Robert Sams on rehypothecation, deflation, inelastic money supply and altcoins

The Bitcoin Foundation held a conference in Amsterdam back on May 15-17.  The video of the events was not uploaded until recently.  The one below covers the panel on economic theory.

Panel: Robert Sams (Founder, Cryptonomics) Robin Teigland (Associate Professor, Stockholm School of Economics) Peter Surda (Economist, Konrad Graf (Author & Investment Research Translator) and moderator Jon Matonis (Executive director of the Bitcoin Foundation)

Over the past several months, Robert Sams has helped act as a non-partisan sounding board to discuss these issues as I did research on these topics.  He also recently launched a start-up in this space called Swiss Coin Group which acts as a liquidity counterparty (see also SCG’s announcement video from Coinsummit last month).

I finally had a chance to watch the panel on economic theory of Bitcoin (above) and below are some transcribed portions of comments by Robert Sams.

Regarding the ‘regression theorem‘:

The idea that something needs to have some underlying use value before it can gain liquidity and become a medium of exchange, first of all it has always struck me as not a derivation of logic and therefore not a theorem but an empirical hypothesis and one that I think that the very existence of Bitcoin has conclusively falsified.

On competing altcoins being sorted out:

I think eventually there is only room for a handful, 3, 4, 5, maybe ten competing cryptocurrencies.  Each filling a niche that satisfies some area of demand, some might have a richer scripting function for smart contracts, one might be embedded in a different kind of protocol.  So there is definitely room for multiple currencies but the very nature of hash-based proof of work, where the security of the network is arrived at by people literally burning money is one that can’t be evenly distributed over a large number of alternative cryptocurrencies.  It’s what you see, eventually most of the altcoins will fail and people will stop mining them, they won’t have any exchange value.  But there will still be room for quite a few.  And you already see it in the distribution of the market capitalization of these things, they follow a power law and I would expect that to continue.

What about altcoins in local communities?

That’s an interesting question.  I think the more local the currency becomes the harder I think it is to use hash-based proof of work as a solution.  Although other types of distributed consensus mechanisms could be used.  Because if as a community currency the overall monetary value of that thing is going to be much much lower, so the amount of seigniorage that comes from the mining award to reward the miners is much lower, so the amount of electricity that is spent securing it, it is something that will be alot easier for someone on the outside to attack it if they wanted to.  On the other hand, the incentive of attacking some small community currency might not be there, so not much of an issue.  So it’s an open question.

Thoughts on fractional reserve banking with bitcoin:

I don’t think it is actually possible to construct fractional reserve banking within Bitcoin.  Because fractional reserve banking, especially in the modern era, it’s one of the great scandals of modern finance is based on an illusion — this 1:1 fungibility between bank deposits and cash.  And you can do that in the conventional analog world because you have this whole institutional framework of deposit insurance, lender of last resort function of the central bank, you can bail out the banks if they fail in order to maintain this illusion that a loan to the bank — an unsecured loan to the bank which is basically what a bank deposit is — is the same thing as cash, and they are not.  And there is not anyway within the crypto space to express such an arrangement.  Sure there will be lending done in Bitcoin, I was talking to a guy last night who is doing just that, that’s fantastic.  But the relationship between the lender and the borrower isn’t one of “well I had some ownership of a pool of loans to people” — that’s something that has a floating net asset value.  It is not treated as a cash equivalent, I can’t use it as a medium of exchange or maybe I could but it would be a medium of exchange that trades like a credit instrument rather than risk free cash.  So I don’t think its even possible to express fractional reserve banking in bitcoin and I think that’s a good thing.

Konrad makes a really interesting point about trusted fourth parties and trusted fifth parties.  You know, it’s not just about being fractional reserve banking, the bank deposit versus cash, it’s about all assets within the financial system: the clearing banks, custodians — also play a fractional reserve-like role.  Most people don’t realize that.  Securities that are on deposit with a custodian bank can be lent out to those who want to sell them short; bonds, the same thing happens.  So that something that is called rehypothecation, these assets get lent and relent and relent, they multiply throughout the system.  So like some particular bond that’s in the system, there might be $2 billion of it outstanding, but the actual quantity of people who own that bond on their balance sheet is like a factor of 10 times that.  It’s just like the multiplication of base money in the banking system and the whole thing creates a systemic instability because the lack of clarity about this relationship between the guy who is entrusted his assets for safe keeping in some clearing bank and exactly do what that clearing bank can do with it.  Now the theory you think that it is governed by the law and the like but when Lehman bankrupt, there were a lot of fund managers and hedge fund managers who didn’t actually realize that their clients money which was supposed to be in a segregated client account was actually rehypothecated and they had to queue up in the bankruptcy courts in order to recover that money.  And one of the things that crypto does is make the sure technical nature of the transference being done by digital signature means that there is no way that you can create these rehypothecation arrangements without making them explicit.  And I think that is great.

Would you take out a 5 year loan in bitcoin knowing you had to pay it back in bitcoin?

