Like many investors we have always been always been a touch suspicious of any company that prefers to list outside of its home market. This issue has recently cropped up again in the London market with the Kazakh miner, Eurasian Natural Resources Corp, dismissing two senior independent directors seen as ‘heavyweight figures‘ in the City. But the real ‘sex & violence’ of late has been in the US listed mainland Chinese companies. The Securities and Exchange Commission (SEC) is now investigating accounting and disclosure issues at a number of Chinese companies listed on US exchanges. These problems have escalated as we have moved from the accounting scandals and potential frauds at the small and largely insignificant Rino International and China Media Express Holdings to the bigger and more concerning problems at Longtop Financial Technologies and (Canadian listed) Sino Forest. Given the likes of Fidelity (Longtop) and Paulson (Sino Forest) are reported to be major shareholders in these companies their plight has attracted a fair bit of US media attention. Recent market movements highlight these recent events have brought Chinese stocks listed elsewhere under greater scrutiny.

The early pioneers in this trend to list in the US – namely the China internet companies – the likes of Baidu, Sina, NetEase, Sohu, etc have been a phenomenal success. Baidu (the ‘Google of China’) has been a 46 bagger (split adjusted) for the investors fortunate enough to participate in its IPO during 2005. These companies had pretty valid reasons for listing in the US in preference to closer to home given the US market’s greater familiarity with the sector, and the larger pool of liquidity that followed the internet stocks in the US market at the time. The theory that the US market and US investors were more capable of properly valuing (at a richer price) these companies was also reasonably valid. Over more recent times the process of listing China shares in the US has been subverted by companies carrying out reverse takeovers of US ‘shell’ companies whereby they could avoid the more onerous disclosure requirements of a primary listing. As a result, they were able to do things like appoint compliant auditors at small firms without attracting much notice. Until this year this did not matter as the companies were all largely ridden up by investors keen to play the ‘China story’. With the recent accounting scandals this has now turned into a nasty pain trade as can most obviously be seen in the Bloomberg Chinese Reverse Mergers Index (CHINARTO INDEX <GO> if you have access to Bloomberg) which is now down over -40% year-to-date.

However, the problems of Chinese offshore listings have not been confined to the US as some Chinese companies have always had a penchant for listing outside of their de-facto home market, Hong Kong. For example, the ‘S Chips‘, Chinese companies listed in Singapore have had a similarly chequered history. Who could forget China Aviation Oil? CAO was China’s monopoly jet-fuel importer that in 2005 lost a bundle on oil derivatives trades something you would think (and hope) it would know a fair bit about. And China Milk, China’s largest manufacturer of bull semen which was also listed in Singapore and remains suspended. This is a personal favourite of ours for some of the photos in its old investor presentations (circa 2006). Even a few HK listings have also been caught up in recent events. China Forestry Holdings (backed by Carlyle Group) is another forestry stock that might not have much in the way of forests. Likewise, Chaoda Modern Agriculture, a vegetable producer is alleged to have overstated the size of some farms in China.

Therefore, this is not a new phenomenon and nor is it confined to any particular exchange. As a result, it highlights lessons for investors as though history might not repeat itself to use a cliché it does tend to rhyme. There are some common themes or ‘red flags’ that investors can look for in any of these investments, but particularly when they are listed a long way from home. These include the following:

• Short track record and years of listed history (a common problem across nearly all listed Chinese companies).
• High levels of cash and high levels of debt.
• Frequent tapping of the capital markets to raise additional funds (across equity, convertibles and debt).
• Frequent M&A activity often designed to obscure underlying trends in the business.
• High and deteriorating working capital requirements. Things can be seen in the cash flow that are not always in the P&L.
• High management / director turnover – particularly worrying is turnover in important roles like the CFO.
• Resignation of auditors and / or frequent changes in auditors (particularly worrying if outside the ‘big four’ firms).
• Opaque background to and the actions of the controlling shareholders.

