– Wei Gu is a Reuters columnist. The opinions expressed are her own —

The Chinese leaders have a dream. The banks pump trillions of yuan into the market, which props up asset prices, creates new demand, and gets the economic engine roaring again. Then, just before inflation starts to surge, the money is drained out of the system.

Others, from U.S. Federal Reserve Chairman Ben Bernanke to Bank of England Governor Mervyn King, share the dream but the Chinese economy, still largely driven by the state, should make it easier to realise. Unfortunately, investors in Shanghai’s stock market have their own ideas — the mere suggestion of credit tightening caused the index to plunge 20 percent in just two weeks to Wednesday’s close before bouncing slightly.

The Chinese policymakers are left between a rock and hard place. At some stage, they must stop pumping money into the system, and prepare to mop it up instead, but timing this to avoid another stock market slump looks close to impossible.

Investors can remember what happened the last time. The central bank’s resumption of sales of one-year bills in July looks similar to the tightening action which began in May 2003. That prompted a six-month fall in stock prices.

That time, Beijing was slow to show it meant business. A couple of reserve rate hikes were largely symbolic, and it was not until late 2004 that interest rates were raised, 18 months after the first move. The market had lost half its value about a year later.

Beijing might not be very effective at controlling wild swings in the market, but it is effective at jump-starting the economy. While Japan had to pump free liquidity into the system for seven years before economic growth returned, it’s taken just half a year for China’s astonishing GDP growth to resume.

This increased economic activity has done little to improve corporate earnings. Take banks as an example, they are the biggest beneficiaries of the loans surge, as new lending tripled the amount on the first six months of last year. But net interest income at China’s largest bank ICBC fell 12 percent during the first half, because lending was less profitable — the interest spread was almost a third less than last year.

The authorities’ hope that rising property prices and investment would increase domestic demand, and hence corporate sales and earnings, has not been realised so far. Urban dwellers feel less well off than at any point since 1999, according to a survey by the central bank conducted in late May.

Chinese policymakers hoped the stimulus would buy China some time before demand from developed markets recovered, but the process of unwinding the West’s huge consumer debt total built up in the past two decades will be slow. Net exports, which contributed about 10 percent to China’s economy, have kept falling, and only recovered slightly in July.

Perhaps the latest market sell-off might prompt the Chinese authorities to maintain loose money policy a little longer, to encourage the buyers back in to share and property markets.

Unfortunately, even if the ploy works, it just sets them up for more difficult times next year.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

– Wei Gu is a Reuters columnist. The opinions expressed are her own —

Please don’t call it a liquidity crunch, but it rather looks as though China might have had to sell a sliver of its vast hoard of U.S. Treasury paper to fund its private sector’s big overseas foray.

China’s holding passed $800 billion in May, sparking speculation that it could reach $1 trillion within a year, but the net June figure, published on Monday, showed a 3.1 percent drop to $776.4 billion, the biggest percentage fall in nearly nine years.

It’s clear that China has been keen to use more of its reserves to secure strategic resources supply overseas, as well as diversifying them into emerging markets such as Africa to help create demand for Chinese exports. The unwinding of global imbalances also means China might have fewer dollars to invest, as its July trade surplus more than halved from a year earlier.

In the past, almost all outflows from China come from the government, which by default put the money into U.S. Treasuries. But now the private sector needs more foreign currency.

Just this month, China’s Yanzhou Coal Mining agreed to buy Australian coal miner Felix Resources for $2.9 billion, and Sinochem Corp. spent $878 million buying British oil and gas explorer Emerald Energy.

The government itself also seems to be getting more adventurous. Its $200 billion sovereign fund finished 2008 with almost 90 percent of its assets in cash, but is determined to put more money to work this year.

This week Reuters reported that the fund will soon invest up to $2 billion in U.S. mortgages as it eyes a property market rebound, and last week Reuters revealed the fund’s talks on a $1 billion-plus convertible bond investment in Fortescue Metals Group.

Not all the June sales of U.S. Treasuries were turned into cash. Half the sales of $51.8 billion short-dated debt were rotated into longer-dated maturities, indicating that Beijing now cares more about yield and worries less about the safety of its investment, reversing an earlier trend of reducing the average life of the holdings.