No.  Well, it depends, I guess if I were selling it short.  But no.  If there was a lending market in bitcoin its most likely to flourish initially as being something that’s denominated in fiat money rather than nominal bitcoin.  Unless the borrower is using it as a vehicle to speculate on a climb in the exchange rate.

On deflation:

I think the deflation criticism of Bitcoin is usually misguided, it usually comes from the economics profession.  The arguments that are made don’t really apply because, the arguments about sticky prices (good’s prices fall faster than wages), about balance sheet effects of debtors being punished because an increase in the purchasing power, none of those really apply in Bitcoin because bitcoin isn’t yet a unit of account.  Contracts and prices are still priced in the fiat currency and expressed in bitcoin by reference to some exchange rate.  So the traditional arguments like, “is deflation is a bad thing” don’t really apply in a bitcoin world.

There is a different reason for why we maybe should be concerned about the appreciation of the exchange rate because whenever you have an economy where the expected return on the medium of exchange is greater than the expected return of the underlying economy you get this scenario, kind of like what you have in Bitcoin.  Where there is underinvestment in the actual trade in goods and services.  For example, I don’t know exactly how much of bitcoin is being held as “savings” in cold storage wallets but the number is probably around $5 billion or more, many multiples greater than the amount of venture capital investment that has gone into the Bitcoin space.  Wouldn’t it be a lot better if we had an economy, where instead of people hoarding the bitcoin, were buying bitshares and bitbonds.  The savings were actually in investments that went into the economy to fund startups, to pay programmers, to build really cool stuff, instead of just sitting on coin.  I think one of the reasons why that organic endogenous growth and investment in the community isn’t there is because of this deflationary nature of bitcoin.  And instead what we get is our investment coming from the traditional analogue economy, of venture capitalists.  It’s like an economy where the investment is coming from some external country where Silicon Valley becomes like the Bitcoin equivalent of People’s Bank of China.  And I would much prefer to see more organic investment within the cryptocurrency space.  And I think the deflationary nature of bitcoin does discourage that.

What about issuing coins after 21 million limit, that would be called Keynes coin?

I wouldn’t call it Keynes coin, not just because of the marketing but conceptually I don’t think it would be either.  This is controversial and difficult.  There are algorithmic, distributed ways of working within cryptocurrency protocol to change the money supply in proportion to the change in its exchange value.  And that can be done, it doesn’t require a central bank, it doesn’t require some cabal of guys deciding what the monetary policy can be, it can be done completely anarchic and distributed way and it would have the property of stabilizing the price of cryptocurrency.

I think the issue if should you have more elastic supply or not it just really comes down to the fact that if you have a fixed supply of something, the only way that changes in demand can be expressed is through the change in price.  And people have expectations of increased demand so that means those expectations, expectations of future demand get translated into present day prices.  And the inelastic supply creates volatility in the exchange rate which kind of undermines the long term objective of something like cryptocurrency ever becoming a unit of account.  And forever it will be a medium of exchange that’s parasitic on the unit of account function of national currencies.  So I do think the issue does need to be addressed.

Audience question on 100% reserve versus fractional banking:

There is a movement underway in the economics profession called limited purpose banking or 100% reserve banking.  It’s not just in the cryptocurrency world that we criticize fractional reserve.  Even Mervyn King before he left his chairmanship with the Bank of England he suggested that this is something that we should look into.  So yes, it is quite possible, there could be consensus — broad base consensus — around taking away the banks ability to create private money.  What do we use to replace that, one side of the argument is going to be that the banks should take the role of issuing the currency they just have to have 100% reserves and ‘gosh those things should be risk free government bonds.’  I think there is an alternative argument that can be made from the cryptocurrency space is that we don’t actually need the banking system to fulfill those functions at all.  And the demand for some medium of exchange in the absence of bank created money will be met spontaneously within the cryptocurrency space.

Audience question, does buying bitcoin and holding them benefit the community?

It’s an interesting question.  I don’t think so.  You could argue indirectly the fact that people buy and hold bitcoin, the price goes up and that attracts all the interest into this space and to some extent that’s true.  So yes, it does provide some investment.  But I think it doesn’t provide as much investment as would be the case in the alternative world where Satoshi implemented the exact same thing but had a different money supply rule.  My view counterfactual is that we would actually see a lot more underlying economic activity in the cryptocurrency space and a lot more investment.

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Proof-of-Gox and Recoverycoins

Yesterday I had the pleasure to moderate a panel discussing Goxcoin on LTB episode #89.  Participants included Adam B. Levine who is the editor-in-chief of Let’s Talk Bitcoin! as well the chief visionary officer to the Humint project (and who wrote the foreword to GCON).  David Johnston is the managing director of BitAngels, the first angel investment network focused on digital-currency startups, and a board member at the Mastercoin Foundation (I also interviewed him for GCON and included his insights in Chapter 3).  And the final panelist was Pete Earle, who is a multi-decade veteran of the financial trading sector as well as an economics writer (the article that sticks out most to me was incidentally his piece on mudflation).