Whilst this is not intended to be an exhaustive list, and each case is somewhat different it does highlight that investors without a lot of time investors can find some common red flags. The starting point should be it pays to start sceptical particularly if the listing is far from home.

A final point to note is that whilst these frauds might look obvious in hindsight none of this is easy to research before the event even with established red flags. For example, both Longtop (Deloittes), and Sino Forest (Ernst & Young) had been audited by big four firms (and of course Enron was audited by Arthur Andersen when there was a ‘Big 5′). Mistakes get made by analysts even with the best of intentions, and often investors have to rely on a company’s word (or integrity) as well as their audited financial statements to reach their investment conclusions. All investors to some extent regardless of their level of due diligence have to decide whether to trust (or not) management’s word as well as their financial statements. The level of due diligence required to research these stocks is high with or without relying on management’s integrity. On a company like Sino Forest it is not easy for any individual institution to marshal enough resources or time to independently validate their acreage and land title against their word. For example, Muddy Waters  reportedly had 12 analysts researching Sino Forest  for over two months to carry out its ‘detailed forensic accounting and legal work’. Whether you believe their research findings are right or wrong this is a huge resource commitment to research just one stock. Even very well resourced fund managers in the Asian region typically have a team of 6-12 analysts looking at portfolios of 50-100 companies. Clearly on each portfolio holding most houses cannot do the same level of due diligence that Muddy Waters are reported to have done on Sino Forest.  But, as highlighted above there are at least some mechanisms and common checklists and templates which all investors who try to follow a fundamental investment process can use to guard themselves against too many blow ups even if they are far from fool proof and cannot lead to a complete avoidance of problems, especially in a market like China.

Naturally investors need to tread carefully particularly the further away they step from home. However, this is also leading to opportunities in some of the US listed Chinese companies that are being tarred with the same short selling brush that do not have any of the aforementioned red flags. However, a sceptical outlook on listings a long way from their home base is not a bad place to start. But, this applies to listings in HK by Russian and Italian companies (or dare we say English football clubs) as much as it does to Chinese companies listing in the US.

An additional support for AUDUSD in the last few weeks has been the reduction of ‘carry’ available in some other ‘carry currencies’. In Brazil for example the government has increased measures to curb ‘excessive’ currency appreciation. In recent months Brazil raised the Tax on Foreign Exchange Transactions (IOF tax) to 6% on fixed income, 6% on offshore bond issuance and 2% for equities. Furthermore government intervention in the FX market to suppress the currency has restricted the supply of US dollars to the local market. Brazilian Onshore funding rates in USD exceeded 6% last week. The combination of these two factors briefly turned the implied forward rate for 1 month BRL (chart 1) negative.

Chart 1 – USDBRL 1 month NDF implied yield

Chart 2 tracks the premium of BRL implied 3 month yields over AUD implied 3 month yields, these were running fairly steadily at approx. 4% as domestic overnight rates in Brazil are 11.75%. According to Bloomberg during the month of April this premium has been squeezed from 4% to as low as -1%, significantly increasing the relative attractiveness of AUD as a carry trade.

Chart 2 – USDBRL implied 3 month yield minus AUDUSD implied 3 month yield

 This dynamic is possibly an additional reason why AUD has continued to perform in the face of a stalling copper price (chart 3) which if recently observed trading patterns had continued would have suggested AUD trading at around parity over the course of the first quarter.