These monthly reports do not tell the whole story, because they exclude trades through London intermediaries. The more accurate numbers are not revealed until February, in the annual survey. Even so, China appears keen to diversify away from U.S. Treasuries, and as the authorities allow more private sector investors access to dollars, this process will accelerate.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –

– Wei Gu is a Reuters columnist. The opinions expressed are her own —

Chinese banks are like enthusiastic runners on an accelerating treadmill. The weakening economy means poor lending decisions are threatening to catch up with them, but the banks are sprinting ahead by expanding their loan books ever faster. They cannot keep this up for ever.

For now things still look fine. China Banking Regulatory Commission (CBRC) this week claimed that Chinese banks were managing credit risk sagely, pointing to record low non-performing loan ratios. Given the massive increase in the number of loans outstanding — up 24 percent since the start of the year — it’s not surprising that the proportion of them that are non-performing at large commercial banks, which accounts for 60 percent of the lending, has declined from 2.4 percent to 1.8 percent in the past six months.

Chinese banks appear to be focusing their lending on regions which have suffered the most in the crisis. The five regions that have shown the largest increase in new loans are the ones that were hit hardest by the downturn, namely coastal cities such as Guangdong, Jiangsu, Zhejiang, and Shandong, plus Beijing. These are also the regions that have experienced among the slowest growth this year. This suggests that loan growth is being driven by official policy rather than the product of bankers seeking the most attractive investment opportunities.

Chinese banks had double-digit NPL ratios before Beijing cleaned them up in preparation for their listing on foreign exchanges. Foreign banks with risk management expertise were brought in, and offered cheap stakes in Chinese institutions to encourage them to share their knowledge. This led to an improvement in lending standards as Chinese banks installed expensive computer databases and formed central credit offices.

It is not clear however how deeply these reforms have been entrenched. The banks remain very decentralized and lending standards are generally lower than their foreign counterparts.

In the past few years, Chinese bankers were restrained by the regulator from going on lending sprees. Banks were given lending quotas to prevent the economy from overheating. This year, with growth the main concern, there were no ceilings.

Chinese banks have clearly now opened the flood gates and are taking on more credit risk. The chief banking regulator Liu Mingkang said at a closed-door meeting in Tianjiin this April that the maximum Chinese banks should lend out a year is 6 trillion yuan ($878 billion), anything above that would be deemed as risky. During the first half alone, they lent out a whopping 7.37 trillion yuan ($1.08 trillion).

The current NPL statistics are irrelevant. The test for Chinese banks will come in the next 2 to 5 years, as the latest wave of lending shows its worth. True, many infrastructure loans seem to have implicit government backing, but less come with strong underlying cashflows. Instead of celebrating the record-low NPLs, the regulator should take it as a worrying sign that Chinese banks are now running hard to stand still.

— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

– Wei Gu is a Reuters columnist. The opinions expressed are her own —

Chairman Mao believed the economy needs to run on two legs, but when it comes to corporate financing, China is advancing in a series of giant hops. Its banks are flooding the market with credit, while equity markets actually supply less capital as a proportion of the whole.

Chinese banks lent out a whopping 7 trillion yuan ($1 trillion) during the first half of this year, tripling the amount during the same period last year. In comparison, new capital raised through the stock market was merely 10 million yuan ($1.46 million), down 50 percent from last year.

This is worrying. Excess bank liquidity has arguably severely overheated the equity market. Companies traded in China command a hefty 40 percent premium to the price of the same shares traded in Hong Kong as cheap loans have lowered the required cost of return and propped up stock prices.

Meanwhile, the uneconomic allocation of credit has squeezed out equity as a method of financing. This debt-dependent system advantages state-controlled firms over a vibrant private sector.

The key to the problem lies in Beijing’s hands. By giving the market more freedom to grow, Beijing will help reduce the debt level of the economy and more importantly, give private companies a channel to raise money needed for growth.

As things stand, tradable equities account for only a little more than a third of gross domestic product, tiny when compared to U.S. market capitalization which is 107 percent of GDP. Meanwhile China’s banking sector looks bloated — total loans outstanding are close to the risky level of 120 percent of GDP. In most countries, the ratio is below 100 percent.