It’s a very thought provoking conversation as it raises real-world use-cases for using cryptoprotocols (such as Bitcoin and Mastercoin) in a more effective, efficient, secure and transparent manner than existing models and frameworks.

Developers can find out more information about the Master protocol white paper.

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Chapter 17 – Architects, aviation and debt structuring

[Note: below is Chapter 17 from Great Wall of Numbers]

There are over 170 cities with a million people in China compared with nine in the US.1 By 2020 China’s urban population will reach 800 million, by 2025 there will be 221 cities with 1 million people and by 2030 there will be more than 1 billion people living in cities.234 While some of the build-outs may turn out to be unsustainable, McKinsey & Company estimates that 50,000 skyscrapers will be built in the next 20 years on the mainland, “the equivalent of 10 New Yorks.”56 In fact, one-third of all the 100 tallest buildings in the world are now on the mainland and one estimate suggests China will surpass the US in skyscrapers by 2017.7 And as China’s urbanization increases (crossing the 50% barrier in 2011, see Chapter 6), according to one argument – these people need to live somewhere.8 Thus numerous foreign architects, currently facing a soft labor market in the West have moved to the mainland, to design and construct a cornucopia of buildings including mian zi gong cheng (面子工程).

For example, it is a truism to note that nearly every country and political class around the world has erected shrines commemorating battles, people and events (e.g., monuments of grandeur, arches of prestige).  In China, “face projects” are called mian zi gong cheng.  While it could be argued that while the productive capacity of such projects range from practical to ‘hopeful’ (e.g., Three Gorges Dam versus the Great Wall itself), there are any number of modern day Pyramids continually being built in mainland China (and elsewhere).9 The reason it is arguably important to study these face projects is that they provide an insight to what Frédéric Bastiat called the “seen and unseen.”10 Or rather, what are the opportunity costs foregone in the construction of such edifices?

For example, the Pyramids in Giza offer a historical illustration of this principle in action.  These Pyramids, while stunning cultural monuments, consumed vast quantities of economic activity that produced little in return.  After a factory is built, it can be used to manufacture any number of products including consumer goods.  Pyramids on the other hand, despite their timeless grandeur, are little more than a decorated tomb, a very large mausoleum.  And while modern graves do provide positive sanitary spill-over effects (e.g., prevent the spread of diseases) it would be disingenuous to argue that the funeral industry is a productive long-term generator for any economy.11 Thus in an alternative timeline, what were other productive uses that the Pyramid materials and workers could have been used in?12

And as Frank Shostak pointed out several years ago, while measured by some modern economic metrics constructing the Pyramids would have looked like a GDP boom (e.g., increased economic activity), the actual reality is that this kind of face project consumed several orders of capital without providing any in return.1314 In short, it was a money pit with no tangible return-on-investment other than psychological feelings of “greatness.”  And you cannot eat “greatness.”15

What is the point of this history lesson?  How does this apply to modern China?  In Mark DeWeaver’s new book he discusses Fuyang airport located in Anhui:

Consider the city of Fuyang in Northeastern Anhui Province, for example.  Located in a relatively remote location in one of China’s poorer interior provinces, the city originally had only a small landing field for flights to Hefei, the provincial capital.  In the 1990s, the local government decided to “raise the city’s profile” by building an international airport.  The original airport’s 400 meter runway was expanded to 2,400 meters (long enough for commercial flights to most Asian destinations) and a 7,200 square meter terminal and other amenities were built at a total cost of 320 million yuan.

In 2004, after being open only a year, the new facility had to be closed because there was not enough traffic to keep it operating.  While it was finally reopened in 2008, as of the beginning of 2011 its website showed only three flights a day.16

When I taught in Anhui I asked several students from the Fuyang area if they had ever used the airport.  They said it was more practical to use the large train station because the airport only had flights to just a couple of cities (Beijing and Shanghai) during the day.  While there is potential growth due to the population size (Fuyang itself is either the 1st or 2nd largest county in Anhui depending on which areas are included), this represents an unproductive asset that would probably not have been built in this location or time frame if left to market forces.

Is this an isolated incident or just a rare exception?  Neither.  According to the Financial Times, in 2010, three fourths of all airports in China lost money.17 In 2011, of the 180 civil airports in operation, more than 70% lost money.18 In fact based on research from Li Xiaojin, a professor at Civil Aviation University of China, an airport in China needs to handle 1 million passengers a year in order to turn a profit.  Yet according to his estimates, 80% of airports do not hit this mark.19 And according to the Civil Aviation Administration of China (CAAC), these losses in 2011 amounted to more than $314 million.20

How does any of this have to do with opportunities for foreigners?