Chart 3 – AUDUSD vs LME 3 month Copper

What should we make of the threat to shut down the US Government? Reversing the debt spiral is of course essential, at some point. What that point is, however, remains much debated. The bulk of government discretionary spending is on defence programmes. Funding wars is very expensive. And much of the rest is on social security. Non-defence discretionary spending is 12% of US GDP. That means cuts here ultimately are not going to solve the problem. What is required is structural changes to social security which are politically explosive. Alternatively lies the equally provocative proposition of increasing taxes or even more radically cutting taxes. Cutting taxes to stimulate growth was an argument popular in the Reagan era, now commonly viewed as discredited by history. The Laffer Curve speaks to the disincentive effects of higher taxes. This of course has a degree of truth, but the extension that lowering taxes will stimulate more growth actually increasing government tax revenues is highly problematic. The use of tax cuts to reduce budget deficits in current circumstances is an extremely contentious proposition, particularly to arch Keynesians such as Krugman. Martin Wolf of the FT goes through the numbers of what solving the budgetary problem through tax cutting versus tax increases looks like here. But increasing taxes, what most would consider the more reasonable solution is hugely problematic. Even at the best of times tax increases are political dynamite, yet should you increase them when the economy is weak? This mirrors another heated debate, does cutting budget deficits boost growth in a downturn. The contentious former adviser to Clinton and Obama described the proposition as oxymoronic. Summers is a lightning rod, seen by many as having changed positions in the Clinton years to support Wall Street interests. It is interesting to note that of the voices demanding deficit reductions and tighter monetary policy the absence of some of the major global investment banks. These are seen by some as principle beneficiaries of expansionary government policy, particularly in the US. In play in this debate is both the functioning of the macro-economy, and the fundamental role of the state. The US now sees itself as gridlocked and without an effective policy. The IMF has now come out and rebuked it for this failure.

Mirroring this is what to make of the European bailouts of the peripheral states, the so called PIGS. Portugal has now followed Ireland and Greece in requiring external support to cover its debts. The price of those ‘bailouts’ is massive fiscal cutbacks. Much as Summers says with respect to English policy, these cutbacks now seem to be producing his predicted major economic contraction in those countries pursuing them. Retail sales figures just released in the UK show the greatest fall in total sales since the data series commenced in 1995.

The question about Greek Debt is increasingly not if it will be restructured but when. Be under no illusion. The issue is not the health of the ‘peripheral economies’ but who is responsible for supporting core banks and the ECB exposure to those economies. Is it the German tax payer? Why shouldn’t the banks take the hit? The alternative, as we saw in sub-Saharan Africa is extended pain at street level. Of course corrupt or inept leadership needs to be firmly dealt with. Corrupt leadership can hide behind street protests. But democracy makes this all very hard. In Portugal, the EU, ECB, and IMF are seeking to extract a pre commitment by all political parties to the terms of the bailout deal ahead of coming elections triggered by the failure of the government to be able to pass the required measures. On the other hand Finland goes to elections this weekend, with voters capable of dealing a blow to requests that taxpayers from healthy economies cover the debts of the ‘periphery’.

Currently the markets see Spain as not vulnerable. The cost of insuring the risk of bank default is declining. Whilst stress tests being implemented again on European banks are likely to show weakness, explaining in part the strength of resistance to writing down debt, as the Financial Times reports, investors are broadly more confident in European banks. The initial interest rate rise by the ECB may not impact the fragile Spanish property market, as in absolute terms rates are still relatively low. But what if the ECB ‘normalises’ interest rates from the current 1.25% to 2-3%? Not all market observers are as optimistic as recent market price movements suggest, Munchau for example at the Financial Times. But for now German growth seems solid. For all the media and blogging airtime given to the debt question on both sides of the Atlantic, is it really now just a sideshow for the markets, or are investors simply complacent? Problems in markets tend not to be triggered within such long focused on problems. For many writing off a portion of debts such as those of Greece would be seen as resolution, good news. Investment risks generally arise from exogenous shocks such as the Japan earthquake, or tipping points within complex systems, such as geopolitical risks triggered by food/oil inflation, combining with challenges such as the Western World’s debt burden. We remain alert.