Admittedly, Germany and Japan also feature similar banking-dominant financing models, whose merit is that by consolidating power and resources they can achieve faster economic growth. But the risk is the government and banks become too powerful, and neither of the two are successful allocators of capital in China.

State-owned banks favour large state-owned firms, which use 84 percent of total bank loans, even though they only contribute 45 percent of GDP and employ merely 25 percent of the labour force. By funding more overcapacity, banks are throwing good money after bad — large industrial enterprises in China already have an average debt ratio of as much as 60 percent.

Large firms are so flush with credit that they have started punting on stocks and properties, while China’s small enterprises are so short of credit that they pay double the legal lending rate for unofficial loans.

In a sign that small firms are being starved of credit, 108 companies applied on the first day that applications were accepted to be admitted to a new start-up stock market which is scheduled to be launched in October. In the past two years, more than 300 companies filed for initial public offering approvals with the main board.

All stock market listings need to be approved by the China Securities Regulatory Commission. At the current approval rate, it will take three years for all 300 of them to come to market.

China is one of the few countries in the world where regulators decide when is the best time for companies to raise money. The argument is that because China’s stock market is retail-driven, regulators should protect shareholders by making decisions for them.

Moreover, authorities fret that an enlarged share base could lead to falling stock prices which could in turn lead to social instability. There is even a school of thought that some bubbles are healthy because the wealth effect will help stimulate domestic consumption. But the wealth effect from stocks will do very little because it mainly enriches the well-off who are unlikely to drive big increases in spending.

Another downside of the bank-dominant financing model is that that China is a lot less efficient in terms of using capital than countries where the stock market plays a larger role. After growing at twice the U.S. rate for at least a decade, China’s broad money supply M2 is poised to pass that of the United States for the first time this year, yet this huge flood of liquidity only supports a GDP one third of the size of America’s.

The need for China to move towards a more balanced financing model has never been this urgent. The lending spree, despite a weak real economy, has put banks at a greater risk of mounting bad debt in a few years’ time. To rebalance China’s economic structure, the country needs to start walking on two feet, not just hopping on one.

— At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund —

–Wei Gu is a Reuters columnist. The opinions expressed are her own–

Chairman Mao used to say the truth is always kept by the minority.

A little-known private Chinese machinery company’s bid for a GM marque has been sneered at by even the patriotic Chinese media, but the deal could succeed where mightier plays like Chinalco’s for Rio Tinto have failed.

True that private sector firms face an uphill battle in China against more dominant state-backed firms, but it seems like double standards when Western observers, who extol the virtues of the private sector taking the driver’s seat, praise Chinalco’s deal but dismiss Tengzhong’s bid for Hummer.

Chinese media’s disapproval of Sichuan Tengzhong Heavy Industrial Machinery’s move has tempered concerns about technology and job transfers to China, as well as questions whether China’s military was behind the bid.

This could give Tengzhong more bargaining power with bankrupt General Motors. Underestimation of Tengzhong could prove beneficial to the buyer in an environment where there are worries about Chinese deals not being completely driven by commercial interests.

No matter how carefully the now busted Rio deal was structured, Chinalco should know that buying pricey and highly political targets like resource companies is going to be greeted by the rest of the world with a great deal of suspicion.

Beijing’s promotion of Chinalco’s former boss Xiao Yaqing to the State Council, or cabinet, only served to reinforce that perception.

In contrast with the outspoken Xiao, the man behind the Hummer bid Li Yan, who now goes with a Buddhist name Suo Lang Duo Ji, tries his best to hide from the limelight, but that does not mean he does not have a plan.

HUMMER LIFT

If the deal goes through, the key question is whether Tengzhong has good strategy to turn around a tarnished GM brand.

China has shown success in the past - GM is already selling more Buicks in China than in the United States.

What Tengzhong could do is negotiating full rights to the Hummer brand and extending Hummer’s powerful brand image to a broader line of industrial vehicles.

Industrial vehicles from airport trucks to oil-field trucks are selling like hot cakes, riding the country’s construction boom.

