Tiger Woman on Wall Stree (19 page)

Authorities tried to minimize media attention by hiding the train cars almost immediately. Here too, their haste proved disastrous: while digging the graves to hide the train compartments, a little girl was found inside, still breathing. The authorities had been in such a hurry to hide the embarrassing equipment failure that they nearly buried a
little girl alive
.

It is not the lack of traditional Western-style human rights that angers Chinese people, as Western media would have us believe. Freedom of speech is an important source of creativity and innovation, but the lack of it is not the overriding issue in China. Rather, most people, from peasants to the middle class, are resentful of the government’s failures to provide two other human rights: the right of equal opportunity to achieve prosperity and upward mobility and the right to be shielded against disasters like the crash at Wenzhou or the Mengniu milk scandal.

Blame it on a face-saving culture, or Mao’s war on religion, or the education system, or propaganda—whatever the cause, China faces a crisis of ethics that has coincided with an increasing focus on wealth and little focus on anything else. In the breakneck speed of China’s modernization, concern for anything but wealth has fallen by the wayside. Money, a thing to be celebrated in the 1980s, had become by the 2000s a very serious matter. It was all the Chinese had to believe in.

  *  *  *  

While the problem of corruption exists everywhere, China surely presents one of the world’s most fertile environments for it. Economic research suggests that corruption results from three factors: the capacity of a certain minority, in either the public or private sector, to control the allocation of licenses, privileges, and other resources; a lack of transparency, including the absence of an independent media and a weak civil society; and a lack of accountability, due to the absence of an independent judiciary or the rule of law. China clearly fulfills all three of these conditions. Tracking corruption quantitatively is nearly impossible, but China scholar Minxin Pei estimates that kickbacks, bribes, and outright theft from the public coffers is equal to 3 percent of GDP—roughly equivalent to the central government’s annual spending
on education
.

I’ve seen corruption in practice since I was in school, when I witnessed families bribing teachers so that their children would get better grades. It’s hard to blame the well connected for taking advantage of their positions, given that cronyism is now so rampant in China. An individual makes a principled stand against this corrupt system at his own political, social, and economic risk. Therefore, few do.

While corruption is innate to all emerging markets, including Africa, Latin America, Eastern Europe, and the former Soviet Union, China is uniquely handicapped by its double status as an emerging and centrally planned economy. Many Chinese have observed that the spread of corruption is closely linked with China’s massive infrastructure build-out, which was fueled by the 4 trillion RMB ($586 billion) stimulus plan in 2009. The stimulus triggered huge investments in megaprojects that temporarily staved off a recession in China, but also spurred a vibrant economy of corruption.

From an economic perspective, corruption is a form of rent seeking in which privileged parties in a system extract value from
their political or social position. The Chinese government takes money from the population in the form of taxes and fees, as well as through less obvious channels, such as providing artificially low returns on deposits at state-owned banks. Much of this revenue is then channeled into government-led investments. But along the way, wealthy and connected politicians and businesspeople siphon off much of the money.

I believe that a big portion of government-led infrastructure spending in 2008 trickled out in the form of bribery, embezzlement, and kickbacks, all of which went to the connected and enfranchised. Interestingly, shortly after Beijing released its massive stimulus package, Macau casino stocks began to soar, led by those companies with the most exposure to VIP gamblers from the mainland. Between the start of the recession and the end of 2012, Galaxy Entertainment Group, Sands China, Melco Crown Entertainment, SJM Holdings, and Wynn Macau all saw their stocks appreciate 3,000 percent, 300 percent, 530 percent, 1,000 percent, and 100 percent, respectively. The observed correlation between infrastructure spending and Macau casino business supports my hypothesis that a big portion of the stimulus was wasted as corruption rent.

This government-led spending has not only wasted money; it has also embedded corruption from allocating contracts and approving bank loans into the engine of the state-driven growth plan. As a result, the party’s economic objectives are deeply intertwined with the profiteering of its affiliates. Chinese people joke about why the government prefers fiscal measures to stimulate the economy: monetary expansion or tax cuts just don’t offer the same kickback opportunities.