For those that missed the SBS documentary ‘China’s Ghost Cities’, it is worth watching if you are interested in China and its property market. It covers some old ground (e.g. New South China Mall in Dongguan which has been covered before by PBS, Ordos in Inner Mongolia covered before by Al-Jazeera, etc). However, it is a good summary of the risks that are rarely talked about in the local market or media which tends to focus on the strong demand out of China that some analysts seem to forecast in a straight line for the next 10-20 years.

The SBS documentary leads with the anecdote that there are ‘around 64 million empty apartments in China’ representing huge oversupply (driven by investors). The 64 million empty apartments is obviously an amazing statistic. However, no one really knows how realistic this number is (it is based on a local survey which revealed that 64.6 million urban electricity meters are registered with no electricity usage). Whilst it’s almost impossible to fully verify the full extent there do seem to be many empty apartments (sitting there as bare shells) in China, particularly in the tier one cities. One only has to travel from the airport in Beijing to the centre of town at night and attempt to count how many lights are on in the large (new) apartment blocks that line the ring roads around Beijing.

Therefore, without knowing all the exact numbers it does highlight the risks of believing all the data and phenomenal growth that has been coming out of China. The poor quality of data argues for a high risk premium whilst most investors (and corporates) have in the past just focussed on the quantity of the growth and not necessarily its quality. As the likes of Pivot Capital have argued before when it comes to Chinese data one can also quibble with the true urbanisation rate in China, the true debt level in China (local Government debt is not reported), and pretty much any piece of economic data that comes out of China.

Likewise we recently heard from a contact a similarly amazing statistic on the property sector that he was told by locals in Beijing that the ‘value of Beijing’s residential GFA (gross floor area) is greater than that of all residential GFA in the United States’ (said as a proud statement or as an April Fools joke!). In a traditional western model this looks like a bubble. However, many properties are not held as investments in the manner we in the west think of as property investment. They are held as a ‘store of value’ that people put their cash into as real interest rates are negative and the A share market is seen as too risky. It is also commonly understood that a significant portion of these properties is held without debt. There is some gearing, but it is held by property developers, more than the end-buyer. Therefore, Chinese property is held a bit like gold in the west, which means it is very hard to predict what would cause the system to roll over.

Whilst we struggle to verify these numbers and it is very hard to be totally definitive on the exact numbers it does at least highlight (for Australian investors, for example) the risks of putting all your ‘eggs in one basket’. As with sub-prime (and the US property bubble) timing is always difficult to forecast. China might continue to grow strongly for a number of years, but history shows us there are often great risks with great opportunities. The Australian miners, the Australian dollar, and even Australian house prices (and by extension the Australian Banks) are leveraged to these risks given the importance of China to all things Australian in its ‘two-speed’ economy.

Europe’s debt crisis comes back to life. The New York Times summarises the ongoing dilemma of European sovereign debt. It is essential to note that this is not just a problem of over leveraged so-called peripheral economies, but the under-capitalised banks of core Europe that have lent money to the periphery. The insistence that peripheral Europe pays back this debt by undertaking Draconian and potential self-defeating belt tightening at the insistence of the core is seen as a prop to those banks. Those policies seem likely to fall at one of a number of inevitable national elections over the next few years. Yet the alternative, to write off (i.e. restructure) a portion of those debts, risks a buyer’s strike in capital markets … but ultimately is inevitable. The stress of it is hitting long forgotten fault lines, artifices and thought forgotten and buried. For example, Belgium, a nation as artificial as Yugoslavia, but seemingly so enmeshed in core European reality struggles to impose an austerity budget. The nation is divided between two significantly unintegrated communities, the Dutch speaking north, and the French speaking south. Belgium only exists because Britain did not want France to be empowered by absorbing the French speaking region some time ago. Now this construct lies exposed, like the Euro. The market waits for Europe to take its medicine, but what is the medicine?

The reality is that there is no single cure. What needs to be implemented is a collection of policies, loosely implemented and coordinated between countries … and that is the challenge. Those policies will include:

1. recapitalising the banks
2. restructuring the debt
3. winding back over-generous welfare structures
4. labour market restructuring to promote new business formation
5. moves to discourage emphasis on high-risk financial profits as opposed to investment in new business.