Over the next five years an additional 82 new airports will open in part because policy makers see these losses as short-term pain.21 Yet this is not entirely without merit as this may just be a modern chicken and egg problem as airports are only useful if there are other airports that connect to them (i.e., the network effect).  If recent trends hold, then the popularity of flying may make these projects more financially feasible.  For example, over 270 million passengers flew domestic routes in China in 2011, up 70% from 2003 – and the International Air Transport Association projects “379 million will be flying domestically by 2014.”22 Furthermore, according to Reuters, in the last decade passenger air traffic has grown 14% a year, which is twice as fast as the growth in train travel.23 Thus despite the added competition from CRH (high speed rail lines) that have been seen as the main reason why domestic carriers have operated at losses for the last 3 months in a row (through January 2013), ultimately many of these airports may turn a profit.24 As a consequence, foreign airport designers may also find opportunities in China.  For example, in building airports in western provinces like Tibet, foreign aviation consultants have been brought in to build transponder landing systems such as Automatic Dependent Surveillance-Broadcast (ADS-B).25

Engines and cleantech

Another opportunity is avionics and engines.  For example, the Aviation Industry Corporation of China (AVIC) is a large SOE with 400,000 employees which has set aside around $16 billion to build a new engine and may spend up to $49 billion on an even larger engine research effort in the next decade.26 And Commercial Aircraft Corporation of China (COMAC), another large aerospace SOE, recently announced that it has now had 380 orders for its domestically made C919 commercial jet.2728 Yet because the nascent domestic aerospace industry has been unable to build and design a reliable jet engine to power the domestically made planes, foreign engine makers are expected to sell $100 billion in engines alone to China over the next 20 years.  Domestic issues also present opportunities to foreign airplane manufacturers, who are expected to sell 5,000 airplanes worth more than $600 billion to Chinese airlines over the next 20 years, as well as to foreign pilots seeking flight time.29

Because of retirement changes in their home countries that have extended the tenure of senior pilots, many junior foreign pilots have begun flying routes in China to accrue flight time.  In fact, over the past several years, Chinese airlines have been actively recruiting pilots in the US, offering various perks and enticing several hundred so far.30 Thus, because of the growing pains on the mainland, there are numerous opportunities for foreign aerospace and aviation experts.  In fact there are only about 6,000 pilots altogether on the mainland, half of whom are students or teaching in aviation schools.31 Yet more than 10,000 pilots are estimated to be needed in order to fill the demand as the industry expands.  For comparison, in 2009 there were 594,285 active certified pilots in the US.32

Again, as noted in Chapter 4, with more than 57 million inbound tourists in 2011, there is certainly potential for air-related services to cater to the growing tourism market.  Yet how these domestic airports and airplanes are built, financed and maintained (public versus private) will have long-term consequences for the overall economy (as well as the local domiciles they are built in).

It is little wonder then that China produces and consumes more than half of all cement globally.  It is also the largest producer and consumer of steel.33 And while the domestic market is fragmented, subsidized and unsustainable at local levels, one of the areas where foreign firms can find new opportunities is developing and selling “cleantech” to cement manufacturers.34 For example, as part of the 12th Five Year plan 10% of these cement facilities are set to use “cleantech” with a goal of reducing waste and emissions.  As a consequence, Switzerland-based Holcim Group (one of the world’s largest cement producers) is beginning to sell its technology to mainland firms.  According to Ian Riley, the head of Holcim Group in China, “[i]f you think about all those things that the Chinese government wants companies to do that require good technology and good management, there are a lot of excellent opportunities indeed for companies such as ours.”35

Another example is Canadian-based Westport, a maker of heavy-duty truck engines that run on natural gas instead of diesel.  While there may be some IT security issues that all firms should be aware of (e.g., see trade secrets in Chapter 13), Westport’s Q2 2012 sales increased 206% year over year, leading its CEO to note that, “I don’t think you can do anything but conclude that it’s very, very encouraging, and China is going to be a fabulous opportunity for natural gas over the next few years.”36 And based on an estimate from China Merchants Securities, the “cleantech” market in China is expected to be worth $473 billion by 2015.37 Furthermore, state owned oil majors and policy makers hope to replicate the natural gas boom in the US onto the mainland by investing heavily into fracking technologies to diminish the use of coal (see Chapter 19 on ‘air pollution’).  Modern fracking is a method utilizing pressurized liquid to force and retrieve previously-hard-to-recover hydrocarbons (e.g. gas and oil) from rock and sand formations.  In fact, one estimate by geologists is “the nation’s recoverable reserves at about 25 trillion cubic meters, on par with the United States.”38 Thus both foreign and domestic firms specializing in the natural gas segment (e.g., extraction, storage, transportation) may find new revenue streams in an industry that is expected to pump “6.5 billion cubic meters of natural gas from underground shale formations by 2015.”

