China finds opportunities in oil price drop

This week, Cnooc announced plans to reduce capital spending as the government and large state-owned enterprises respond to the collapse in oil prices. China’s third-largest oil producer said it would cut development spending by 67 per cent and, albeit less dramatically, reduce exploration and production capital expenditure.

At the same time, the Beijing government and refiners such as Zhuhai Zhenrong have increased their purchases of crude oil to record levels. Sinopec, another big state-owned energy enterprise, opened up a tank farm for crude oil on the resort island of Hainan in November.

These apparently contradictory signals reflect changes in the sources of growth in a slowing Chinese economy and show how the government and corporate China are exploiting the collapse to reduce their longer-term vulnerability to price swings in the volatile energy market.

It is easy to understand why Cnooc is cutting back spending. The economy is growing slightly below the level the cadres have commanded and slowed to 7.1 per cent in the final quarter of 2014. Reinforcing that trend is the fact that the energy intensity of Chinese production has gone down. Chinese crude oil demand per unit of gross domestic product has been dropping by 4.3 per cent a year since 2005, according to data from JPMorgan Private Bank.

Moreover, as the sources of growth shift slowly from manufacturing to services and from exports to domestic demand, that drop will probably accelerate, making further oil capex cuts likely — and shareholders happier.

But China is also looking ahead and taking advantage of the speedy and unexpected reversal in the oil price.

The increase in demand for crude on the mainland comes because China is exploiting lower oil prices to dramatically boost its storage capacity for both commercial and strategic reasons. By doing so, it will address one of its perennial weaknesses, its reliance on imported energy, and make itself more competitive.

The move comes at a moment when pessimism about Chinese prospects generally is on the rise. That downbeat attitude reflects chronic excess capacity, an overbuilt property market and concerns about a corporate sector that has borrowed too much, whether in renminbi or appreciating US dollars.

The way China is taking advantage of the declining oil price also suggests that some of the pessimism is unwarranted. The dramatic expansion in commercial and strategic holdings of crude while the price is half of what it was just months ago is only part of the story. The government is also increasing taxes rather than pass on the full benefit of bargain fuel prices to consumers.

Those taxes will go partly to dealing with China’s monumental environmental issues, according to Miswin Mahesh, Barclays’ commodities analyst in London. That spending should be good for China and its neighbours, if the past is any guide.

Up to now, Chinese growth has been good news for the rest of the world. In 1990, China’s contribution to global GDP growth was 5 per cent. Since 2010, the figure has swelled to more than 40 per cent. Its role as a crutch for world growth has become especially important as the growth rate of other emerging markets has fallen. (Last year emerging markets as a whole grew only 4 per cent — the worst figure since 2009 — and this year may even drop slightly below that.)

China’s demand for crude is already lifting the fortunes of shippers and others. Among the biggest beneficiaries of the increase in Chinese appetite for crude is Iran, says Amrita Sen, chief oil analyst with Energy Aspects in Houston and London. Indeed, Chinese demand for oil from Iran accounts for more than India, Japan, and South Korea combined. (All these countries have received specific exemptions from US-imposed sanctions on Iran, and they may also import more than the level the waivers allow.)

Earlier on, before China received permission from the US to procure Iranian oil, the country paid for its Iranian imports in renminbi. But today, Ms Sen says, the Chinese are using dollars. That benefits both sides. Tehran finds dollars more useful than renminbi as there are still controls on what Iran can do with its Chinese currency.

At the same time, China has clearly decided it is better to obtain real assets such as oil with its dollars than to purchase paper securities. Right now, both US Treasuries and the US dollar look attractive, while oil does not. But China always takes the long view — and in the long term neither Treasury securities nor the greenback seem as attractive as they do today — at least as seen from Beijing.

Source: http://www.ft.com/intl/cms/s/0/b083f7b4-ab8d-11e4-b05a-00144feab7de.html#axzz3Qnw9Fh8K

China’s Stimulus Quagmire

Even with Monday’s 7.6% decline, China’s stock market is on a historic tear, having risen more than 50% over the past year. Yet much of this investor frenzy is based on three flawed premises: that China’s decelerating growth necessitates stimulus, that such stimulus will reduce borrowing costs for firms, and that lower borrowing costs will incentivize spending and ultimately jumpstart growth.

New data from my firm’s China Beige Book—the largest private study of China’s economy—belie each of those assumptions. Our data make it clear that China doesn’t desperately need to stimulate its economy, that its recent attempts to lower interest rates via stimulus have done the opposite, and that if Beijing opts for large-scale stimulus anyway, it won’t work as intended.

Market participants often seem to misunderstand what China’s slowdown means. While the economy has continued to decelerate broadly, important components—including profit performance and the labor market—have shown overall improvement since 2014’s second-quarter nadir. In the just-completed fourth quarter, China Beige Book data on sales, profits and job growth all looked a bit better, as they had in the third quarter. This is a tentative rebound, to be sure, but it is hardly the gloom and doom narrative that most commentators (glued to older data) have now accepted as gospel.

Recent “stimulus” measures, including November’s cut to the benchmark lending rate, haven’t reduced borrowing costs for firms. The opposite has happened. Since last year’s second quarter, according to our data, the cost of capital has risen across the board—for bank loans, shadow-bank loans and especially bonds.

Perhaps most frequently overlooked: Firms still don’t want to borrow. The share of firms applying for and receiving loans dropped again in the fourth quarter, to the lowest levels we have recorded since beginning to survey in the first quarter of 2012. Since then, the share of firms borrowing has now dropped by more than half.

Crucially, firms don’t want to spend either. In the fourth quarter, growth in capital expenditure ticked down for the fourth straight quarter, also notching our survey’s all-time low.

Even the fourth quarter’s best performers—services firms—are caught in the wave: In multiple regions this quarter, including those that house the critical cities of Shanghai, Guangdong and Chongqing, services firms saw improved revenue growth, yet the proportion that hiked capital expenditures dropped anyway, in some cases dramatically. If firms don’t want to spend, monetary stimulus is a lost cause.

Plummeting crude-oil prices are a reason for optimism, given that China is a huge net consumer of energy. Our data track a steady pattern of disinflation in the Chinese economy since the first quarter of 2013, with sales prices, wages and material-input costs all continuing to rise, but ever more slowly. With the impact of cheap oil yet to be felt, 2014’s disinflation could become outright deflation in 2015.

Producer deflation is much better for an economy than consumer deflation. But with the economy slowing, Japan undertaking record quantitative easing and the eurozone headed in that direction, any sort of deflationary headwind may make it awfully hard for Beijing to resist another large stimulus of its own.

Here we get to the critical takeaways for investors: China’s slowdown may create the illusion that China has little choice but to stimulate, but our data show otherwise. Yet even if such stimulus is ultimately enacted, it simply will not work as intended.

Firms haven’t been interested in borrowing or spending on new projects for a year now. It is possible that low enough interest rates could change their behavior but to date rates haven’t been pushed downward by easing measures.

Instead, what companies are most likely to do if more liquidity is injected into the system is jump deeper into the roaring stock market. Already some of the inflows into stocks have come from the floundering property sector that Beijing has tried to stabilize.

If more firms move capital into stocks, the result won’t be more growth but rather more out-of-control prices for equities. And the structural impediments that are slowing China down will remain untouched.

Source: http://www.wsj.com/articles/leland-r-miller-chinas-stimulus-quagmire-1421688876

Chinese insurer emulates ‘Buffett model’ with Waldorf purchase

The previously obscure Chinese insurance company whose global shopping spree has raised eyebrows in the investment world is pursuing a Warren Buffett-like strategy in which investment returns drive growth and insurance plays only a minor role.