Then with these policies in place there will be belief that some of the bailout mechanisms will be more than band aids. Implementing these policies cuts across ALL vested interests – business, labour, future retirees, banks, government. The grid locking is predictable and huge. The cost of not doing so will be a version of the ‘lost decade’ seen in Japan. Europe already has its own version, Italy, which has stagnated rather than taking on those interests. And Europe is now caught in collective finger pointing. The debate is primarily how the bailout mechanism, i.e. the bandaid, will be funded. If it is from taxpayers, it signifies potentially blowing out the debts of countries such as Germany, political dynamite. Or should it be funded off the balance sheet of the European Central Bank? This was ultimately the US solution. Sacrilege. Maybe if the bandaid is big enough, a pickup in US growth can allow Europe to trade its way out of the problem, as it has in the past. But this smells like wishful thinking.

And equity markets have been relatively well behaved, because they are anticipating that ‘something will be done’, and now it is bond holders that will pay. But can this transition be effected so smoothly? Is market calm wisdom, complacency, or is the question just too hard? Watch this space.

With the start of the important consumer electronic trade fair in Las Vegas we will be seeing a string of product announcements. There’s going to be a lot talked about in financial markets, with the following topics likely to be popular:

• One of the most significant areas is making tv smart. This is likely to further impact media models. Traditional delivery platforms will be increasingly challenged by interactive tv.
• Video conferencing, whether it be on your phone or tv, is set to become ubiquitous. Skype is a leader in this space, reaching across an increasing range of platforms, but there are many prospective players.
• NFC - near field communications - are close to turning your mobile phone into a payment device.
• Sony looks set to finally launch a PlayStation Phone. HP looks set to launch a slate, along with everyone else. Their slate looks set to use the Palm Operating System they acquired.
• And will we store our music and videos on home based networks, or in the ‘cloud’, to be accessed by any of our devices attached to the internet. A range of services looks set to be launched. Cloud computing is more a business-focused idea, but we are all going to be hearing a lot about it over the coming year. Business models are likely to be revolutionised and corporate IT departments scaled down, as much functionality moves away from expensive in-house platforms.
• On line shopping is challenging retail models around the world, from America to Australia. But technology is on the verge of making a big impact on a much wider range of our activities,  for example revolutionising learning processes. Devices like iPad are more than just a new way to read text books, but portend interactive educational experiences. We watch closely.

2010 has been an interesting year for environmental, social and governance (ESG) factors within Asia’s equity markets. Much like BP’s Deepwater Horizon spill in the Gulf of Mexico, the ‘Foxconn suicides’ at Hon Hai over May and June could in time prove to be the turning point that turns the analysis of ESG more into the mainstream with greater incorporation into fundamental equity research. Rather than seeing ESG somewhat as a ‘tree hugging’ exercise, an alternative way of understanding sustainability issues is it is actually one of the best barometers to assess corporate management. It is a good way to try to speak to how companies can minimise reputational risk, protect their franchise and sustain long-term competitive positioning and returns.

Since Hon Hai’s story went into the mainstream press a number of subsequent events across Asian markets have added to the ESG momentum. We have had material environmental and legal issues at Sterlite Resources/Vedanta in India, the leaking of acidic waste at Zijin Mining’s largest copper plant in China, and accusations from Greenpeace on Sinar Mas’ forest clearance methods. Clearly as we have seen globally it is no surprise the materials and energy sectors have arguably the most acute ESG issues to assess and try to understand. However, ESG issues are far from confined to just these sectors. Recent events in India highlight the point where concerns on the microfinance companies lending practices and rates has been quickly followed by a wider loans-for-bribes scandal. Both developing stories can to some extent or other be interpreted as material ESG issues, and all of these events have had a strong bearing on the share price returns of the effected companies.