If the Sichuan company, which already makes fuel tankers, dump trucks, tow trucks and fire trucks, wants to compete against the likes of Caterpillar in this niche market, will it have a better chance branding its vehicles as ‘Tengzhong’ or ‘Hummer’?

While the Hummer brand has indeed become a lightning rod for critics of America’s love for SUVs, the brand has also won acclaim as outperformers on rugged roads.

By using Hummer for industrial vehicles, Tengzhong can bypass Hummer’s gas-guzzler image problem. Will you care how much gas a fire truck uses?

The company is talking about selling a greener version of Hummer and extending to emerging markets.

If Tengzhong could further broaden Hummer’s offerings to include small SUVs, their sales are likely to jump in China, a country just starting to fall in love with big cars. China’s SUV sales rose 25 percent in 2008, outpacing the 18 percent increase of passenger cars.

Hummer might have a reputation of being a millionaire’s toy, but they are still coveted in China. An online survey by Sina.com shows that more than 60 percent people want to own a Hummer that costs more than half a million yuan (about $70,000).

Of course, the global auto industry has had its fair share of cash-rich investors who tried to revive ailing brands and failed, but Chinese entrepreneurs should not be underestimated.

Critics had scoffed at Geely Automobile’s founder Li Shufu some 15 years ago.

After Li dropped out of school, he made refrigerator parts, then refrigerators and motorcycles, before pushing to make cars for the masses.

Today, Geely is one of the few Chinese automakers that export - Geely now supplies London’s black taxis.

Defying media reports that regulators in China might block the Hummer deal, China’s Ministry of Commerce said on Monday that Tengzhong’s bid for Hummer is normal behaviour for a company seeking to take advantage of the global downturn to broaden its horizons.

This makes sense. The acquisition has the potential to meet China’s strategy to move up the manufacturing value chain.

Moreover, the repeated disappointment by state-backed acquirers should have taught Beijing that buyers like Tengzhong are their best bet to drive China’s great wall of money to global markets.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –

— Wei Gu is a Reuters columnist. The opinions expressed are her own. —

When U.S. Treasury Secretary Timothy Geithner told students at Peking University that China’s holdings of U.S. Treasury bonds were safe, his answer drew loud laughter from the audience.

Even economist and columnist Paul Krugman, who is often critical of U.S. economic policy, found himself defending America when he was repeatedly asked the same questions in China recently: Will you (U.S.) underwrite the value of China’s holdings of U.S. government debt? Will you be prepared to pay a much higher rate of interest against the risk of high inflation and dollar depreciation?

This is a big change from two decades ago, when many Chinese felt the best way to preserve their savings was to convert yuan into dollars on the black market.

Dollars are still affectionately called “mei jin” in Chinese, which literally translates to “American gold”, but they are now also referred to as toxic assets by many in China.

Last week’s decline in U.S. bonds and the dollar after the sale of $100 billion in new U.S. Treasuries have made the Chinese even more concerned about the country’s estimated $1.4 trillion of reserves parked in dollar-denominated assets.

The Chinese government wants to assuage rising domestic fury about the losses China faces on its $2 trillion foreign reserves, so the country’s economists have come up with various options for Washington to “guarantee” the value of China’s dollar holdings.

China craves such a guarantee because it has no choice but to keep buying U.S. debt. Were it to stop doing so, the value of its existing holdings would be imperiled.

LIFTING CAPITAL CONTROLS IS KEY

There is, however, something Beijing can do to rid itself of the shackles of its reliance on U.S. Treasury bills: allow its companies and citizens to invest more freely abroad, and loosen its grip on the capital account.

When the private sector buys dollars from the central bank to invest abroad, the pile of foreign currency the central bank has to manage will decrease over time.

Currently, Beijing enjoys a near-monopoly on investing externally (as well as domestically) as it is virtually the only holder of dollars in the country given the stringent controls on foreign exchange holdings.

Given the huge volume of funds Beijing handles, and the requirement to keep reserves in liquid securities, much of the cash has found its way by default into the U.S. Treasuries market.

The yuan has appreciated about 20 percent against the dollar in the past four years, while returns on U.S. Treasuries at most match that, meaning the reserves have made no money in yuan terms.

