revolving credit facilities worth $5.6
billion. While Sa’ad develops real estate, infrastructure, hospitals, and owns a 1,000,000 m2
manufacturing facility, it also owns a 3.5% stake in HSBC bank. Sa’ad’s creditors include
BNP Paribas and Citgroup, which are on the hook for at least $1 billion of losses. The two
top a list of 37 creditors who loaned the Sa’ad group $5.6 billion.
The $14.7 billion in losses on loans to the Algosaibi and Sa’ad Groups might only be the tip
of the iceberg. Huge amounts of credit were extended to Middle Eastern entities on the
presumption that regional energy revenues secured the loans. Bloomberg reports that at
least $64 billion was provided by non-Middle East banks to Saudi borrowers since 2004; a
roughly equivalent amount was loaned across the remainder of the region. The largest for-
eign creditors are among the shakiest banks in the U.S. and Europe: HSBC, Citibank, the
Royal Bank of Scotland, and BNP Paribas. The reader should see where this is going.
The Middle Eastern banks do not look like they can withstand the onslaught, with each
country’s central banker speaking publicly about the need for “solidarity” and “a common
front.” On May 20, the U.A.E. withdrew from a proposed currency union with Saudi Arabia,
probably due to Saudi Arabia’s unwillingness to cover losses on the assets of Saudi corpora-
tions.
The global banks, for their part, claim to be prepared for the deluge. BNP Paribas has a
‘war chest’ of $5 billion dollars set aside against their total world-wide loan book of 508
billion Euros, while Citgroup has access to various U.S. government loan facilities to cover
write-downs; the British banks have been promised similar facilities by the government of
the U.K., though one wonders how much more credit the Bank of England can summon at
this stage.
This situation bears watching, as it is unclear how the banks – still licking their wounds –
will be able to make up the losses. In general, writing down real estate portfolios throughout
the G-10 was painful enough. With central banks and government budgets stretched to their
limits at present, losses on developing world assets may prove to be quite painful indeed.

Chinese Decoupling?
Due to the recession in the G-10 countries and the rapid deterioration of developing
world economies, many are counting on China to drive global growth. Undeniably, China’s
economic miracle is among the great stories of the post-Soviet era. Between 1990 and 2000,
China’s real GDP increased by 257% according to official Chinese government statistics;
between 2000 and 2008, average headline GDP growth was an astonishing 9.7%. The IMF
now counts China as the world’s third largest economy, surpassed only by the United States
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and Japan. The signs of this transformation are easily visible to casual travelers to the middle
Montreal, PQ kingdom. A visitor to China in the early 1990s would have observed seas of people riding
H 3 G 2W 8 bicycles on unpaved streets. Today, those dusty roads and bikes have been replaced by super-
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highways and cars.
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F: (514) 393-3453 In light of China’s spectacular growth over the past 25 years, many observers are predict-
www.interinvest.com ing a rosy second half of 2009 for the Chinese economy. One hears that Chinese GDP growth