As a result, moving into 2011 we continue to be on the look-out for the upcoming areas where ESG factors could have a significant impact on future stock price returns. One potential area is the casinos (or ‘integrated resorts‘) in Singapore. There is no doubt that since opening earlier this year both the casinos have been incredibly successful on all financial metrics. By next year Singapore with just two casinos may surpass the Las Vegas strip as the second largest market in the world (after Macau) by gross gaming revenue. However, there are signs of ESG issues starting to bubble away beneath the surface. It is a source of ongoing local debate as to whether the IR’s have provided sufficient benefit to all of Singapore’s residents. The extent to which undesirable activities like money laundering might be taking place through the IR’s, and the extent to which two large foreign corporations (Las Vegas Sands and Genting Bhd) are making money at the expense of local social clubs are still far from clear. The Straits Times newspaper has already carried a number of relatively critical articles as highlighted by the recent banning of free shuttle bus services from the ‘heartlands’ of Singapore to the casinos.

Other areas to watch for emerging potential ESG issues within Asia include the China internet for the questionable sustainability of the young Chinese consumers growing internet gaming addiction, and within the booming education sector in markets like China and India it will be interesting to follow how the for-profit sector manages some of the inherent conflicts with their business model that we have seen in some other markets, like the US. If nothing else recent events suggest that into 2011 more investors are going to be paying greater attention to ESG issues within a larger number of their investment decisions both in developed and emerging markets, and across more sectors of the market.

Compared with historic levels, US households are carrying a significant amount of debt relative to their assets and income.  Just comparing current levels to the year 2000 highlights this point: total household debt to GDP is 92% versus 66% in 2000, mortgage debt is 69% versus 46%, debt to disposable income is 118% versus 90%, and because of the reduction in housing values mortgage debt to real estate assets is 54% versus 37%. The levels have improved materially from late 2007 through a combination of increased savings and write offs, however they are nowhere near back to 2000 levels. To get back to 2000 levels today household debt would require a 28% cut in debt outstanding or $3.8trl.

This would be devastating to the US economy. But it’s also very unlikely, because low interest rates are making it relatively easy for households to service their current debt even if they don’t have the confidence to actually increase borrowing. In fact, US household servicing costs appear to be at the bottom end of the last 30 years despite the huge run up in nominal debt balances.   

The most likely path is a few years of subdued household spending and this, in combination with even modest income growth, could make a significant difference to these measurements of household balance sheets.  If we assume that  household debt levels continue to reduce at approximately 2% pa to 2012 and that household income growth picks up to 4% over the next two years then debt to disposable income would fall to 100%  and household debt to GDP would fall to 80%.

 

Neither of these levels is back to 2000 levels. However, assuming interest rates do not change materially, this reduction would imply that the financial obligations ratio (FOR) would fall to 16.20% of disposable income or close to the lowest readings of the past 30 years i.e. at current interest rates households may not see a need for further deleveraging . Of course interest rates will likely be higher at some point but this would probably be linked to faster nominal income growth so the effect on the FOR would be muted.
 
Given that households are already saving $670b a year versus an implied yearly pay down of debt of $262b, this scenario could be achieved without an increase in the savings rate. This means that in this scenario US households should be able to increase spending in line with income growth at the same time as significantly reducing their debt levels relative to GDP and income. So while household spending may not accelerate over the next two years it may not be as big a drag on the economy over the next few years as some believe.  

 

What are the risks to this relatively benign deleveraging process scenario?

The most stable metric over the past 30 years has been the FOR. This suggests that this is the most important way in which households make judgements about how much debt they should take on. However prior to the crash in housing prices the mortgage debt to real estate assets ratio was also relatively stable while nominal debt balances were rising (as per the first chart). The housing bust obviously reduced the value of housing assets which led to a blow out in this ratio; however mortgage balances are only reducing very slowly and mainly through write offs. This suggests that for the moment the FOR ratio is more important. If however house prices fell further then this may propel households to increase their savings ratio further to at least try to stabilise the mortgage to asset ratio. This increased saving would further impinge demand and in the worst case start a further downward spiral in the economy through further reduced out put and labour demand.