Ancillary services

In December 2012 I spoke William Song, a software engineer at TravelSky (中国航信).  TravelSky is a state-owned enterprise based in Beijing that manages a computer reservation system that handles all of the airline travel data and increasingly others such as hotel and railways (similar to Sabre and Amadeus in functionality); or in industry vernacular they develop a global distribution system (GDS).  According to him “we have a monopoly in the sense that we are the sole provider of information technology related to booking, reservations, pricing and ticket settlements on the mainland which we aggregate from airlines; we generate revenue every time an e-ticket is issued with partner airlines.   Consequently, consumers using domestic online travel agencies (OTAs) such as eLong and Ctrip (the equivalent of Priceline) and Qunar (similar to Kayak) indirectly utilize our system in booking their air travel.”  In 2011 TravelSky generated $589 million in revenue compared with Sabre and Amadeus who together generated more than $6 billion in revenue during the same period.39

The way GDS systems like TravelSky work is, “basically for each passenger that boards a flight, the airlines pay a ‘booking fee’ to our company (like a commission).  In return the airlines use our system to distribute flight information and ticket prices to travel agencies and airports that can use this information to provide services to passengers.  In other words, when you buy a ticket and use it, all of the flight logistics information systems behind it are managed by our company.  From a technical standpoint these databases are huge considering the size of the current industry in China and that it includes the data for all procedures of the whole journey.  Yet because we were originally a department of CAAC (Civil Aviation Administration of China) we still maintain close ties to the indigenously made software stacks.  Thus one of the challenges for both domestic and foreign companies that have experience making this kind of software is that in the short-run there will not be a second or third company like us, so there are not many opportunities for their expertise.  In fact, all of the SOEs which have monopolies over their respective industries such as rail, gas and telecom have other SOE companies like us to help them develop and restore the data.”  And this is where ancillary services and business models can be built for, such as fulfilling the needs of travel agency owners.

In March 2013 I spoke with David Tang the owner of a travel agency in Guangdong.  According to Tang, “one of the challenges created by TravelSky’s monopoly is that their interface is very dated – it uses a command-line style system reminiscent to DOS.  As a consequence, travel agencies around the country hire outside vendors to develop easier-to-use front end software packages that hook into TravelSky’s system.  My company has been around for more than five years and we have spent at least 100,000 RMB ($15,000) this past year to work with a vendor in Shenzhen to develop a customized interface.  Ctrip and other agencies have also built their own systems.  Thus one of the business opportunities is to provide the hundreds of travel agencies around the country with customized interfaces to work with TravelSky’s databases.  In addition, foreign GDS systems like Amadeus have begun to be used on the mainland as a way to book hotels and I predict that at some point the government will allow foreign competition to take place in the GDS field with airline bookings as well due to the fact that foreign technology is probably 10 years more advanced than the domestic GDS capabilities.”  Ctrip is publicly listed on NASDAQ and is the largest OTA in China, with 36 million hotel bookings and 30 million flight tickets handled through their system annually.40

While Tang’s last point is speculation, William Song suggested one future business opportunity may come from opening this up as well.  Song noted that, “I think that OTA aggregation services which are easy to use and can eventually utilize our data can make a small fortune.  For example, apps for smartphones which can aggregate destination times and prices no matter where you are.  Both incumbent and start-up travel agencies will be able to use AI robots (or ‘spiders,’ a program that can collect data) to recalculate information and provide services and metrics to the end customers.  For example Qunar is one such domestic start-up, whose founding team came from Kayak.  Even though the real time flight information is stored in our database, direct access to this is usually unneeded today because we continuously distribute the flight information directly to airlines and OTA’s who in the future can be scanned by the AI robots for use by other services such as smartphone apps.  Or in other words, eventually 3rd parties can use robots to crawl through our databases or our partners’ databases to collect information.  Thus there are opportunities for new competitors in this segment.”

Rails and a paddle

As I mentioned in Chapter 9, when I first arrived on the mainland four years ago, I spent time sight-seeing in Shanghai before moving to Bengbu.  And as I mentioned in Chapter 4, my initial encounter with proficient English speakers colored my view of the populace (e.g., selection bias, see Chapter 9 about EFL).  Similarly, the trip to Bengbu itself skewed my view on economic developments on the mainland because the trip was done on a new high-speed train traveling at 300 kilometers/hour.  It took approximately 3 hours, a journey that just 10 years ago would have taken half a day on older rolling stock.  At the time I wondered if other travelers on the mainland had similar access.  The short answer is yes, the longer answer however dovetails into mian zi gong cheng and opportunities therein.

Two years ago a broker friend at Morgan Stanley similarly asked me what my perception of the high-speed rail network was, “Have you ever been on one?  Are they packed and profitable?”

Like many public projects, the high-speed railway system (CRH) began with objectively good intentions: build a state-of-the art transportation network capable of connecting and bringing commerce to all corners of the mainland.  Yet as Ludwig von Mises showed, such centrally managed plans cannot efficiently achieve the stated goals.41 Similarly, the Railway Ministry is now massively indebted in part because in its push to build a 20,000 kilometer nationwide high-speed rail network, subpar materials were used in certain sections and billions have been siphoned from the budgets via corruption.