This month alone, Beijing-based Anbang Insurance Group announced the purchase of Manhattan’s Waldorf Astoria hotel for $1.95bn and Belgian insurer Fidea for an undisclosed price. South Korean media have also reported that Anbang is considering acquiring a controlling stake in state-run Woori Bank.

Such ambitious investment may seem strange for a company that ranks eighth among Chinese life assurers with only a 3.6 per cent market share, far below leaders China Life and Ping An, which control 25 and 14 per cent, respectively. 

Yet a look at Anbang’s business model suggests the company is more like a private equity fund with a side business in insurance. Rather than profiting from the excess of premiums over claims, analysts say Anbang aims to generate earnings through investment returns.

Chinese entrepreneurs have expressed admiration for the “Warren Buffett model” in which insurance premiums provide cheap funding for far-flung equity investments.

Fosun founder Guo Guangchang has frequently cited the example of Mr Buffett in outlining intentions to transform his industrial conglomerate into a strategic investment group.

In China, however, the strategy of using insurance as a platform for unrelated investments is riskier, since the core insurance business is less profitable than in the west.

Roughly 70 per cent of “life assurance” products in China are more akin to certificates of deposit. The customer pays a premium only once, and the insurer guarantees the return of principal plus interest after five to 15 years.

Insurers earn razor-thin margins on such products, which are sold mainly through banks and must compete for funds with lenders’ own high-yielding wealth management products.

Protection-type products, which only pay out in the event of an accident, illness or untimely death, deliver higher margins because the insurer doesn’t pay out on every policy, but still comprise only a small fraction of China’s overall insurance market.

Privately held Anbang collected Rmb33bn ($5.4bn) in life assurance premiums in the first eight months of 2014 versus only Rmb3.4bn in property and casualty fees, government data show.
Its profitability has been further compromised by its rapid growth strategy. Premiums have grown from Rmb1bn in 2005, the year after Anbang’s founding, to Rmb36bn so far this year. That has required big spending on hiring sales agents and paying commissions to banks that champion their policies.

“I can’t see how they’re making a profit, with all the reserves they have to put away and all the acquisition costs. I would be stunned,” says Sam Radwan, co-founder of Enhance, a management consultancy that advises China’s insurance industry.

Premiums at Anbang’s life assurance unit amounted to only 8 per cent of assets by end the of 2013, compared to 16 per cent at China Life. That suggests Anbang is using equity capital, rather than premiums, to finance its purchases.

China Life and Ping An have both ventured into foreign real estate over the past year, following regulations enacted in 2012 permitting such investments by insurers. But their core businesses are more diverse and profitable than Anbang, meaning investment returns are icing on the insurance cake.

Still, in other respects Anbang seems well-suited to the Buffett model given the proven ability of founder and chairman Wu Xiaohui, son-in-law of late paramount leader Deng Xiaoping, to raise funds from China’s elite state-owned companies. 

Anbang raised its registered capital to Rmb30bn in April this year, up from Rmb12bn in 2011 and more than the Rmb28bn in registered capital at rival China Life.

A complete shareholder list is not publicly available, but the company has wooed investors including state-owned oil refiner Sinopec and SAIC Motor, China’s largest carmaker, according to state media. Anbang could not be reached for comment.

If it succeeds in efforts to emulate Mr Buffett, the danger is that Anbang ends up resigning itself to unprofitability in its core business and basing its strategy solely on high-risk investments.

“If you’re playing the asset game and pushing your yield, you can get yourself into a lot of trouble,” says Mr Radwan.

Source: http://www.ft.com/intl/cms/s/0/9b6f1036-5424-11e4-80db-00144feab7de.html

China economics

China’s economy has always been a knotty issue. Assessing what is going on in a real economy with more than 1bn people is not easy. On Thursday, the central bank cut interest rates for the second time in two months. The benchmark lending rate will be lowered by more than the deposit rate and banks have the option of offering loans at a bigger discount to that benchmark. This is about boosting lending and should in principle be good news for investors in commodities.
But the reality is that demand for commodities and machinery this year has not been about end use. China’s copper imports surged by more than half in the first five months, and steel demand was robust. Yet industrial production growth slowed to just 10 per cent. Soya bean imports were strong at the same time as consumption growth moderated. Both trends are due to the fact that anything with monetary value that can be stored has been used as collateral to secure loans. Traders have then fed those funds into the shadow banking system to be lent out over the short term for higher returns.

 

 

Construction machinery makers such as Zoomlion and Sany Heavy have felt the impact of these trends. Despite the slowdown in fixed asset investment, their sales are soaring. Cash-strapped customers need machines for collateral to secure loans just to stay afloat. Half of the machines Zoomlion sold (on credit) in the first quarter have never been turned on, Jefferies notes.

The need for short term financing also shows up in the mix of formal lending. While total loan demand has not fallen, it has shifted to short-term borrowing. Industry is using short-term money not for productive investment but to roll over debt and fund working capital. This is not sustainable.

As interest rates moderate and access to loans from the formal banking system improves, China’s commodity carry trade is becoming less attractive. The peculiarities of commodity demand in China mean that looser monetary policy can never be a buy signal.

Source: http://www.ft.com/intl/cms/s/3/fd9c2206-c076-11e1-982d-00144feabdc0.html#axzz1zrglDctg

Investment: Prudence without a purpose

GENGHIS KHAN SQUARE in Kangbashi, a new city in the northern province of Inner Mongolia, is as big as Tiananmen Square in Beijing. But unlike Tiananmen Square, it has only one woman to sweep it. It takes her six hours, she says, though longer after the sandstorms that sweep in from the Gobi desert. Kangbashi, or “new Ordos”, as it is known, is easy to clean because it is all but empty. China’s most famous “ghost city”, it has attracted a lot of journalists eager to illustrate China’s overinvestment, but not many residents.

Ordos was one of the prime exhibits in an infamous presentation by Jim Chanos, a well-known short-seller, at the London School of Economics in January 2010. Mr Chanos argued that China’s growth was predicated on an unsustainable mobilisation of capital—investment that provides only for further investment. China, he quipped, was “Dubai times 1,000”.

His tongue-in-cheek reference to the bling-swept, debt-drenched emirate caused a stir. But not everywhere in China shrinks from the comparison. One property development that actively courts it is Phoenix Island, off the coast of tropical Sanya, China’s southernmost city. It is a largely man-made islet, much like Dubai’s Palm Jumeirah. Its centrepiece will be a curvaceous seven-star hotel, rather like Dubai’s Burj Al Arab, only shaped like a wishbone not a sail. The five pod-like buildings already up resemble the unopened buds of some strange flower. Coated in light-emitting diodes, they erupt into a lightshow at night, featuring adverts for Chanel and Louis Vuitton.

After a visit to Ordos or Sanya, it is tempting to agree with Mr Chanos that China has overinvested from its northern steppe to its southern shores. But what exactly does it mean for a country to “overinvest”? One clear sign would be investment that was running well ahead of saving, requiring heavy foreign borrowing and buying. The result could be a currency crisis, like the Asian financial crisis of 1997-98. Some veterans of that episode worry about China’s reckless investment in tasteless property. But although China invests more of its GDP than those crisis-struck economies ever did, it also saves far more. It is a net exporter of capital, as its controversial current-account surplus attests. Indeed, for every critic bashing China for reckless investment spending there is another accusing it of depressing world demand through excessive thrift. China is in the odd position of being cast as both miser and wanton.

Even an extravagance like Kangbashi is best understood as an attempt to soak up saving. The Ordos prefecture, to which it belongs, is home to a sixth of China’s coal reserves and a third of its natural gas (not to mention its rare earths and soft goat’s wool). According to Ting Lu of Bank of America Merrill Lynch, Kangbashi is an attempt to prevent Ordos’s commodity earnings from disappearing to other parts of the country.