Since 1953, China’s economic policies and national development have been guided by a series of wide ranging five-year plans that lay out the key economic and social goals in what is now the world’s second largest economy. At the moment the 12^th of these Five Year Plans (12^th FYP), covering 2011-15, is being formulated. There is obviously significant market interest in the plan as China sets out specific economic targets, development goals and strategies for the next five years. The detailed timetable for the formulation of the 12^th Five Year Plans is as follows:

• October 2010 – The Communist Party will approve the outline of the 5YP with the Fifth Plenary Session of the 17th CPC Central Committee meeting over 15-18th of October.
• December 2010 – The annual National Economic Work Conference will likely lay out some of the policies that will be introduced in the 12^th FYP.
• March 2010 – The 12^th FYP will then be formally approved and released to the public during the annual gathering of the National People’s Congress.

So what can we expect? It has already been well flagged by Premier Wen Jiabao and other senior leaders that the upcoming 12^th FYP will target consumption, urbanisation, energy efficiency, and new ‘strategic’ industries. As a result, the key areas of focus are likely to include: improving income distribution, social housing, tax reform on land/property (including potential reform of the ‘hukou‘ household registration system), and the promotion of new ‘strategic’ industries like clean energy, information technology, biology, and high-end equipment manufacturing (like aerospace). The need to build a better social safety net, such as better healthcare and the pension systems, are also likely to be a key feature of the 12^th FYP. On a number of occasions Premier Wen has also noted China should accelerate the growth in service industries to increase the weight of service industries in China’s overall GDP contribution. All of these are significant subjects in themselves, but China’s changing power demand dynamics over the next five to ten years looks to be one of the most interesting aspects of this FYP.

This should be especially the case given the only targets that are unlikely to have been met from the 11^th FYP (that covered 2006-10) relate to China’s energy efficiency and emissions. For example, China’s energy consumption per unit GDP had dropped by only 15.6% which is 4.4% below the 11^th FYP target of 20%. In total, whilst the 11^th FYP clearly over-achieved on economic growth, it did underachieve on some of its social goals. As a result, going forward how China manages to curb its carbon emissions is important for the long-term investment opportunities in China as well as the environment. China has already stated its target of ‘reducing carbon emissions per unit of GDP by 40-45% by 2020 from the 2005 level‘. Whether or not this is achievable is debatable, but it is clear that carbon reduction will be a bigger area of policy focus going forward, including the 12^th FYP. China’s National Energy Bureau also recently proposed the New Energy Development Plan, which includes a total investment of Rmb 5trillion (US$750 billion) over the next 10 years to boost clean energy and efficiency. This suggests a bigger focus on boosting nuclear and wind power and increased investment in clean coal technologies. Currently coal (thermal power plants) represents approximately 75% of China’s total power capacity, and is likely to remain the dominant power source for the country. How quickly this level falls with new energy plan targets will clearly be important to watch.

This 12^th FYP could set China on a course whereby they sacrifice some economic growth for meeting more of their social goals. There has been some talk in the market that China will likely target slower growth over next five years with a more ‘conservative’ target of 7% annual growth from a previous target of 7.5% (which of course it has handsomely exceeded in the 11^th FYP). This does highlight that China now to some extent, seems willing to sacrifice some economic growth to achieve energy conservation and emission reduction targets, as well as some of its goals on improving income distribution. Most investors are fully aware that China has been suffering from an imbalance between consumption and investment, with the Investment/GDP ratio increasing from 35% in 2000 to 48% in 2009, while Consumption/GDP ratio has fallen from 46% to 36% during the same period. What is perhaps a little less well known is that disposable income in China has grown at just 9.3% from 2000 to 2009 which is well below industrial production growth which averaged 16% over the same period. Likewise services only accounted for 43% of China’s GDP in 2009, versus 63% in the US. Therefore, it seems almost a given that the 12^th FYP will include measures to increase the share of services and employees’ income in total national income.