In developed economies, the private sector tends to attract talent, because it tends to be more entrepreneurial and efficient and therefore offers better financial rewards and more exciting career opportunities than jobs in state-owned enterprises (SOEs).
In China, however, the SOEs have the upper hand in attracting and retaining employees, due to hidden perks associated with corruption. Especially in recent years, China has seen a surge in the number of college graduates both taking the civil service exam necessary to get government jobs and applying to work
at SOEs
.

The government has thrown in with the crony class and has cut the many millions of hardworking people with fewer connections out of the profits of China’s economic growth. This has worsened the already-wide income gap between the rich and poor in China and furthered social anxiety, causing the Chinese people to lose confidence in their government.

It is hardly a coincidence that as corruption blossomed with Beijing’s stimulus package, the global fashion houses saw Chinese demand for Western luxury goods surge. Luxury sales in the mainland expanded an impressive 30 percent in 2011, making it one of the world’s fastest-growing markets. High-end stores sprang up. Shin Kong Place, a luxury shopping mall that opened in Beijing in 2007, recorded store sales growth—a matrix measuring retail store performance—of
30 to 50 percent annually
.

The hunger for luxury goods also spilled beyond the Chinese borders, as many Chinese went abroad to buy luxury goods to avoid high domestic taxes. Stores catering to the wealthy in major shopping destinations such as Tokyo, London, and New York began employing Mandarin-speaking salespeople and stocking Chinese teas. Chinese shoppers had become the world’s preferred customers; by 2012, they consumed one-quarter of the
world’s luxury products
.

Well-known luxury brands—such as Swiss watchmaker Richemont, the owner of Cartier; Swatch Group, the owner of Omega; LVMH, the owner of LV brands; and PPR, the owner of Gucci and Bottega Veneta—benefited handsomely from the stimulus, witnessing 20 to 30 percent sales growth year over year in Greater China (including Hong Kong and Macau) between
2009 and 2013. CEOs of high-end companies came to view their brand’s China momentum as the defining source of their future success.

But events in 2012 and 2013 called that assumption into question. After occupying Nanjing Road in Shanghai and the trendy neighborhoods of Guomao and Chaoyang in Beijing, these brands couldn’t wait to invade China’s small cities, only to realize that few people in China’s less populated cities could afford diamond watches or luxury handbags. At roughly the same time, global luxury brands discovered that their revenue was vulnerable to policy changes.

The reason had to do with the source of Chinese demand. It is impossible to get an accurate number of how many luxury items are bought for personal consumption as opposed to being given as gifts—often as bribes. JL Warren, my research firm, estimates that for high-end Swiss watches with price tags of more than 50,000 RMB (roughly $8,000), 40 to 60 percent of purchases are for gifting. Although most analysts attribute the surging demand for luxury products to the rise of China’s middle class, these figures clearly imply that currying business favors is a powerful driving force in the market.

Another powerful source of demand for luxury items comes from what I call China’s “mistress economy.” A slew of sex scandals in China at the beginning of 2013 showed just how much power and sex go hand in hand in China. One Guangdong deputy chief was sacked after evidence emerged online that he had
47 mistresses
, while sex tapes made by a property developer led to the firing of 11 officials
in Chongqing
.

In China’s male-dominated culture, many officials keep a beautiful, refined mistress draped in Prada—or keep dozens of them if they can afford it. Infidelity is rife among all class levels in China, but among officials mistresses have become a de rigueur status symbol similar to flashy Cartier watches and luxury cars.

Chinese mistresses are unique in that they have far more material demands than their counterparts elsewhere. These young Chinese women are in a search not for love, but for cash, high-end apartments, expensive cars, and logo-emblazoned luxury products. They know that their affairs almost certainly have expiration dates; like everyone else in China, they are trying to amass as much wealth as possible before their luck—or their country’s—runs out.