China as a whole saved an extraordinary 51% of its GDP last year. Until China’s investment rate exceeds that share, there is no cause for concern, says Qu Hongbin of HSBC. Anything China fails to invest at home must be invested overseas. “The most wasteful investment China now has is US Treasuries,” he adds.

When talking about thrift, economists sometimes draw on a parable of prudence written three centuries ago by Daniel Defoe. In that novel the resourceful Robinson Crusoe, shipwrecked on a remote island, saves and replants four quarts of barley. The reward for his thrift is a harvest of 80 quarts, a return of 1,900%.

Castaway capital

Investment is made out of saving, which requires consumption to be deferred. The returns to investment must be set against the disadvantage of having to wait. In Robinson Crusoe, the saving and the investing are both done by the same Englishman, alone on his island. In a more complicated economy, households must save so that entrepreneurs can invest. In most economies their saving is voluntary, but China has found ways of imposing the patience its high investment rate requires.

Michael Pettis of Guanghua School of Management at Peking University argues that the Chinese government suppresses consumption in favour of producers, many of them state-owned. It keeps the currency undervalued, which makes imports expensive and exports cheap, thereby discouraging the consumption of foreign goods and encouraging production for foreign customers. It caps interest rates on bank deposits, depriving households of interest income and transferring it to corporate borrowers. And because some of China’s markets remain largely sheltered from competition, a few incumbent firms can extract high prices and reinvest the profits. The government has, in effect, confiscated quarts of barley from the people who might want to eat them, making them available as seedcorn instead.

What has China got in return? Investment, unlike consumption, is cumulative; it leaves behind a stock of machinery, buildings and infrastructure. If China’s capital stock were already too big for its needs, further thrift would indeed be pointless. In fact, though, the country’s overall capital stock is still small relative to its population and medium-sized relative to its economy. In 2010, its capital stock per person was only 7% of America’s (converted at market exchange rates), according to Andrew Batson and Janet Zhang of GK Dragonomics, a consultancy in Beijing. Even measured at purchasing-power parity, China has only about a fifth of America’s capital stock per person, depending on how its PPP rate is calculated.

Boom, boom

China needs to “produce lots more of almost everything”, argues Scott Sumner of Bentley University, even if it does not produce “everything in the right order”. Its furious homebuilding, for example, has unnerved the government and cast a shadow over its banks, which worry about defaults on property loans. But it still needs more places for people to live. In 2010 it had 140m-150m urban homes, according to Rosealea Yao of GK Dragonomics, 85m short of the number of urban households. About three-quarters of China’s migrant workers are squeezed into rented housing or dormitories provided by their employer.

Nor is China’s capital stock conspicuously large relative to the size of its economy. It amounted to about 2.5 times China’s GDP in 2008, according to the APO. That was the same as America’s figure and much lower than Japan’s. Thanks to China’s stimulus-driven investment spree, the ratio increased to 2.9 in 2010, but that still does not look wildly out of line.

Malinvestors of great wealth

In Defoe’s tale, Robinson Crusoe spends five months making a canoe for himself, felling a cedar-tree, paring away its branches and chiselling out its innards. Only after this “inexpressible labour” does he find that the canoe is too heavy to be pushed the 100 yards to the shore. That is not an example of overinvestment (Crusoe did need a canoe), but “malinvestment”. Crusoe devoted his energy to the wrong enterprise in the wrong place.

It is surprisingly hard to show that China has overinvested, but easier to show that it has invested unwisely. Of China’s misguided canoe-builders, two are worth singling out: its local governments (see article) and its state-owned enterprises (SOEs).

China’s SOEs endured a dramatic downsizing and restructuring in the 1990s. Thousands of them were allowed to go bankrupt, yet those that survived this cull remain a prominent feature of Chinese capitalism. Even in the retail, wholesale and restaurant businesses there are over 20,000 of them, according to Zhang Wenkui of China’s Development Research Centre.

SOEs are responsible for about 35% of the fixed-asset investments made by Chinese firms. They can invest so much because they have become immensely profitable. The 120 or so big enterprises owned by the central government last year earned net profits of 917 billion yuan ($142 billion), according to their supervisor, the State-owned Assets Supervision and Administration Commission (SASAC). It cites their profitability as evidence of their efficiency. But even now, returns on equity among SOEs are substantially lower than among private firms. Nor do SOEs really “earn” their returns. The markets they occupy tend to be uncompetitive, as the OECD has shown, and their inputs of land, energy and credit are artificially cheap. Researchers at Unirule, a Beijing think-tank, have shown that the SOEs’ profits from 2001 to 2008 would have turned into big losses had they paid the market rate for their loans and land.

Even if the SOEs deserved their large profits, they would not be able to reinvest them if they paid proper dividends to their shareholders, principally the state. Since a 2007 reform, dividends have increased to 5-15% of profits, depending on the industry. But in other countries state enterprises typically pay out half, according to the World Bank. Moreover, SOE dividends are not handed over to the finance ministry to spend as it sees fit but paid into a special budget reserved for financing state enterprises. SOE dividends, in other words, are divided among SOEs.

The wrong sort of investment

Loren Brandt and Zhu Xiaodong of the University of Toronto argue that China’s worst imbalance is not between investment and consumption but between SOE investment and private investment. According to their calculations, if state capitalists had not enjoyed privileged access to capital, China could have achieved the same growth between 1978 and 2007 with an investment rate of only 21% of GDP, about half its actual rate. A similar conclusion was reached by David Dollar, now at America’s Treasury, and Shang-Jin Wei of Columbia Business School. They reckon that two-thirds of the capital employed by the SOEs should have been invested by private firms instead. Karl Marx made his case for collective ownership of the means of production in “Das Kapital”. Messrs Dollar and Wei called their riposte “Das (Wasted) Kapital”.

Perhaps the best that can be said of China’s SOEs is that they give the country’s ruling party a direct stake in the economy’s prosperity. Li-Wen Lin and Curtis Milhaupt of Columbia University argue that the networks linking the party to the SOEs, and the SOEs to each other, help to forge an “encompassing” coalition, a concept they draw from Mancur Olson, a political scientist. The members of such a coalition “own so much of the society that they have an important incentive to be actively concerned about how productive it is”. China’s rulers not only own large swathes of industry, they have also installed their sons and daughters in senior positions at the big firms.

The SOEs provide some reassurance that the government will remain committed to economic growth, according to Mr Milhaupt and another co-author, Ronald Gilson. The party officials embedded in them are like “hostages” to economic fortune, “the children of the monarch placed in the hands of those who need to rely upon the monarch”. That gives private entrepreneurs confidence, because the growth thus guaranteed will eventually benefit them as well—although they will have to work harder for their rewards.

What are the implications of China’s malinvestment for its economic progress? At its worst, China’s growth model adds insult to injury. It suppresses consumption and forces saving, then misinvests the proceeds in speculative assets or excess capacity. It is as if Crusoe were forced to scatter more than half his barley on the soil, then leave part of the harvest to rot.

The rot may not become apparent at once. Goods for which there is no demand at home can be sold abroad. And surplus plant and machinery can be kept busy making capital goods for another round of investment that will only add to the problem. But when the building dust settles, a number of consequences become clear. First, consumption is lower than it could be, because of the extra saving. GDP, properly measured, is also lower than it appears, because so much of it is investment, and some of that investment is ultimately valueless. It follows that the capital stock, properly measured, is also smaller than it seems, because a lot of it is rotten. That would make for a very different kind of island parable, a tale of needless austerity and squandered effort.