As I mentioned in Chapter 10, in their bid to build rolling stock for the CRH project a Japanese consortium of locomotive and rolling stock designers (the same ones that built the Shinkansen) were edged out of the mainland market by the very technology they had designed and transferred to CSR, a domestic SOE that now builds half of the rolling stock.42 While it might be assumed that with this “free technology lunch” that the CRH project now gained would have resulted in fewer long-term costs, the reality is that building a rail network – as in any country – requires significant capital expenses for land, labor, tracks, ties, signal boxes and electrical conduits.  Similarly, because the state effectively still owns all land (e.g., private individuals can lease land from the state for 50-70 years, after which time it reverts back to the state), it might be assumed that property costs would reduce the bottom line.  Yet again, the assumption is incorrect.

In February 2011, Liu Zhijun, the railway minister was fired amidst a probe that alleged a variety of bribery and kickback charges.43 Upon investigation, one case mentioned by the National Audit Office noted $28 million that “was misappropriated by individuals or companies involved in building the Beijing-Shanghai high-speed railway.”44 And as Evan Osnos, a reporter for The New Yorker, recently described this was not an isolated case.  For example, another account from the National Audit Office found on the accounting books of a SOE a “sixteen-million-dollar “commission” to an intermediary in return for contracts on the high-speed rail.”45

This was only the tip of the iceberg as Osnos’s research found that this public-works project eventually encompassed payouts and bribes that are still being uncovered; amounts that dwarf those listed above:

Like many others, Ding knew something that government auditors uncovered only later: China’s most famous public-works project [the Railway] was an ecosystem almost perfectly hospitable to corruption—opaque, unsupervised, and overflowing with cash, especially after the government announced a stimulus to mitigate the effects of the 2008 global financial crisis. It boosted funding for railway projects to more than a hundred billion dollars in 2010. In some cases, the bidding period was truncated from five days to thirteen hours. In others, the bids were mere theatre, because construction had already begun. Cash was known to vanish: in one instance, seventy-eight million dollars that had been set aside to compensate people whose homes had been demolished to make way for railroad tracks disappeared. Middlemen expected cuts of between one and six per cent. “If a project is four and a half billion, the middleman is taking home two hundred million,” Wang said. “And, of course, nobody says a word.”

While the investigations are still ongoing, by one account former Railway minister Liu had taken a “4% kickback on railway deals,” another estimate suggests he netted $152 million.46 Zhang Shuguang, former deputy general engineer of the Railway ministry reportedly embezzled $2.8 billion into US and Swiss banks.4748 All told the Railway Ministry is in debt by at least $330 billion and posted a loss of $1.4 billion in the first half of 2012.4950515253

How did it get to be this size?  The Rail Ministry in China was essentially an autonomous entity – with its own schools, hospitals and until recently even its own judicial system – that only had to answer to itself.54 And as a consequence and as part of a major revamp implemented by the new Xi administration, the Rail Ministry is now being split up, with the Ministry of Transport taking over the railway construction and network planning.55 The operational units of the Rail Ministry will be spun off and separated into a new state-owned enterprise managed by the State-owned Assets Supervision and Admission Commission (SASAC).

This is not to say that corruption, bribery and kickbacks do not occur in other countries, nor am I suggesting that this scandal will doom the Chinese growth story or that the high-speed railway network will never be completed.  Rather, I am citing this to be even handed, to show that just because planners come up with “big hairy audacious goals” this does not automatically translate into instant successes.5657

In fact, Mark DeWeaver’s book cites dozens of such stories including several others like the Loudi “White House” and a half dozen amusement parks built by local governments which gone bankrupt.58 Many Olympic venues alone from the 2008 Beijing Summer games have gone into disuse and several have been demolished.5960

Despite $141 billion in investments and another $134 billion approved for future expansions, none of the nearly two dozen subway metro systems on the mainland is profitable.61 This is not to say that these subway systems do not generate substantial revenue.  Rather they do not generate enough revenue to cover their expenses (i.e., they are operating at a loss).  And because some projects may not provide enough return on investment to maintain the capital stock some party or multiple parties are subsidizing these activities.  For example, only one of Shanghai’s lines is profitable.  Beijing’s metro will post a loss of about $150 million in 2012.  And Shenzhen’s metro charges an average of 2.8 yuan per trip yet the actual costs are 5.9 yuan per trip.62 According to The Atlantic one of the reasons it is costly is that “[a]t 500 million yuan per kilometer, or about $80 million, their pricetags are not that much cheaper than they are in Seoul, where wages are much higher.”63

Similarly last year the Los Angeles Times detailed a number of other face projects built by local governments, that while creative and innovative – such as a $44 million hotel designed to look like a ping pong paddle – ultimately produce little in terms of sustainable economic activity.64 The one silver-lining for foreigners is that the demand for Western educated architects can be high in certain provinces, especially for those willing to work on mian zi gong cheng.6566 In fact, according to industrial designer Michael Young, “China will produce as many world-class designers as Japan within 20 years.”67 Notable examples include Wang Shu, who won the 2012 Pritzker Prize, the world’s top prize in architecture.  Thus foreign architects may find new opportunities in training and working with domestic firms on a variety of projects over the coming decades.