Private sector investors would be more likely to be interested in stocks and commodities than in “boring” Treasuries. Buying stakes in the world’s best companies and securing natural resources are also in China’s strategic interest. China’s sovereign wealth fund has progressively been doing that on behalf of its 1.3 billion people, but the fund only accounts for 10 percent of China’s reserves.

China has talked about “cang hui yu min”, meaning dividing some foreign currency holdings among its citizens. So far, it has put some dollars on state-owned banks’ balance sheets, partly in an effort to mask the rapid pile-up of its reserve holdings, and allowed Chinese investors limited access to foreign securities through certain funds.

For ordinary Chinese, there is growing interest in investing beyond Chinese assets. People do want to diversify their yuan holdings, buy property abroad for children studying overseas and invest in foreign bluechips. But under current rules they are not even allowed to buy stocks of Chinese companies traded in Hong Kong.

Beijing has also stressed a “going abroad” strategy in recent years, but Chinese companies with global ambitions still have to go through lengthy approval process. That partly explains why China’s outbound foreign direct investment accounts for about 3 percent of the global total, far below its share of world trade and economic output.

Now is a good time to loosen some control, since China’s economy is healthier than most others, the risk of big capital outflows is relatively lower.

Admittedly, even reform of this sort is fraught with short-term risk because the markets will punish the dollar as soon as it senses the effect of what the Chinese are doing.

But what is clear is that the key to preserving the value of China’s reserves lie in the hands of Beijing, not Washington — pursuing a U.S. guarantee for China’s current investment strategy is barking up the wrong tree.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –

– Wei Gu is a Reuters columnist. The opinions expressed are her own –

China has talked about plans to allow foreign companies to float on its domestic stock markets for at least a decade, but that’s all there has been: talk.

Now would be a good time to convert some of that talk into action. Beijing has been struggling with its own investment strategies: the state gets feeble returns on the U.S. Treasury bonds it owns, and its equity stakes in foreign financial firms are well under water.

So why not diversify by allowing 1.3 billion Chinese citizens have a go rather than a few bureaucrats working for China’s sovereign fund? The many might even do better than the few. And it would give Chinese savers a chance to buy global blue chips at credit-crunch prices.

The idea of opening up China’s equity markets to foreigners may seem fanciful, but it dovetails with another big national objective. China wants to build Shanghai into a global financial centre by 2020, but that requires a deeper and internationalised equity market. Only when that is in place will foreign money descend on Shanghai, together with an army of bankers, lawyers and accountants.

The market capitalisation of Shanghai is now the world’s fourth largest, but it is dominated by state-owned firms with only a handful of foreign joint ventures and a few private companies.

The market is off-limits even to many of China’s own best and biggest companies, such as the world’s largest telecom operator China Mobile and China’s top offshore oil and gas producer CNOOC.

They are listed in the offshore market of Hong Kong and despite their expressed interest to return to the mainland, continue to fail to win the green light from Beijing.

Indeed there is no other country which relies more heavily on offshore financing than China. One fifth of the foreign companies listed on Nasdaq are from China, the largest percentage in the world. By pushing its top companies to list abroad, China has gained foreign capital at the expense of the development of its equity market.

Meanwhile back in Shanghai too much money is chasing too few good listed companies. The same companies are often valued at a premium in the mainland versus in Hong Kong.

Chinese investors need more and better investment opportunities. China needs to realise the competition of the 21st Century is not just about amassing capital, but also about building companies that can create wealth.

WHO COMES FIRST?

In the past decade, most of the barriers to open equity markets have been removed. China completed a share reform programme that allowed formerly untradeable state-owned shares to trade, and China’s accounting rules are now similar to global standards.

A big block remains in the shape of China’s capital controls, which prevent firms from repatriating profits, but the State Administration of Foreign Exchange recently said it will consider relaxing the controls once foreign companies are allowed to list.

When China first talked about introducing foreign listed companies a decade ago, Unilever, whose Lux soap 20 years ago was as coveted in China as Louis Vuitton bags are now, was expected to be the first.

Although that seems unlikely now, multinational manufacturers are still expected to be interested in the hope that a China listing can raise their profile in what is seen as potentially their biggest market.

Instead, first in line will probably be foreign banks keen to raise money in China to fund their local operations. As things stand, their yuan deposit base is too small due to their limited branch network.