Fortunately there is another side to China’s story. It has not only accumulated physical capital but also acquired more know-how, better technology and cleverer techniques. That is why foreign multinationals in the country rely on local suppliers—and also why they fear local rivals. A Chinese motorbike-maker studied by John Strauss of the University of Southern California and his co-authors started out producing the metal casings for exhaust pipes. Then it learnt how to make the whole pipe. Next it mastered the pistons. Eventually it made the entire bike.

China “bears” like Mr Chanos sometimes neglect this side of the country’s progress. In his 2010 presentation he compared China to the Soviet Union, another empire in the east that enjoyed a stretch of beguiling economic growth. Like the Soviet command economy, China is good at marshalling inputs of capital and labour, he pointed out, but China has failed to generate growth in output per input, just as the Soviet Union failed before it. Yet this analogy with the Soviet Union is preposterous.

Economists refer to a rise in output per input of capital and labour as a gain in “total factor productivity”. Such gains have many sources. One textile boss got 20% more out of his seamstresses by playing background music in his factory, recalls Arnold Harberger of the University of California at Los Angeles. The striking thing about the growth in China’s total factor productivity is not its absence but its speed: the fastest in the world over the past decade. Between 2000 and 2008 it contributed 43% of the country’s economic growth, according to the APO. That is just as big a contribution as the brute accumulation of capital, which accounted for 44% (excluding information technology). Thus even if some of China’s recent investment has in fact been wasted, China’s progress cannot be written off.

And even if some of China’s past investment has been futile, adding nothing worthwhile to the capital stock, there is a consolation: it will leave more scope to invest later, suggesting that the country’s potential for growth is even larger than the optimists think. The right kind of investment can still generate high returns. But what if the mistaken investments of the past disrupt the financial system, preventing resources from being deployed more effectively in the future?

 Source: http://www.economist.com/node/21555761

In China, Kraft Craves Snacks Business

EIJING—Kraft Foods Inc. is hoping Ritz crackers that taste like beef stew and Oreos that taste like birthday cake will help it reverse its trailing position with the world's largest population of snackers.

The world's No. 2 food company by revenue after Nestlé SA plans to unveil a slew of new products, broaden distribution channels and rev up marketing in fast-growing China, said Shawn Warren, Kraft Foods China president, in an interview. The U.S.-based company aims to capture more of China's snack-food market, which is expected to reach an estimated 77 billion yuan ($12 billion) by year end, up 44% from 2008, according to research firm Euromonitor International.

"We want to lead the industry here," said Mr. Warren, who declined to disclose spending figures and other specifics.

Key to the effort will be an addition of products to meet Chinese palates. Kraft recently introduced cookies that taste like the sort of white cake eaten at birthday parties, joining the company's other cookie flavors in China, including green tea, ice cream, and mango and mandarin orange.



Kraft will also broaden its Ritz line, Mr. Warren said. Ritz is a wheat-based cracker sold with cheese and peanut-butter fillings in the U.S. In China, Kraft is launching Ritz with a potato base and flavors labeled "fantastic beef stew" and "very spicy chicken."

But the Northfield, Ill., company faces crowded shop shelves in China jammed with products from increasingly powerful international and domestic competitors. It will also need to convince increasingly health-conscious Chinese consumers that it has offerings for them. The snack-food segment is fragmented and full of rivals that have niches in products that are uniquely Chinese, said Torsten Stocker, a partner at U.S.-based consulting firm Monitor Group.

The top 10 snack-food sellers by market share in China are dominated by Chinese competitors—and Kraft doesn't rank among them, according to Euromonitor. Want Want China Holdings Ltd., a Taiwan-based company, ranks No. 1 in market share, according to Euromonitor's most recent data. U.S.-based PepsiCo Inc. is the No. 5 snack-food company and has been expanding its Lay's brand in China to suit Chinese tastes, launching potato-chip flavors such as lobster cheese and lemon tea.

Kraft's goals come as the company plans by year end to spin off its snack-food business to form Mondelez International Inc., which will aim to capitalize on growth opportunities in emerging markets such as China.

Oreo, which Kraft launched in China in 1996, is a close second to a Chinese, Nestlé-owned brand in terms of share of the country's cookie market, according to Euromonitor. Cookie sales in China rose to 38 billion yuan in 2011, a 53% increase from five years earlier, according to Euromonitor.

With brands including Toblerone and Cadbury chocolates, Halls cough drops and Tang flavored-drink mix, Kraft has already gained a strong hold within China, consultants say, but they add that the company has room to grow in the country.

Kraft plans to broaden its distribution channels to go deeper into China, beyond the 250 cities where it has sales bases. It also hopes to bolster its marketing with more well-known figures such as former basketball star Yao Ming, whom the company tapped in 2010 to appear in its commercials.

Kraft is also tweaking its packaging to appeal to local customers. The company plans to roll out for Chinese consumers Ritz crackers and Chips Ahoy cookies in portable cup-like packages that resemble containers of ramen noodles.

"The society is shifting and there's a greater need for food that is on-the-go," Mr. Warren said.

Wei Xiaopo, an analyst at brokerage CLSA Asia-Pacific Markets, said acquisitions will be one of the main ways that food companies can gain ground in the fragmented market. Nestlé has gained the top ranking in the sweets category by acquiring last year Chinese candy company Hsu Fu Chi International Ltd., the maker of sweet-onion- and cucumber-flavored cookies.

Mr. Warren declined to say whether Kraft will follow Nestlé's lead with an acquisition of a major local competitor. The company plans to follow the recipe it used with Oreo's expansion across China, Mr. Warren said, adding that it will also focus on developing new products, which accounted for 30% of revenue from China in 2011.

Mr. Warren said he is aware that Chinese are increasingly worried about their health. To address that, the company has developed a cracker line, Pacific, with flavors such as sesame and red date that Chinese consumers associate with health and traditional Chinese medicine.

Kraft's snack business has gained attention by adopting the new Mondelez name. The business doesn't yet have a Chinese moniker, said Mr. Warren, who added that it will likely be introduced later this year.

Mr. Warren declined to say where China is likely to stand as a percentage of sales at the snack-food business, and Kraft doesn't break out country data. But China has been a key driver for Kraft's overall growth for years, with sales from the country having increased about 60% year-to-year for the past five years, Mr. Warren said.


Source: http://online.wsj.com/article/SB10001424052702303395604577434071750952662.html?mod=WSJASIA_hps_MIDDLEThirdNews

Avatar 2: Made in China?

FOURTEEN years ago James Cameron’s film “Titanic” shattered box-office records in China, as it did nearly everywhere else in the world. Its impact was especially shocking in a market that was captive to a conservative, state-dominated film industry, with no ability to produce a blockbuster of its own. Mr Cameron’s ballyhooed “Avatar” broke China’s records again in 2009 and 2010, despite more than a decade of development. Now the film bureaucrats in Beijing have a chance to accomplish something that would have been unthinkable until very recently: co-producing Mr Cameron’s “Avatar” sequels.

Mr Cameron arrived in Beijing on Saturday and will soon be attending a screening of “Titanic 3D” at the Beijing International Film Festival (the re-release opened earlier this month to staggering sales in China). But his most important business will be conducted in private meetings, including with state-owned China Film Group. Speaking in an interview on Sunday, he said a priority of this trip was to explore a co-production deal with the Chinese firm on “Avatar 2” and “Avatar 3”. Mr Cameron says he would need to be satisfied in advance that his planned films would meet the approval of censors. If that key condition can be met, he is keen on the potential payoff. “There are economic advantages,” as he puts it.

