Tuesday, November 16, 2010

Policy Lending May Not be Your Friend

TMM notes that while the Ring Cycle continues to play out in Europe (with a likely Wagnerian ending long term, but a plug short term) things are looking progressively worse for risk assets in Asia. Today more rumors came of monetary tightening in China across the board as well as a rate rise in Korea. If that wasn't enough, the State Reserve Board, that wonderful Chinese entity that imported hundreds of thousands of tons of copper concentrate in early 09 and single-handedly engineered a Lazarus-like rise in the base metal complex, seems to now have gone all offered with auctions of aluminum ingots amongst other metals. Chalco and other metal names in Asia have suffered pretty horribly as a result of this as has the entire index: combined with property curbs (they just keep coming, don't they?) and insane rises in food prices, it is quite clear the Wizards of Beijing who pull the levers on China are in a full-fledged inflation panic and are doing anything within their grasp to get it under control. TMM can't help but feel with some good news in the offing in Europe and pain in Asia that buying EURAUD is not an idea without its merits.

One story that did catch TMM's eye was the Bloomberg one on the pending Solar Panel glut. TMM have followed the rise and fall of this sector for some time and consider it a good object lesson in the perils of policy lending. You see, circa 2004-2005 solar was really taking off due to subsidies in some sunny places (Spain) and not so sunny places (Germany). Some astute folks decided that given low manufacturing costs, economies of scale and whatnot that they would move their production to China like Suntech or move into truly massive scales of production like Q-Cells. As you can see from the chart below (white - Suntech; orange - Yingli Green Energy; yellow - Q-Cells; green - Canadian Solar), things were pretty good until 2007, but have been dreadful since. Why?


The answer is that margins absolutely collapsed due to an insane number of new entrants and growth really, really slowed down. Here is Suntech vs their margins and revenue growth:


And here is Q-Cells which is a pretty ugly story:


All in all there really weren't any winners in this sector as you can see below: the Chinese producers got canned just as hard as the Europeans:


The reason is that around 2005-2006 China decided that solar and particularly polysilicon was a great industry and they wanted to get big in it - real big. Even during late 2007 and early 08 when aggregate bank lending was tightening you could still get loans for solar companies to expand production into the teeth of an ugly downturn at the same time as China real estate CDS widened out horribly because that sector was cut off from lending onshore. The result was that *a lot* of solar capacity got built and margins in the industry went down. Capital intensive projects underwritten on 25% EBITDA margins realized 15% margins and the equity in many cases has not seen daylight since.

Its important to note here that policy lending ain't all bad: in Japan during its period of rapid growth from the 60s to the early 80s lending "window guidance" existed but was more organized: a lot of loans got printed but only to a select few who would duly create oligopolistic pricing and not cannibalize one another. Not bad for investors though really bad for consumers. Princes of the Yen has more. Ultimately policy lending impact on your book comes down to more how it gets done than anything else - it's always a form of redistribution one way or another.

So it caught TMM's ear recently when at a lunch they heard two friends in the special situations and PE business complain at length about how many battery company deals they were seeing.
- "How is it that all these guys already have half their cash lined up from state banks?"
- "Look at the margins - this stuff will be fine no matter how much of a muppet the promoter is."
Which makes TMM wonder: can the likes of BYD in Hong Kong survive the onslaught of a bunch of hyper-subsidized competitors? Sage of Omaha beware: the PBOC are not your friends.

4 comments:

Nic said...

I like your EURAUD technically. I was looking at EURNZD, GBPAUD too and thinking they looked like great buys this weekend too and AUDCHF is a bearish Gartley pattern.
Even AIB looks good at the moment

Anonymous said...

Bronte Cap had some good stuff on that sector (speaking as a dilettante).
Thanks for the AUD crosses reminder, had fallen off my radar, but I think a general point about avoiding USD for a while is worth making too, even if some crosses are messy.
& thanks for reopening anon
keep up the good work TMM
Cheers, JL

DrChaos said...

The intent of Chinese policy lending is NOT to yield profitable lending, or profitable companies.

It is intended to yield a wealthy and powerful nation.

Technology manufacturing requires intense, and concentrated investment and the long-term expertise of key employees. A profit oriented company will fail and eliminate such people in a downturn. These downturns can be greatly exaggerated by non-profit-seeking state-directed expansion combined with hypermerantilist trade and currency policies. This effect is not unintentional.

The purpose of the Chinese policy is to acquire manufacturing capacity and expertise in technology, and destroy the technical capability of competitors.

Because of competitive substitutability and high capital investments, technology manufacturing is substantially less profitable than other corporations, but it contributes far more to net GNP and national capability. Compare to highly-profitable rent-seekers like 'brand names', institutionalized financial institutions, feudal landowners or Mafia protection rackets. Technology manufacturing is the worst choice for a shareholder, and the best choice for human society.

Nemo Incognito said...

Dr Chaos, maybe so until your banking system falls on its rear end.... having spent my first year or so in the business looking at Chinese NPL pools I assure you that all those capital raises at Chinese banks generally are needed. I spend a lot of time making fun of Chalco but at least they pay their coupons - many aluminum smelters now don't and no one wants to buy them.