One company that benefited from both these trends was the high-end Swiss watchmaker Compagnie Financière Richemont SA (already mentioned above). After entering China around the onset of the global financial crisis in 2008, Richemont saw its sales grow 20 to 30 percent per year. The company owns many global leading luxury brands, including Cartier, IWC, Jaeger-LeCoultre, and Vacheron-Constantin. Due to its sky-high prices, almost all Richemont’s brands were sought after as gifts to grease palms in Chinese business relationships. Richemont saw a surge in demand from Chinese consumers both in and out of the mainland that pushed the company’s stock up 230 percent between 2009 and 2013.

But good things usually don’t last, especially in China. Judging by consumer behavior—such as how many watches were purchased in bulk and how many watches were bought without adjusting the band size to the buyer’s wrist—store managers and their distributors estimated that roughly 40 to 50 percent of purchases were intended as gifts. This high percentage of gift-driven purchases left the company’s business vulnerable to changes in the political environment and policies. Richemont’s revenue was what stock analysts call high risk, meaning it could dissipate unpredictably.

That is exactly what happened in 2012. The Swiss company experienced a slowdown in business around the time of the once-in-a-decade leadership transition in November. After realizing how much popular resentment their old bosses had caused,
China’s new leaders, led by Xi Jinping, the country’s president, launched an anticorruption movement. The government restricted or banned the giving of many extravagant traditional gift items, ranging from the ill-tasting Chinese liquor Mao Tai and the famous Longjing green tea to Hermès bags and Swiss watches with price tags of more than 50,000 RMB (roughly $8,000 at the time). To convince the masses that Beijing was serious about this new policy, Xi also required all senior officials to liquidate their real estate assets overseas or else risk being removed from the party.

Today, with nearly 50 percent of its revenue coming from China, Richemont is effectively a China story, a company whose sustainability relies largely on Chinese consumer demand. In a recent conference call to investors, CEO Johann Rupert was asked about the prospects of the company’s growth globally. He answered, “I feel like I’m having a black tie party on the top of a volcano. . . . That volcano is China. . . . the food’s better, and the wine’s better, and the weather is great, but let’s not kid ourselves. There is a volcano somewhere, whether it’s this year, in 10 years’ time, or in
20 years’ time
.”

Richemont has felt the pinch of the anticorruption measures, but it is far from alone in that. Gucci’s parent company, PPR, revised its China strategy and decided to hold back new store openings in 2013. LVMH, another popular luxury brand in China (largely because of its conspicuous logo, which appeals to a Chinese pack mentality), was also caught off guard by the unexpected slowdown and decided
to call off its expansion
into smaller cities.

Many analysts failed to foresee the slump because they didn’t realize that the growth of these stocks came in large part from free-riding the corruption boom. Many sell-side firms ascribed these luxury names a high earnings multiple under the assumption that the demand came from the ever-rising Chinese middle class.

In reality, the demand came from a tiny portion of the population with concentrated power and privilege and therefore wealth.
But since this power and privilege shift with the change of bosses in Beijing and the policies they create, this demand should be considered risky. On Wall Street, risks should translate into a valuation discount. Analysts ought to assign this group of stocks a China discount, not a China premium.

  *  *  *  

Before I left China that summer, I had a conversation with an old friend, a former CFO of a few publicly listed companies. It drove home the point that the country was gripped by a crisis of confidence. I had stopped in Beijing for a few days, and he insisted on picking me up in the latest addition to his fleet of Porsches—a sleek black SUV. Given that our lunch destination was only a few blocks away, sitting in the snarl of Beijing’s notorious traffic for far longer than it would have taken to walk was a bit over the top.

Over the phone, he had said he had some business to discuss with me. I was looking forward to hearing what he had in mind. After some idle chitchat over dim sum, my CFO friend cut to the chase so fast that he didn’t even bother to remove the chicken foot he was gnawing on from his mouth. “Can you recommend some good hedge funds offshore for us to invest in?” he asked.

Even someone as connected and successful as my friend didn’t feel safe leaving his wealth, mostly garnered from pre-IPO stock options, within China’s borders.