The economic advantage he has in mind would be on the tail end, when the box office takings are divvied up. Mr Cameron does not need funding assistance for his films (a common reason for other foreigners in search of Chinese partners), but he would like China to share more of its blockbuster revenues with him. When “Avatar” made $200m in Chinese ticket sales, China was returning to Hollywood only 13% to 17% of the receipts on imported films, a far lower share than the American studios receive from other foreign markets. Going forward China will share up to 25% of the takings from imports, per an agreement announced during Xi Jinping’s visit to Los Angeles in February. That remains lower than Mr Cameron might be able to negotiate in a co-production deal. Chinese producers, after all, can collect up to 45% of the box office for domestic films, the 55% remainder going to satisfy the cinemas and distributors.

Mr Cameron’s meetings this week come shortly after the news that “Iron Man 3”, starring Robert Downey junior, will be a Chinese co-production. The gravitational pull of the Chinese movie market, nonexistent less than a generation ago, is now an undeniable force, sucking in all Hollywood blockbusters (and lesser projects) that venture within its event horizon. Hollywood studios, independent producers and directors regularly cycle through Beijing in search of partnerships with Chinese production houses—often seeking money to finance their movies, as well as access to a suddenly lucrative market.

This year China will surpass Japan as the world’s second-largest movie market, after America. Chinese box-office takings totalled 13 billion yuan ($2.06 billion) in 2011, an increase of 30% from 2010, which in turn had been more than 60% higher than in 2009. The number of movie screens has doubled in five years to more than 10,000 (and is projected to reach 15,000 in speedy fashion), and the new screens are mostly digital and 3D-capable. Meanwhile America’s market is stagnating. Takings in North America (America and Canada combined) declined by 4% in 2011, to $10.2 billion. Mr Cameron suggests that by the time “Avatar 3” is released later this decade, China may well rival America as the top movie market. That may be a stretch, but then just wait till “Avatar 4”; Mr Cameron calls it a possibility. He says he has stopped producing non-Avatar films or even considering non-Avatar scripts. “I’m in the Avatar business. Period, that’s it. I’m making ‘Avatar 2’, ‘Avatar 3’, maybe ‘Avatar 4’,” he says. “I think that within the Avatar landscape, I can say everything I need to say that I think needs to be said, in terms of the state of the world and what we should be doing about it.”

What Mr Cameron had to say in “Avatar”—about environmental exploitation, about the rights of people to their land—was rather political (Mr Cameron proudly declares it “not a subtle film”). The film resonated with some viewers in China as mildly subversive, and it did not receive quite the same blessing from Beijing as did “Titanic” (Jiang Zemin, then China’s top leader, was a fan). But it did not run afoul of censors. A famous scene in “Titanic”, in which Kate Winslet’s character poses nude for a drawing, was censored for the 3D re-release in China. Mr Cameron counts that as progress; he says that “somewhat” more was censored the first time the film was released in China. He surely has the leverage, with the value of “Avatar” as a franchise, to get the script assurances he would need to make a co-production work. He also says that he will not let any political concerns about China or its human-rights record interfere with his doing business here. “I’m going to do what’s necessary to continue having this be an important market for my films,” he says. “I’m going to play by the rules that are internal to this market. Because you have to.”

Indeed, as in many other industries, China has the market leverage to get what it wants from the foreign potentates who once dominated the film business. But what would China get in exchange for giving up some of its take at the box office to Mr Cameron? For one, Han Sanping, the powerful chairman of China Film Group, would affix his name to what could be one of the biggest blockbusters of all time, “Avatar 2” (and “3”, etc). Co-producing a James Cameron film would mark quite a symbolic turnaround for China, from the days of “Titanic”. Mr Han is often referred to in film circles as the godfather of Chinese film. If Mr Han wants a producer credit, Mr Cameron may find himself not terribly inclined to refuse.

Source: http://www.economist.com/blogs/analects/2012/04/international-film-industry

Digging a Hole in China's Black Gold

China's love affair with coal will endure, but for investors the romance is gone.

For the last few years, investors in China's coal sector have been mining a rich seam. From the beginning of 2005 through the end of 2011, the benchmark Qinhuangdao thermal coal price rose 81%, supporting strong growth in profitability and enviable margins at mining majors such as China Shenhua Energy.



But as any miner will tell you, the longer you work a seam, the more difficult it is to extract value. China's thermal coal prices have fallen nearly 10% in the last three months.

A seasonal fall from the winter peak, and a cyclical slowdown brought about by China's slowing construction and monetary tightening, are only part of the picture. Those effects will fade, but coal miners will still have to battle against structural pressure for lower prices.

In 2008, China's 60 biggest miners—the efficient elite from a sector with 9,000-plus firms—accounted for just over half of domestic production. Since then, the big have gotten bigger and the small are getting edged out.

Michael Parker, coal-mining analyst at Sanford Bernstein, estimates that this year the top 60 miners will account for 80% of output.

The assumption has always been that it is the very low-cost guerilla mining operations that will go to the wall, pushing prices up. In fact, Mr. Parker argues that it is the small industrial operations—working difficult seams, and with poor access to transport—that will be the first to go. The exit of these high-cost outfits means that spot prices will increasingly be set by bigger more-efficient producers—and that means pressure for prices to stay low.

With structural forces aligned against a return to rising coal prices, investors in China's black gold should be wary of digging themselves into a hole.

Source: http://online.wsj.com/article/SB10001424052970203918304577242270708211732.html?mod=WSJ_Heard_LEFTSecondNews

Repo Rate Foretold China's Reserve Move

SHANGHAI—The timing of China's latest decision to ease conditions for bank lending came as a surprise to the markets.

But to anyone alert to the liquidity squeeze in the interbank market, in particular the sharp rise of the benchmark short-term interest rate, Saturday's announcement of a lower reserve requirement for banks was less of a shock.

In the week before the People's Bank of China's announcment, the weighted average rate on seven-day repurchase agreements, or repo—the most widely used funding instrument in China's interbank market—had surged, signaling that the country's banks were uncomfortably short of funds.

Early Friday the rate hit 7%, its highest level in a month, up 3.37 percentage points from a week earlier—mainly due to a five billion yuan (US$794 million) share offering by China Communications Construction Co., as depositors hoping to subscribe pulled a total of 180 billion yuan from the banks.

That matters for the real economy because the repo rate represents the cost of capital for China's banks, and is passed along to their borrowers.

The Chinese central bank has proven to be skillful in adjusting liquidity, controlling the ups and downs of the repo rate through its regular open-market operations and use of the reserve requirement ratio.

In 2009, with the global economy on the brink of crisis, the central bank sought to encourage investment by flooding the financial system with liquidity. The repo rate fell to 1% in the opening months of the year, which was key to pushing the banks into their stimulus lending spree.

In 2010, with the focus on controlling inflation, the central bank started to withdraw liquidity, sending the repo rate higher, a trend that continued—with some bumps—through 2011 and into 2012.

Looking back at Saturday's move with the benefit of hindsight, the surge in the repo rate provided a heads-up. The PBOC on Friday provided another signal of the urgency of easing liquidity conditions, using an unscheduled open market operation to inject cash into the system. By Friday's close, the seven-day repo rate was down to 5.31%.

Saturday's cut in the reserve requirement ratio is intended to do the rest of the job.

"We weren't expecting an imminent cut, but it didn't come as a big surprise either," UBS economist Wang Tao said of the reserve-ratio reduction. "In recent days, interest rates rose quite a bit in the interbank market, showing that liquidity is very tight."

The seven-day repo rate is increasingly seen as a key measure of liquidity conditions in China's financial system, and a more sensitive indicator of the direction of monetary policy than the rather static fixed-deposit and lending interest rates. Traded by banks, insurers, brokerage firms and fund-management companies, it also serves as a benchmark reference rate for pricing fixed-income derivatives such as interest-rate swaps.