Structuring debt

In an era of a closed capital account and relatively cheap public capital (as discussed in Chapter 5 and Chapter 10), both of which incentivize capital consumption and fixed asset investment, these types of cases will probably continue into the foreseeable future.68 All told these projects and other local government financing vehicles (LGFVs) that received stimulus funds since 2009 account for approximately $5.4 trillion in loans.697071 Despite the ban on municipal bonds (see Chapter 10), these LGFVs issue bonds called chengtou which are traded in secondary markets.  Andin 2012, 942 billion RMB ($150 billion) of chengtou bonds were issued by these LGFVs.72 Thus experts in debt restructuring may be able to do consulting for local banks when publicly traded bond markets become a reality.  And one advantage of having a publicly accessible bond market is as Shawn Mesaros mentioned to me, “domestic banks could then become facilitators.  They could offload debt and focus on value added services, creating new investment vehicles which allow for diversification.”  Another advantage is that a bond market would allow for liquidating non-performing loans and spread and distribute risk away from “too big to fail” financial institutions.

And as mentioned in Chapter 5, foreign experts in debt structuring may find new opportunities on the mainland due to this ongoing business cycle.  For instance, foreign firms specializing in managing distressed loans such as those used to finance the construction of tech parks, have already capitalized on opportunities on the mainland (with mixed results), including Shoreline Capital Management who raised $300 million for a new fund last year specifically to invest in distressed Chinese debt.73

Another opportunity, although probably out of the reach of most SMEs and entrepreneurs is what Siemens has provided to several mainland subway systems: propulsion systems.  Under several different agreements, Siemens has sold equipment packages that include gearboxes, auxiliary converter units, traction motors, traction converters and train control systems.74 In fact, as of 2010 Siemens maintained 90 operating companies and 61 regional offices in China alone across all of its divisions (including healthcare and energy).75 It has 30,000 employees on the mainland, generated $8.4 billion in revenue from China in 2012 and “nearly 90% of its raw materials and semi-manufactured goods are purchased from the Chinese local market.”76 This is part of an effort to develop and install their mobility technology which is used and deployed in nearly a dozen mainland metros and railways.  Thus irrespective of the long-term financial sustainability of metro expansion plans, there may still be opportunities in the short-term for foreign component manufacturers in this sector.

Yet a word of warning.  During California’s requests for bids in 2011 for a proposed high-speed rail project (HSR), Chinese firms offered to help build it.  However the technology that Chinese firms were planning to build the HSR infrastructure (cars, signals, gearboxes) are all based on technology transfers from Siemens, Kawasaki and Bombardier.77 Thus the foreign firms found themselves competing with their very own technology as China now tries to build HSRs in other countries.  This turn of events resulted in a series of press releases and some protests, yet subsequently both Siemens and Bombardier continue to transfer technology and sell equipment to Chinese firms.78 Be sure to speak with an attorney (see Chapter 10) before transferring any technology.79

Takeaway:  There are some opportunities for foreign firms and individuals that want to participate in the airline and aerospace industry as well as a number of opportunities for foreign architects.  However, while it is impossible to predict what the exact opportunities forgone in the construction of these face projects are, we do know that ceteris parebus, that there are other productive choices that market forces would have gravitated towards instead (e.g., allowing capital to accumulate instead of being consumed).  And as a consequence, the countless face projects dotting the mainland arguably act little more than a weight, a drag on overall growth.  What other productive uses could both the skilled and unskilled laborers that built these uneconomic airports, railways, amusement parks and stadiums been used in instead?  The answer to that is left to the imagination of the reader.