HSBC is said by British officials to be in discussions to be the first foreign company to go public in China. The bank, with a Shanghai branch office that opened some 150 years ago, has gained a lot of goodwill for promising not to sell its strategic investment in Bank of Communications while other foreign banks rushed to the exits.

A full listing of foreign companies will offer an upside for China Inc. in that domestic firms with global ambitions will be able to bid for firms using their own shares and Chinese shareholders will have a say on global deals.

In addition, by allowing the Chinese to buy a piece of the world’s blue chips on their home soil, the change will assist in the country’s ambitions to make the yuan an international currency while keeping a certain amount of capital controls.

China’s leaders have made clear they see the credit crisis creating opportunities to flex their financial muscles. Here’s one opportunity they shouldn’t let pass them by.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –

– Wei Gu is a Reuters columnist. The opinions expressed are her own. –

Beijing may criticize American consumers for spending money they do not have, but the truth is Chinese leaders do the same, they just make sure it doesn’t end up on their account.

In its $585 billion economic stimulus package, the central government is contributing just a quarter of the funds needed, leaving the rest of the tab to banks, local governments and the private sector.

By comparison, the U.S. Treasury is expected to fund all of America’s $787 billion economic recovery plan by incurring more debt through the issuance of Treasury bills.

But just like in the West, there’s no such thing as a free lunch.

The Chinese central government might have successfully transferred most of the risks and financing costs to banks and local governments from its own balance sheet, but if bad debt piles up the chickens will still come home to roost in Beijing.

China and the United States leverage themselves in different ways. America uses government credit to raise money directly from the market. China uses quasi-government financing, so that the real costs of the plan — though indirectly ultimately a cost to Beijing — are impossible for investors to gauge.

Beijing will have no trouble finding local governments and banks eager to help finance the stimulus plan for two reasons: it’s in their political interest to please the central authority, and with liquidity abundant, they are eager to lend and projects in the stimulus plan at least have government backing.
Indeed, a record for new yuan lending in January shows banks have already responded to Beijing’s call to support stimulus efforts. But there is a serious downside to the Chinese model.

“The main problem with relying on banks rather than incurring a larger explicit budget deficit is one of transparency,” said Tao Wang, head of China economic research at UBS. “Relying on bank financing makes it less transparent how much spending takes place in relation to various stimulus projects.”

China’s budget deficit is expected to swell only modestly due to spending associated with its economic recovery plan, to 3 percent from 0.6 percent last year. In contrast, the U.S. federal deficit will shoot up to 12.3 percent this year from 3.2 percent.

WHY IS BEIJING SO KEEN?

Many economists say they do not understand why Beijing is so keen to keep the financing off its books. The state’s balance sheet is probably the strongest in the world and they have no qualms about using state power to drive economic growth.

Some Chinese economists think the government is trying to avoid the scrutiny of the National People’s Congress. But the NPC has traditionally behaved as a rubber stamp parliament and there is little reason to believe that would change now.

Hongbin Qu, HSBC’s China economist, reckons that it just comes down to the Chinese way of doing things. He cited the way Beijing handled the costs of last year’s Sichuan earthquake as an example — the central government called upon 21 richer provinces to each partner with a heavily hit county to take responsibility for the rebuilding efforts.

“The Chinese government is used to buying a meal and getting someone else to pay,” Qu said. “The central government really should dole out more money because public service is its responsibility.”

Beijing has used smoke and mirrors to maximize government spending in the past. The previous administration issued government debt of $746 billion to fund almost $3 trillion worth of projects to pull China out of the Asian financial crisis — again ultimately spending four times what it put in.

Beijing has asked banks to issue low-interest “policy loans” of more than 10 years to local government entities for stimulus-related infrastructure projects. With very little down payment for the loan required, the banks have no buffer built in for potential downsides. Moreover, investors will not know how much those potentially problematic loans are, as it will just be part of the overall bank lending.

If this approach is pursued heavily, it could eventually put at risk banks’ balance sheets, their reputations and investor confidence. But again, because the projects are ultimately backed by the central government, the banks are only too happy to lend.