Central bank operations aren't the only mover of China's money-market rates. China's banks are constantly buffeted by forces that add to or subtract from their capacity to lend. Moves by the PBOC are often seen as shifts toward either tightening or loosening. In reality, they are more often attempts to counteract the external shocks that knock money markets off course.

The current account is typically the main source of fluctuations. A current account surplus in most months of the year means extra funds coming into the banking system, requiring the central bank to raise the reserve requirement to soak up additional liquidity. Between August 2003 and June 2008, it raised the ratio to 17.5% from 6%, a series of increases that was as much about counteracting the inflow of funds from a growing current-account surplus as about tightening policy.

Speculative capital sometimes finds a way to evade the government's controls, and that also affects liquidity in the banking system. Analysts blamed capital outflows at the end of 2011 for drying up bank funds and forcing the central bank's hand on lowering the reserve requirement.

Initial public offerings can also have a marked impact. China's equities are typically priced low to ensure a bounce on the first day of trading. That leads to a rush to subscribe, as in the China Communications Construction case, with tens of billions or even hundreds of billions of yuan leaving the banking system as depositors chase the hot stock.

For most investors, keeping track of all the ins and outs of China's capital flows is not worth the trouble. But the seven-day repo rate provides a short cut. If it surges, some combination of forces is draining the system of liquidity. If it dips, banks are flush with cash.

To be sure, the repo rate doesn't always reveal what the central bank has in mind. It stayed little changed in the run-up to the last reserve-requirement cut in late November. And at the end of December, when banks' surging year-end cash demand pushed the seven-day repo rate up by 2.59 percentage points in a week, the central bank refrained from acting.

But analysts say that's a reminder to keep other factors in mind, rather than an excuse to ignore the repo rate's clues to the policy outlook.

"Any sharp increase in the interbank seven-day repo rate might be a catalyst for the final introduction of a cut in banks' reserve-requirement ratio, but economic fundamentals are still key to determining such crucial easing measures," said Zhang Junjie, a bond analyst at Ping An Securities.

Source: http://online.wsj.com/article/SB10001424052970204909104577236414128744998.html?mod=WSJASIA_hps_LEFTTopWhatNews

Mining Investors Can Take Their Pick

Times are a-changin' for global miners.

Glencore and Xstrata's proposed $90 billion tie-up will bring a unique model to the sector, combining mining with commodities trading. In truth, the world's biggest mining companies are already following divergent paths, from BHP Billiton's investment in shale gas and potash, to Rio Tinto and Vale's single-commodity focus. The question for investors is which model offers the most reliable returns.

Risks for miners are certainly accumulating. A hard landing for the Chinese economy would hit commodity prices hard, particularly iron ore, where China accounts for 60% of global demand. High energy and salary costs are eating into margins. Governments are also targeting the sector: The threat of outright mine nationalization lingers in places such as South Africa and Mongolia.

Against this backdrop, BHP Billiton's model is the most defensive, given its focus on a few major projects across a range of commodities in politically stable countries. Its problem lies in matching some investors' hopes for short-term returns against its desire for a portfolio to satisfy long-term commodity demand.

For example BHP's large investment in U.S. shale gas may not see a positive return before 2020 if gas prices remain subdued, HSBC estimates. BHP's heavy capital-expenditure program means its free cash flow yield could trail its peers by next year, limiting scope for higher dividends or share buybacks, according to brokerage Jefferies.

Still, BHP's balance between risk and reward looks attractive relative to its rivals. At 8.8 times expected 2012 earnings, the shares trade more cheaply than all but those of Rio Tinto and Brazil's Vale, according to FactSet. Yet Rio relies on one Australian iron-ore mine for 70% of its earnings. Vale is even more concentrated on iron ore; it accounts for more than 90% of its operating profit.

True, Anglo American is more diversified, but its political risk is higher, with around 40% of earnings generated from assets in South Africa. Glencore-Xstrata, meanwhile, is likely to grow more through acquisition. But that could take it into lower-quality assets in politically risky areas; claims that Glencore's trading arm will enhance and smooth earnings remain unproven.

Merger mania may have brought near-term excitement to the mining sector. But for investors with a longer horizon, BHP Billiton still looks a keeper.

Source: http://online.wsj.com/article/SB10001424052970204062704577222902312816094.html?mod=WSJ_Heard_LEFTTopNews

The Yuan's Problem With the Dollar

The arrival of Chinese Vice President Xi Jinping in the U.S. next week refocuses attention on the yuan-dollar exchange rate.

Financial markets are pessimistic about the outlook for yuan appreciation. Expectations for the year ahead are for 2%-3% nominal gains against the dollar in 2012, compared with 5.1% in 2011. With China's exporters facing a tough year, and falling inflation also weakening the case for yuan appreciation, such muted expectations make sense.

But there is also another variable at work, and one which is outside the control of Beijing: the value of the dollar.

If the dollar is flat against the euro and the yuan gains 5% against the dollar, it also gains 5% against the euro. But if the dollar gains 5% against the euro and the yuan gains 5% against the dollar, the yuan gains more than 10% against the euro.

In short, if a stronger-than-expected recovery in the U.S. combined with continued uncertainty about the future of the euro means the dollar strengthens, it will be more difficult for China to chalk up even limited bilateral gains without having a serious impact on competitiveness. Pessimistic predictions about the outlook for yuan appreciation could very well come true.

But if expectations of continued loose monetary policy in the U.S. and a brighter outlook for the euro push the dollar down, the pressure will be in the opposite direction. A falling dollar opens space for bilateral appreciation without denting competitiveness too much. A weak dollar also raises the cost of the commodities that China imports, so allowing the yuan to follow it down means importing inflationary pressure.

The U.S. will take the opportunity of Mr. Xi's trip to bend his ear on the need for sustained appreciation of the Chinese currency. But at least some drivers of the yuan dollar exchange rate can be found closer to home.

Source: http://online.wsj.com/article/SB10001424052970204369404577205960431147348.html?mod=WSJ_Heard_LEFTTopNews

China’s economy: Two twists in the dragon’s tail

DATA points sometimes change faster than debating points. It is conventional wisdom that China’s export-led growth squeezes consumers at home and competitors abroad, even as it adds inexorably to the country’s huge foreign-exchange reserves. But figures released this month complicate these arguments.

China still runs a sizeable trade surplus. But its net exports fell in 2011 (in absolute terms) for only the third time since 2000, subtracting 0.5 percentage points from its growth. Thanks to home-grown spending, China’s economy still managed to expand by 9.2% in 2011, remaining surprisingly strong even in the fourth quarter. This growth owed an unusual amount to consumption (both public and private), which contributed over half for the first time since 2001. As a consequence, the share of consumption in China’s GDP edged up in 2011 after falling for ten years in a row.

The mainstay of China’s growth remains investment, on which its economy remains worryingly dependent. Indeed, when China’s critics are not bashing it for overexporting, they bash it for overinvestment in property. Its housing boom is, however, slowing markedly. China this week reported that the price of new homes fell in 52 out of 70 cities across the country in December, compared with the month before. Households are struggling to obtain mortgages; developers are finding it almost impossible to obtain a loan. The drying up of foreign funds is particularly dramatic, points out North Square Blue Oak, a research firm based in London and Beijing. Foreign capital fell by 65% in December, compared with a year earlier.

The flight of foreigners from property partly explains another unusual twist in the China story. Its foreign-exchange reserves fell in the fourth quarter for the first time since the height of the Asian financial crisis in 1998. The drop was small, from $3.2 trillion to $3.18 trillion, but also a little mysterious. China still exports more than it imports, and attracts more foreign direct investment than it undertakes. These two sources of foreign exchange must, then, have been offset by an unidentified drain.