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will continue unabated by setbacks elsewhere in the world, that China has “decoupled” from
the G-8 economies as a result of shifting trade flows and its developing domestic market, etc.
It has become fashionable to claim that China has become the one ‘safe’ investment in the
global economy, indeed, that China might even pull the U.S. and Europe out of their eco-
nomic downturns, and therefore, global asset allocations ought to be rebalanced with China
‘overweight’ in the near term.
With all due respect to the tremendous achievements of modern China, it seems that those
who expect it to continue leaping forward at breakneck speed, immune to the global down-
turn around it, do so on the basis of a number of deeply flawed assumptions.
The first assumption that we question is that China’s export economy can thrive amidst a
global downturn. In 2008, China exported $1.48 trillion in goods, accounting for 31.8% of
China’s GDP. As much as media pundits might enjoy trumpeting the growing economies of
Asia and their gradual ‘decoupling’ from the economies of the Atlantic, the fact remains that
more than $400 billion of these exports were sent to the U.S. and Germany alone in 2008.
With global consumption declining, and with consumers in the U.S., Japan, and Germany
abruptly retrenching (e.g., savings rates in the U.S. have moved from negative territory to
6.9% in under 12 months!), it is hard to see how Chinese exporters can avoid feeling at least
moderate pain. Adding to their difficulties, protectionism is quietly reappearing in the G-8,
and Chinese manufacturers are bound to suffer from the double whammy of having to crack
shielded markets in the midst of a recession and global consumption cut-back. Reports that
large Chinese plastics and metal manufacturers are operating at 70% of capacity reinforce
this view.
The second questionable assumption is that domestic consumption in China can pick up
the slack created by weak exports. The Chinese consumer is notoriously conservative, saving
approximately 35% of his income annually. While the Chinese government is attempting to
‘stimulate’ domestic spending by offering tax incentives on the household appliances, cars,
and capital goods that foreign consumers will not be importing this year, as well as added
infrastructure spending on roads and public transportation, early reports indicate that the
expected income bump has not been huge.
What’s more, the easy money is producing unintended consequences. One visitor to
Interinvest reported that large Chinese government-controlled banks have been issued or-
ders to extend consumer credit and to offer corporations “take it or leave it” low-interest
loans – even if they do not have any projects that they intend to undertake. The results are
predictable: renewed real-estate speculation and, in the words of the official Shanghai Secu-
rities News, a stock market “asset bubble.” Former Chinese lawmaker Cheng Siwai was quoted
to the effect that 2.4 trillion of the 4.58 trillion yuan included in China’s stimulus spending is
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flowing to investment assets, and the report concluded that “Nearly half of China’s newly
Montreal, PQ created liquidity has been circulating in the financial system instead of flowing into the real
H 3 G 2W 8 economy to support growth.”
Canada Which brings us to the third flawed assumption about the Chinese economy, namely, that
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F: (514) 393-3453 China’s immense foreign exchange reserves – Bloomberg puts them at $1.9 trillion excluding
www.interinvest.com gold – will be put to work buying commodities, thus bidding up prices. On the one hand, it

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is clear that China is hoarding commodities: Wah Kwong Maritime Transport Holdings
CEO Tim Huxley is quoted to the effect that more than 90 freighters carrying iron ore were
idling outside of Chinese ports mid-month; in the words of an FT editorial, “the further
away from China you go, the cheaper the metal.”
The Chinese government is hoarding commodities precisely because prices are cheap, at
least relative to 2007 highs. With metal inventories in China bulging, however, and with
prices once again rising, surprise – Chinese commodity purchases are decelerating. In late
June, Chinese officials announced that “strategic” purchasing would end. Those who expect
Chinese commodity purchases in 2009 to shoot the values of natural resources back to their
2007 stratospheric levels are expecting Chinese buyers to bid up prices – against themselves
But what if Chinese policy makers come to fear that U.S. dollar depreciation will eat away
at the value of China’s foreign exchange holdings, or, in the words of Li Lianzhong, chief
economist at the Communist Party’s in-house think-tank, “Should we buy gold or U.S. Trea-
suries? The U.S. is printing dollars on a massive scale, and in view of that trend, according to
the laws of economics, there is no doubt that the dollar will fall. So gold should be a better
choice.”
Alas, the largest holder of U.S. treasuries worldwide is… China. Evaluated in dollar terms,
64% of Chinese foreign reserves are held in U.S. dollars. Perhaps one might imagine China
gradually balancing down its dollar holdings on the margin, but a rapid purchase of foreign
currencies or commodities would simply depress China’s core holding: U.S. dollars. Chinese
talk of a new “global reserve currency” should be considered in light of China’s stake in the
world’s current reserve currency.
The economic historian Niall Fergusson has dubbed the China-U.S. relationsip
“Chimerica,” a term that neatly describes the symbiotic connection between the world’s
fastest growing emerging market and the world’s largest economy. China has developed
itself by looking abroad, and availing itself of global capital, global markets, and global
trade. While one should expect China to continue its growth and modernization for years to
come, it is hard to see how it can replicate the rapid progress of the past decade under the
prevailing difficult economic conditions of 2009.

Dov Zigler and Dr. Hans Black

Maison Interinvest
3655 rue Redpath
Montreal, PQ
H 3 G 2W 8
Canada
T: (514) 393-3232
F: (514) 393-3453
www.interinvest.com

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