Also worth watching will be debt issued by local government investment vehicles. Local governments are not only expected to contribute to the 4 trillion yuan stimulus package, they have also pledged 18 trillion yuan to supplement the national plan.

But local governments don’t have the money and are not legally allowed to run deficits or borrow. They get around this restriction by setting up vehicles that package their debt like company debt, which is expected to flood the market this year.

Many of these vehicles generate little profit on the operating level and the debt is guaranteed by equally weak companies, but they still get triple A ratings because of the implicit guarantee by the government.

“On the surface the government has little financial burden but the reality is it just put risks at another place,” said Vincent Chan, head of China research at Credit Suisse.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund. –

– Wei Gu is a Reuters columnist. The opinions expressed are her own –

Abundant liquidity, government support and a strong yuan fueled Chinese companies’ overseas buying spree.

But since they went out at the peak of the market and did not have a clear strategy for acquisitions, it should come as no surprise that most of those deals have turned sour. Once bitten, twice shy.

Crisis-ridden companies around the world are hoping that cash-rich Chinese buyers will come to their rescue, but the Chinese are not eager after getting their fingers burnt.

Chinese regulators are now giving more scrutiny to foreign deals, forcing interested buyers to lay out the most pessimistic scenario when seeking their approval.

Bankers said Beijing is skeptical about buying everything except resources, which is seen as important to China’s strategic interest and involves few integration challenges.

BUYING THE BRAND

Chinese manufacturers thought they had found a winning strategy by making goods cheaply in China and slapping a prestigious Western brand on it.

But the strategy hit a wall as companies such as TCL struggled for years to turn around businesses it bought in North America and Europe.

Lenovo’s purchase of IBM’s PC unit was widely lauded as a rare success until it announced a broad restructuring and profit shortfall earlier this month.

The acquired unit has a high exposure to large enterprises in developed markets, a segment that was hit hardest by the economic downturn, said Xin Zhao, an analyst at Cazenove.

“Before China caught the globalization wave our teachers in the West ran into problems,” said Yang Mianmian, president of China’s electronic appliance giant Haier, which last year spurned an offer to buy GE’s electronics unit.

“The financial crisis has changed our thinking and now we are looking more at rural demand.”

One of the potential pitfalls has been overpaying. Chinese buyers lack experience in valuation methodology and are at risk of paying too much. Moreover, they often do not have a strong understanding of the target experience, and tend to underestimate culture differences and powerful unions.

Some deals have not only incurred hefty losses but turned into a public relations nightmare as the crisis bites harder.

Take the example of Ssangyong Motor Co, South Korea’s No. 5 automaker, which filed for bankruptcy on Jan. 9 after getting hit by the global slump in car sales.

Analysts reckon SAIC Motor Corp, which owns 51 percent of Ssangyong, would be prepared to let the sport utility vehicle maker fail.

Some South Korean media have accused SAIC of all along planning to strip Ssangyong’s technology and dump it afterwards.

“Chinese companies have now realized there are many pitfalls on the road abroad and are learning from their experience,” said David Yu, partner at Llinks Law Offices, who advised SAIC on the deal.

FINANCIALLY SOUND

Chinese companies are financially sound — three state-owned banks trail only Warren Buffett’s Berkshire Hathaway on the global cash-rich groups list. But they’d better not try to bottom fish now.
The temptations are great — many Western brands long seen as out of Beijing’s reach are now fighting for Chinese attention.

Ford, for example, is looking for buyers to take up Volvo and a bank representing it has pitched it to at least three Chinese automakers.

“Chinese automakers need to be extremely cautious about those seemingly once-in-100-years opportunities to avoid failures which will not be recovered in many decades,” said Yankun Hou, an analyst with Nomura Securities.

To avoid more big losses, Chinese companies should cut their teeth on smaller deals in growing industries and markets, mindful that acquiring technology is much easier to manage than buying brands because it doesn’t involve taking over the whole operation.

“It is not clear that all the bad news is yet out, so assessing a target bank’s exposure is still challenging for any investor,” said Holger Michaelis, a partner with The Boston Consulting Group in Beijing.

“The timing however appears good for screening potential targets, but with a focus on smaller deals in less risky segments, like wealth management and asset management.”