The worry is that China’s capital controls have sprung a leak. “Hot money”, attracted by the country’s growth, may be flowing out as the property market falters. Some even speculate that China’s rich may begin to smuggle their new-found wealth out of the country en masse.

These fears are overblown, for now. Some of the drop probably reflects a change in the value of China’s euro holdings. Some does represent the departure of short-term money, but an ebb and flow of hot money is not unusual. Moreover, some kinds of hot money are more scalding than others, says Stephen Green of Standard Chartered. At one end of the thermometer, an exporter might delay the conversion of his legitimate foreign-exchange earnings. In other, warmer cases, an importer might illegally overstate the size of his purchases, so as to remit more money out of the country. Capitalists eager to take their money out also have other cards to play. Mr Green estimates that last year about $185 billion might have passed from mainland China through the VIP rooms of Macau’s casinos.

Victor Shih of Northwestern University reckons that China’s richest 1% hold $2 trillion-5 trillion in liquid wealth and property. If they were ever to smuggle that money out, the outflow would dent even China’s reserves. That would be a disaster for China’s economic management, putting heavy downward pressure on the yuan. At least China’s critics could no longer trot out another familiar accusation—that it undervalues the exchange rate.

Source: http://www.economist.com/node/21543176

Booming Mongolia: Mine, all mine

“GOIN’ to OT?” drawls Andy, a burly tattooed man with that worldly air common to those who have done time in the American army. The gate at Incheon airport in South Korea is packed with travellers, mainly Mongolian expatriates on their way home, waiting to board a flight to Ulaanbaatar. Andy’s is a fair guess as to the destination of one of the few other Western passengers. “OT”—Oyu Tolgoi, or “Turquoise Hill”—is in the middle of nowhere, a desolate spot in the Gobi desert, another hour-and-a-half’s flight south of Ulaanbaatar (inevitably, “UB”). But it is the site of the biggest foreign-investment project in Mongolia, a copper-and-gold mine that is springing up at a remarkable speed and is expected, by 2020, to account for one-third of Mongolia’s GDP.

For Andy, who normally “does security” in places such as Afghanistan, Nigeria and Somalia, OT is a rest cure. Conditions are comfortable, the locals are a delight, and nobody tries to shoot him. And there are the transits through UB, a veritable Bangkok of the steppes—at least if your comparators are Kabul and Mogadishu. In the OT bus from UB airport into town, Andy is on tenterhooks waiting for the overnight hotel allocation. He is delighted with his billet—one where overnight guests are readily tolerated. The other news is less cheery: the airport bus will leave at four in the morning.

UB is a boom town on the frontier of global mining. Hotels are bursting; the Irish pubs, of which there are several, are heaving with foreign miners, investment bankers and young local women with very long legs and very short skirts. French bistros serve steaks the size of tabloid newspapers. Dozens of cranes punctuate the skyline. The streets, empty 20 years ago, are now clogged. It is hard to believe on the clear sunny mornings the city enjoys much of the year, but UB’s air is now as polluted as anywhere—second only to the Iranian city of Ahwaz, according to a recent study by the World Health Organisation. In the winter, when temperatures average from -10 to -30 centigrade, and often fall to -40 at night, UB burns a lot of coal.

Another sign of a boom is the effort to keep the city functioning through these crippling winters. When a Singaporean firm was building a joint-venture brewery to make Tiger beer, it was so anxious to finish in time for the summer-drinking high season that it hired patio heaters the size of jet engines for the construction site. Without such aids, building stops in the Mongolian winter. It is too cold to pour concrete.

A glitzy mall on the corner of the main Sukhbaatar Square houses the sort of establishments you come across in the better class of airport: chic boutiques, pricey restaurants, expensive-watch shops and, of course, an outlet of Louis Vuitton, which sells posh luggage. The shops usually look empty, which is reassuring for those nostalgic for the UB of the recent past—small, drab and poor, and offering its visitors, as one unhappily put it, a choice of “mutton, mutton and mutton”, but at least refreshingly different from other capitals.

Central Tower, as it is known, is a new ornament to downtown Ulaanbaatar. It is built next door to the lot where once stood the former headquarters of the former Mongolian People’s Revolutionary Party, the MPRP (it has since dropped the “R” word), which for seven decades until 1990 ruled Mongolia as a one-party state and rock-solid Soviet satellite. The building was burned down in rioting in 2008 after a disputed election. The use to which the site has now been put is as good a symbol as any of the new aspirations of Mongolia’s ruling class.

Dreams under your feet

To pay for these dreams, Mongolia is being dug up and sold to China. Already, more than 80% of its exports are minerals, a proportion expected to rise in a few years to 95%. Mongolia makes mining geologists salivate over its known riches and unexplored potential—for copper, coal, gold, silver, uranium, molybdenum, and on and on. Some 3,000 mining licences have been issued.

It is not just that Mongolia is a treasure-chest of geological wealth. It is slap-bang next to the world’s biggest and fastest-growing market for most minerals. Put together Mongolian supply and Chinese demand, and Mongolia will be rich beyond the wildest dreams of a population many of whom, a generation ago, saw themselves as nomadic herders. With just under 3m people, Mongolia has a chance of becoming a Qatar or a Brunei: a country that has only a small population but almost all of it, in global terms, loaded. Brian Fisher, an Australian economist who has conducted a study of the economic impact of OT, says Mongolia “sounds like Australia in 1930”.

In the third quarter of 2011 Mongolia’s economy grew by 21% compared with the same period in 2010. Even sober economists think the country is going to have to get used to this sort of thing. The IMF expects growth to average 14% a year between 2012 and 2016. In 2013, the year production is due to begin in earnest at OT, it is forecast to reach 22.9%. Others think it will be at least twice that.

Indeed, OT is the force driving many of these short-term projections towards the sky. Its construction is a big factor in this year’s boom. From 2013 its sales will start adding an average of about five percentage points a year to the national growth rate up to 2020, when its impact on the economy will peak. By November last year over $3 billion had already been spent on OT, a figure that will rise to $6 billion by 2013 and $10 billion by 2020. For Mongolia, a $6 billion economy, this is enormous.

So is the scale of the logistical challenge of building one of the world’s biggest copper mines in the middle of the desert. All supplies have to be brought in by road, from China to the south. Some 18,000 workers, including about 10,000 Mongolians and 6,000 Chinese, have to be housed and fed. Water had to be found, and is to be piped from an underground aquifer over 50km (32 miles) away. Electricity is to be provided first from China, then by a purpose-built power plant. And local people have to be compensated, coaxed and cajoled into believing that the mine is in their interests, not just those of the foreigners who are running it.

The project is a joint venture between the Mongolian government (34%) and Ivanhoe Mines of Canada (66%), which is in turn 49% owned by Rio Tinto, the mining giant that is managing OT and has put up most of the money. Already the Turquoise Hill, where the colour of the soil first betrayed the presence of copper to prospectors decades ago, has vanished. A huge pit is opening up for the first phase of the mine. Two shafts have been sunk for the second, underground, phase. On top of one, a tower is soaring. It will be the tallest structure in the Gobi, and perhaps in Mongolia. The workers are housed in long prefabricated buildings or, for the luckier ones, traditional gers, circular felt tents (equipped with untraditional en suite facilities, TV and Ethernet cables).

All this is justified commercially by the expectation that this mine will produce 450,000 tonnes of copper a year, making it one of the world’s five biggest mines, as well as being a big gold producer. And it will have a life of at least 50 years. The more they look, the more potential geologists find in the area. It will be what Rio calls a “first-quartile” mine in terms of costs—ie, among the cheapest. And its proximity to China means that the cost of transport should not be prohibitive. The price of copper is especially vulnerable to swings in market sentiment. But global supply is constrained, and barring global economic Armageddon, demand is not going to collapse.

