The Mystery of Mr. Wu Greg Grillot May 17, 2005 The Daily Reckoning PRESENTS: Recently, Greg Grillot took a trip to the Far East... and between exploring terracotta warrior tombs in Xi'an, and drinking the healing "Sea Horse with Reptiles Liquor," he pondered the enigma that is the Chinese banking system... Yesterday afternoon, a wizened Manchurian fellow with an enormous, yet calming, black mole on the tip of his nose beckoned me over to his rickety rickshaw. I have no idea what language he spoke to me: maybe Mandarin, perhaps Manchurian - definitely not French -but he felt certain I understood him. We hurtled through the chaotic traffic in Beijing's ancient Hutong district. Hey - if the cars and buses don't acknowledge right of way, why should my hardy pedal pusher? Maybe he felt invigorated pulling along a young, 143-pound sapling in place of the usual quarter-ton cargo of elderly, flabby American couples. In any case, he certainly cut off a fine share of buses and Honda sedans on our way to the tortuous labyrinth of alleyways and enmeshed houses of the 800-year-old neighborhood where Mr. Wu patiently awaited me. Mr. Wu is a kind man. He's a long-retired archaeologist -- meaning he most likely excavated dynastic treasure and terra cotta warriors for the glory of Mao. Mr. Wu is of the eternally young variety of Asian elders. He smiles with his eyes and mouth as he answers questions through his interpreter -- he understands English, but doesn't speak it. My companion, The Supper Club's Karim Rahemtulla, asked Mr. Wu some interesting questions. Here's a portion of their conversation: Karim: "How has your standard of living changed in the last two decades?" Mr. Wu's interpreter: "Thirteen years ago, his pension was 250 yuan a month. Now it is 2,500 yuan. [250 yuan = $30.21 and 2,500 yuan = $302.06 at the time of this writing. Because the yuan is exactly pegged to the dollar, those conversions will no doubt be precisely the same when you read this... but not forever.] He recently had a cash offer to buy his home for US$300,000, which he's lived in for 50 years, and his two sons live here, too. He won't sell, though. He wants to leave this house on to his sons and his wife after he passes..." The other folks that joined Karim and myself on the tour asked some questions about Mr. Wu's single outdoor bathroom, his marble-tiled living room, etc., while I noted a subtle cloud of suspicion pass over Karim's face. After Mr. Wu graciously answered the final questions, I followed Karim outside into the courtyard amid the beautifully painted porcelain dining set and vacant birdcages. "Greg, something doesn't add up here. His pension shot up 900% in 13 years while inflation snoozed at 2-5% per annum. How could the government pay him that much more in such a short period of time? I'll tell you some more about the banking system when we get back to the hotel." Karim was right - my happiness for the kind old man's recent prosperity nearly overawed my critical faculties. A gaping enigma lay somewhere between 900% and 2-5%... something didn't add up. Why does it matter, though? He's a nice old man, and it doesn't seem to occur (or matter) to him that anything is wrong with this situation. In fact, the more you look around, the more you notice that no one seems to know, or care, how so many people can produce so much so cheaply... and sell it below production cost. How does the Chinese miracle work? Are the Chinese playing with economic fire? All over Beijing, you find people selling things for less than they must have cost to make, like watches - I fended off the 24-cent "Woe-lex" slingers and landed in the comfy cab of my furiously beckoning and smiling Manchu friend... absorbed in confused economic thought, I gazed at the passing Shicha Lake. Weary from my reeling thoughts, I returned to the hotel. Plopped in a fine fake-leather chair in the lobby of Beijing's Grand Hyatt, I tried to answer three interwoven questions: 1. How did Mr. Wu's pension jump 900% in 13 years, when the average rate of inflation loomed under 5% annually over the same time period? 2. How can you buy a disposable cigarette lighter in Beijing for 12 cents? 3. Why does the love of my life have to pay back the money she borrows on her credit cards? Okay, the first two questions look enigmatic to me - the third has a simple, reflexive answer. But the answer to the final question just might unlock the first two. I recalled the rich Cuban cigars I've been smoking with my travel mate, newfound friend and vintage Harley restorer, T.M. Offering me ignition, he laughed about the 12-cent lighter he bought from a street monger. I thought: "12 cents... hmm... I know labor's cheap. Cost of living's damned cheap, too... but how can it possibly be so rock bottom that they can sell lighters and working counterfeit watches for 12-24 cents?" The more you look around, the more you wonder. I recalled one of Karim's recent quandaries: "I took a 20-minute cab ride today for $1.50. The gas prices here are the same as in America - crude's cut in dollars - so let's say we used a half gallon. The gas alone cost $1.10. Now include the driver's time, the vehicle's cost with wear and tear -- that cab's gotta operate at a loss. How's that possible...?" At this point, I wondered how much virtue would cost me in the narrow alleys here - I'm not wealthy, and my aforesaid love would appreciate it if I picked some up... virtue never comes cheap, and that's why it's so rare... a moral luxury item... although some would say the demand for it is (or at least should be) inelastic, but back on topic for now! Back at the Hyatt, in the realm of numbers that either do or do not add up, Karim and I looked over the books of a Chinese steel company. Its year-over-year gross sales increased at a fine, steady clip... but despite these increasing sales, its debt ascended a bit faster than its sales. So its net profits slowly dwindled over time. Convenient - despite increasing sales, its taxable revenue went down. But it also looked like the company never pays down its debt... which is a good deal, if you can get it. But in a free market system, a free lunch is mythical (like my virtue). If the Chinese aren't paying their debts... is there any limit to the amount of money the banks can lend? Just who are these banks, anyway? Could this be the key? Alexander's sword to my Sino-Gordian knot? In the land of the world's greatest capitalists, there's one business that isn't even remotely governed by free markets: the banks. In the simplest terms, the banks and the government are one and the same. Like modern American banks, the Chinese banks (read: the Chinese government) freely loan money to fledgling and huge established businesses alike. But unlike modern American banks (most of them, anyway), the Chinese banks don't expect businesses to pay back the money lent to them. That's what the perpetually rolled-over debt on the steel company's books told us. So peering hyperopically from a panoramic view, here's how China looks to me: domestic steelmakers, lighter producers, and cabbies produce their goods and services for free. So they can peddle their wares for far less than production costs. Free money, via loans not needing repayment, essentially lets the steel company produce steel for next to nothing and then sell it at market price. Which, in the West, is far below what you'd pay for a company that had to worry about profits and paying back loans or selling at ABOVE the cost of production. That may be how T.M. bought a 12-cent Chinese lighter to inflame our $20 Cubans. That may be how Karim's cabbie barely pays for gas with his fares. (I wish I could collect a free paycheck - please don't read this, Mr. Bonner!) But even more than that, I wish my love, like the Chinese steel barons, didn't have to pay her credit card bills. It would be nice to get a free lunch every single day of the week, and dessert too! No, wait - my greatest wish is this: to purchase that virtue for 12 cents. Enough of the virtue stuff - Karim mentioned something about the savings and loan crisis that swept over America. Even if it's a deliberate policy, an economy can't be deliberately inefficient in allocating capital. Things cost money. They cannot, typically, cost less than the value of the raw materials to make them. The whole cannot be worth less than the sum of the parts... anymore than you can buy virtue in a dark alleyway in Beijing. Some laws of economics, like the laws of ethical behavior, can be bent, but not broken... at least not without consequences. Regards, Greg Grillot for The Daily Reckoning 321gold Inc