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund –

– Wei Gu is a Reuters columnist. The opinions expressed are her own –

China is pulling all the stops to keep the economy growing by at least 8 percent, a pace considered necessary to absorb millions of migrant workers and graduates that hit the job market every year.

Ironically, with all its attention focused on the vigorous “defense of the eight”, Beijing risks losing sight of its ultimate goal — creating enough jobs to preserve social peace — and may end up engineering a jobless recovery.

Not only the rate of growth is important, but also its sources. Expansion led by capital-intensive industries will not be as effective in creating jobs as one driven by more labor-intensive sectors.

Statistics of the past three decades show that with the focus on investment, rise of heavy industries and China’s wish to move up the value chain, more and more economic growth has been needed to create the same number of jobs.

The latest efforts to shield the world’s fourth largest economy from the global financial crisis, including a nearly $600 billion stimulus, also focus on capital-heavy infrastructure projects.

“If your concern is jobs then targeting growth is not the best approach because the link between growth and jobs is not fixed, and different sources of growth have widely different impact on employment,” says Bill Bikales, a senior economist for the United Nations Development Program.

“It is unusual that China starts with a growth target,” He added. “(U.S. President-elect Barack) Obama has spoken several times about how many jobs he wants to create but he does not say how much growth he wants to produce.”

To boost employment and maintain social stability, Beijing should put more emphasis on labor-intensive sectors and move away from capital-intensive heavy industries that have been favored in recent years, several economists say.

Traditionally, China’s development policies have favored capital-intensive industries, such as auto, steel, machinery that are seen as key to modernization and sustained economic growth.

NEGLECTED LIGHT INDUSTRIES

In recent years the authorities have tried to move away from low value-added light industries, even though they have played a big part in the boom of the past three decades and have a potential to create more jobs, especially for unskilled workers.

China reckons it needs to add about 9 million jobs every year — about 3 percent of its urban workforce — for the 8.4 million some villagers moving to the cities every year. However, since early 1990s it has met the goal only when growth exceeded 10 percent. And over the years the link between growth and jobs has weakened.

In the 1980s, each 1 percent increase in gross domestic product led to a 0.3 percent rise in employment. This has dropped to a mere 0.1 percent jobs gain in the following decades, leaving the authorities undoubtedly frustrated that the country’s stellar growth performance has had such a modest impact on jobs.

The stimulus package and other measures aimed to help leading industries may help Beijing hit its growth targets, but may again disappoint leaders on the jobs front.

“Investing in capital-intensive sectors can stimulate growth in the short-term but has limited impact on employment,” said Yang Du, chief of division of labor at the Chinese Academy of Social Science, a top government think tank. “This might lead to a jobless recovery.”

Urban registered jobless rate stood at 4.0 percent at the end of September, which does not count migrant workers. The real unemployment is closer to 9.4 percent, reckons the Chinese Academy of Social Science. The World Bank estimated in its December report that right now, China needed to grow 9.5 percent to keep unemployment steady.

Premier Wen Jiabao has urged state-owned companies to “do everything possible” to refrain from job cuts. He said the auto industry’s current difficulties concern him the most because the industry has a long supply chain.

But as China’s companies are increasingly privatized and more profit-minded, ordering them to refrain from laying off people is unlikely to prove very effective.

The premier is probably betting on a wrong horse with his focus on the carmakers, not only because cars are being sold less briskly but also because growth in such capital-intensive industries is not effective in absorbing migrant labor, a group that the financial storm hit hardest.

Most of China’s migrant workers are employed by small private exporters. Large investment concentrated in a few industrial sectors could make urban-rural income disparity and overall inequality even worse.

World Bank economists Jianwu He and Louis Kuijs suggest China should shift its focus to the services sector from industry, and recommend Beijing to let consumption, instead of investment and exports, to play a bigger role in the economy.

The authors acknowledge, however, that changes cannot be made overnight. Otherwise growth will collapse and employment conditions will still suffer.

“Reducing the importance of investment needs to be a gradual process and needs to go hand in hand with higher efficiency, more reallocation of labor out of agriculture, better allocation of capital, and a redirection of factors and resources towards sectors that require less capital,” they wrote in a report.

– At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund.–