Yurts revisited

OT, however, matters not just in itself, but as a test of Mongolia’s ability to work with foreign investors to pull off such mammoth undertakings. Next in line is Tavan Tolgoi (Five Hills), the world’s biggest untapped coal deposit, also in South Gobi province. Notional shares in this project have already been distributed (electronically) to every Mongolian born before March 31st 2011. With a general election due in 2012, this adds political urgency to an ambitious scheme to raise billions of dollars for the mine through an initial public offering of shares in Ulaanbaatar and London. This will double the market capitalisation of the sleepy UB stock exchange.

Mongolian coal production is expected to increase from about 16m tonnes a year now to 40m by 2020 and 240m by 2040. Again China provides a ready market, but the mining boom has exacerbated Mongolian fears of a Chinese takeover by commercial stealth. So feasibility studies are under way on the costly options of building railways to take coal to Russia, and thence out to Korea and Japan via Vladivostok, or to Dandong on the Chinese-North Korea border and thence by sea to South Korea.

A touch of Dutch on the steppes

Not everyone in Mongolia looks at the growth projections and goes giddy with delight. Many worry about the economic, environmental, social and strategic costs of becoming “Minegolia”. Economists fret about a “resource curse”, or “Dutch disease”. If even the Netherlands can be vulnerable to this—whereby wealth floods in as natural resources are exploited, pushes up the exchange rate, inflation, or both, and renders other industries uncompetitive—how is poor Mongolia to cope? And the Netherlands never had a year like the one Mongolia can expect in 2013, when the economy will grow by a quarter and the current-account balance will lurch from a deficit of 14% of GDP into surplus.

Furthermore, Mongolia, a 20-year-old democracy, is prone to populist policymaking. Even as the economy is booming, political parties are tempted to promise handouts. After pledges made at the previous election, every Mongolian, rich or poor, gets 21,000 togrogs ($16) on the 15th of every month. The big parties have declared a no-handout pact ahead of the next election, and the government has set up a “fiscal-stability fund” to smooth the commodity cycle. But the temptation to dip into the till will mount as voting nears.

For economists, the resource curse is a risk Mongolia has little option but to take. As Mr Fisher, the Australian economist, puts it, its comparative advantage is in commodities and mining services. There is no point in trying to compete in manufacturing with “the biggest factory on the planet” next door in China.

Mongolia is still a desperately poor country. It has just graduated, in development-bank speak, to “lower-middle-income” status, with a GDP of around $2,000 per head. The population of UB has expanded by 70% in the past few years, to about 1.2m now. Some poor people still spend the winter nights beneath the streets (open manholes are a pedestrian hazard), huddling near the pipes for warmth. The city is sprawling outward through valleys in all directions along dirt roads lined with clapboard fences, behind which former herders live in gers.

One such herder, given the name Igor by Russians he knew in his youth, describes a common life path. A few years ago, herding in Central province, he lost many of his sheep to a dzud, one of the periodic climatic disasters that hit Mongolia—a summer drought that results in too little pasture and too little hay for the winter, followed by heavy winter snow and colder-than-usual temperatures. Igor sold the rest of his livestock to pay for his children’s schooling, bought a pickup truck and moved to UB, where he makes a living hiring it out. He finds UB going from bad to worse, as more people come to town and scramble to earn money. All there is to look forward to is the summer pilgrimage home, to drink airag (fermented mare’s milk) with his friends in a ger.

It is not just the weather that drives herders into town. Some are mining refugees, fleeing environmental devastation. Besides the licence-holders Mongolia has tens of thousands of illegal gold prospectors, known as “ninja” miners because the green plastic bowls they carry on their backs to sift for specks of the metal make them look like mutant turtles. Their use of mercury and cyanide has poisoned rivers.

Mongolia’s most flamboyant environmental campaigner is a former herder called Tsetsegee Munkhbayar. He made his name helping clean up the Onggi river, and then for his extreme forms of protest, involving shooting at mining equipment or vehicles. In April 2011 he led a group of supporters into Sukhbaatar Square on horseback to demand talks with the government. Mr Munkhbayar, a grim-faced man looking out of place behind a desk in his UB office in knee-length boots and traditional jacket, believes that if Mongolians exploit the mines, “we will never develop.” He suggests an alternative future of herding, dairy-farming and tourism. As he talks he is interrupted by a loud blare of traditional Mongolian music. It is the ringtone on his mobile.

And not a drop to drink

One UB resident, visiting the OT site as an interpreter for a foreign journalist, cannot stop herself from weeping at what is being done to the area and to her country. For the outsider, the bleak brown desolation of the Gobi is not a landscape that evokes sympathy. And it needs an awful lot of Gobi to sustain a flock of goats and camels, so, vast though the OT project is, the number of herders directly affected is small. But the translator sees ruin: “You can’t drink copper; you can’t drink gold.”

In fact, the aquifer tapped for OT is too deep to affect surface water, too saline to pass human-consumption standards and so big it will be no more than one-third depleted after 50 years of the project. The big danger environmentalists see from its use is that even a future natural drought may be blamed on OT. It will be hard for the project to deny water to distressed local herders. That might lead to overgrazing.

Such a massive undertaking is bound to distort the local economy and disrupt the environment. Compared with the ninjas, the multinationals and the development banks that will help raise the largest-ever project financing for mining can at least claim to be part of the solution. They are conducting impact assessments and bio diversity studies. The project is also providing jobs, and creating more employment for locals through subcontracts.

But it will struggle to be popular. Oyun Sanjasuuren, an independent member of parliament, says mining is bound to be political because it is “the main thing in the country”. And the face of Mongolian mining over the past 15 years has been “mostly ugly”. Miss Oyun says she entered parliament as a centrist, but now finds herself on the right as the main parties have shifted steadily to the left. OT has not been helped by tactless remarks made in the past by Robert Friedland, Ivanhoe’s boss, about “the cash machine we intend to build”, and how nice it was to have so few people around and “no NGOs”.

The wealth generated by the miners is an obvious target. And the militant Mr Munkhbayar has many fans even among young urban Mongolians who moan that development is arriving too slowly. Like him, they wish it could come from some other industry. Every herder, says one environmentalist, hopes that at least one person in his family will carry on the life. But that may be changing. Twenty years ago it was hard to meet anyone in UB who identified with the city. Even if they were born there, they saw “home” as the “aimag”, or province, from which their parents came. Now a new generation of city-dwellers feels less attached to the countryside and to nomadic herding traditions. Their numbers are swollen by young people returning from an overseas education to chase the new opportunities the mining boom is throwing up.

One such, a young man called Damdin, is finding life difficult. After 15 years in Fairfax, Virginia, he has forgotten most of his Mongolian. He left Mongolia with his mother, who was fleeing his alcoholic father. At school in America the other Asian students were scared of him, despite his short stature; Mongolians, he says, have the reputation of being psychos. Now back in UB, living in a ger with his father who spends his time playing games on Facebook, his ambition is to open UB’s first skateboard shop.

When The Economist encountered him, outside a derelict Buddhist temple in a ger district in the middle of the afternoon, and later at the nearby police station, he had just been punched and robbed of his phone by friends of the friend he had lent it to (“It was 4G, man!”). He was drunk, despite saying he is always teased as a wuss for sticking to beer when real men drink vodka. He was cradling a little street-puppy he had rescued from his muggers, knowing his grandmother would not let him take it home. He presented as forlorn a picture as could be imagined of the pain and dislocation of being caught between two worlds. But he said he had no intention of going back to Virginia.

Source: http://www.economist.com/node/21543113