An understanding of the details of the 12^th FYP will be important for investors not just in China, but also markets like Australia which have benefitted from China’s growth plans that have been so well executed over the past five to ten years. Investors need to be aware that the 12^th FYP could be a clear signpost that China is changing its growth model as it moves away from its investment driven growth. It could also highlight to Australians they should think about providing other goods and services to the China market beyond iron ore and coal that have been so neatly tied into China’s industrial production. The opportunities in services like education and tourism seem almost ignored in a relative sense. In Australia’s case it is a reminder as it celebrates how well exposed it is to the ‘China growth story’ that Australia needs to position itself to be exposed to the best parts of the story over the next five to ten years, and not just focus on what has worked so well over the past five to ten years. With A$32 million Sydney homes wanting to be demolished by Chinese buyers, Queensland Rail’s IPO being sold as an ‘Asian growth story‘, and champagne fuelled ‘parity parties‘ it will be a challenge to ensure this is not ‘as good as it gets’ for Australia, especially if the 12^th FYP follows its likely path over the next three to six months.

After receiving substantial political and populist momentum coming into the Copenhagen Climate Council (December 2009), governments are now increasingly deadlocked on progress towards lower carbon infrastructure. The inter generational argument for change has given way to the near term fiscal realities of badly over stretched sovereigns using neo classical austerity to balance their budgets versus adopting a Keynesian stimulatory pathway. Either doctrine does easily fit with the necessary long term changes to carbon infrastructure policy required.

According to the International Energy Agency (IEA) fossil fuels represent >85% of global energy consumed, with oil (37%) and coal (25%) the largest two components. These contributions are not forecast to change much towards 2030 under current global policies. Without regulatory change, and in the absence of a carbon price, the economics of fossil fuel burn remains compelling, as a 2007 study performed by the British Government (Department of Trade and Industry) confirmed:

Total (i.e.: capital and operating) cost of generating one MWh of electrical energy:

• Coal fired generation = GBP 27 / MWh (= 1x)
• Gas fired generation = GBP 37 / MWh (= 1.37x)
• Nuclear generation = GBP 38 / MWh (= 1.41x)
• Solar panel generation = GBP 49 / MWh (= 1.81x)
• Wind turbine (onshore) generation = GBP 56 / MWh (= 2.07x)
• Wind turbine (offshore) generation = GBP 83 / MWh (= 3.07x)

Under these assumptions, particularly coupled with the uncertainty of the nuclear fuel cycle, fossil fuels will remain embedded in our society. Countering the notion of unconstrained coal supply growth, two US academics Tad Patzek (University of Texas) and Greg Croft (St Mary’s College) have recently tabled a peer reviewed document focussed upon “peak coal”, that the world is currently extracting its maximum coal production of 7 million tonnes per annum. Under this thinking, production will taper off; not as a consequence of depleting reserves (indeed the world has enough coal reserves to burn for well over 100 years), but our inability to extract it commercially.

For example the authors cite^[1] that Alaska’s North Slope has enough coal reserves to rival continental US, but logistics prohibit it from being commercialised. Further the study examines Russia, China and other energy consumes and draws similar conclusions. A similar thesis, focussed on oil supply, performed in the 1950s by M. King Hubbert correctly predicted US peak oil supply around the 1970s. The implicit conclusion is that the catalyst for carbon policy and sustainable energy practises may well shift from climate change to the harder economic realities of ever tightening coal markets. The price shock inherent in such a scenario would be similar to that faced by the OECD in the twin oil spikes of the 1970s. Will “peak coal” provide the ultimate carbon change catalyst?

^[1] As quoted in New York Times – 30 Sep 2010