  1. While city limits and boundaries are arbitrary and different in every country, according to their 2010 estimate the 9 cities are: New York, Los Angeles, Chicago, Houston, Philadelphia, Phoenix, San Antonio, San Diego and Dallas.  See Annual Estimates of the Resident Population for Incorporated Places from the US Census Bureau []
  2. China’s urban population to hit 800 million by 2020 from People’s Daily []
  3. China’s Megacities from Bloomberg []
  4. One of the upcoming challenges that policy makers face with this urbanization is reforming the Hukou, or household registration system.  See Eight Questions: Tom Miller, ‘China’s Urban Billion’ from The Wall Street Journal []
  5. This is not to say that these properties will lay dormant, especially as the middle class grows and rural migrants continue to move to Tier 1 cities.  See Who Says China is Building Too Much? from The Wall Street Journal Building the American Dream in China from The New York Times []
  6. Some of these property developments lay vacant.  For example, the Kangbashi New Area in Ordos, Inner Mongolia, is a master planned city designed for over 300,000 people yet is home to only a fraction of that.  Thus becoming a modern example of a Potemkin village.  Another purportedly similar Potemkin-esque village is the One City, Nine Towns residential project that had a goal of attracting 500,000 affluent residents.  One such town was Thames Town (泰晤士小鎮) which is a replica city modeled after classic English buildings along the Thames river that has failed to attract residents and is relatively deserted.  Another example is Xinagluowan Business District in Tianjin.  Again, this is not to say that this will lead to any kind of macro-level collapse, but rather serves as illustrations to temper bullish expectations and intentions.   See China’s ubiquitous ghost cities from Financial Times, Ordos: The biggest ghost town in China from BBC, Chinese City Has Many Buildings, but Few People from The New York Times, Where is Everyone from Daily Mail, Ordos, China: A Modern Ghost Town from TIME, Ordos Bust Creates Mecca for Used Luxury Car Buyers from The Economic Observer, China’s Ghost Towns Won’t Have a Hard Landing from Bloomberg and One city; nine towns; no people from Global Times, Inside the McMaoMansion: How China copies the west from Shanghaiist, One City, Nine Ghost Towns from Pop-Up City, 天津滨海新区响螺湾众多房企项目烂尾、封盘 from Caijin and China’s ghost towns and phantom malls from BBC []
  7. See China builds one skyscraper every five days from Want China Times and China Skyline Getting Bigger, More Skyscrapers Than USA from Forbes []
  8. Many of the migrant workers and less affluent (such as students) are part of a demographic group called yizu or ant tribe (蚁族).  These consumers typically live in residential apartments that have been reapportioned to accommodate many multiples of what the buildings were typically designed for (e.g., 10 people inside 3 rooms).  The wear and tear and lack of maintenance may consume more capital than is generated to repay the loan used to finance its original construction (e.g., non-performing loan).  See China’s Graduates: An Ant’s Life from The Wall Street Journal, Ant tribes and mortgage slaves from The Economist and What Worker Shortage? The Real Story of China’s Migrants from The Wall Street Journal []
  9. One alternative scenario regarding the Dam is that a number of smaller ones could have been built upstream instead.  Other issues involve the displacement of villagers and the actual financial cost which by one estimate is twice the official number.  See China Admits Problems With Three Gorges Dam from The New York Times []
  10. Selected Essays on Political Economy by Frédéric Bastiat []
  11. The funeral industry may have been bustling with a glut of customers during the Black Death, but ultimately provided little in the way of long-term capital accumulation or production.  Or in other words, if dying was an engine of growth then the world wars, the mass democides and genocides of the 20th century should have created an economic boom (e.g., “bomb our way to prosperity”). []
  12. Khufu’s Great Pyramid alone consists of roughly 2.3 million limestone blocks that were quarried 500 miles up the Nile at Aswan.  Thus if this project itself had not been undertaken – ignoring the resources consumed by the construction and final assembly crews – the thousands of quarry workers alone that had to be fed and sheltered could have worked on other productive projects such as building towns and villages, constructing buildings for blacksmiths and millers, or even just farming additional crops.  While it is impossible to say what additional crops and farm labor would have added to the overall economy, we do know ceteris paribus that by removing healthy productive workers from economic-surplus generating activities, other knock-on activities that could only take place with a surplus of crops (like research and development which require some laborers to forgo toiling in the fields) will likely be delayed, stunting technological change, innovation and growth.  This is in addition to the 8,000 tons of granite and 500,000 tons of mortar plus the agriculture and lodging that was required to feed and shelter the tens of thousands of workers at both the quarry and construction sites.  The alternative opportunities foregone by diverting and redirecting scarce labor and resources towards these unproductive assets is left to the imagination of the reader.  See Explore Ancient Egypt from PBS and The Great Pyramid by John Romer []
  13. What is up with the GDP? by Frank Shostak []
  14. While dual and even triple track accounting and statistical book keeping probably does occur in other countries, it is important to distinguish and recognize that economic activity is not the same thing as long-term economic productivity or growth.  Otherwise ‘white elephant’ projects would be a boon and not a bust.  See Local Exaggeration in GDP: 5.8Trl Higher than Central Data from Caijing []
  15. This is in reference to the French phrase, “Qu’ils mangent de la brioche” (Let them eat cake) which was purportedly said by Queen Marie Antoinette upon hearing hoi polloi faced a shortage of bread.  While she probably never said that exact phrase, the historical context is germane as the 18th century French Royal family was able to continually live an opulent lifestyle at the Palace of Versailles due to wealth confiscation of the peasantry.  During the purported time frame, because of a famine there was no bread to eat, which was a major staple.  Thus telling the peasantry to eat desserts and cake showed how disconnected she was with the plight of the populace.  Similarly, despite the vast quantities of agriculture needed to support the Pyramid workforces, the lavish lifestyle of the Pharaohs – the sheer opulence of their mausoleums (originally covered in gold and marble which were later looted) – is another display of Royal despotism that is wholly disconnected with reality.  This is also a tangential twist to eating “confidence.”  During the height of the 2008 financial crisis one of the ideas for kick-starting consumer consumption was by “instilling confidence into consumers.”  Yet no matter how much ‘jawboning’ takes place, you cannot eat confidence. []
  16. Animal Spirits with Chinese Characteristics by Mark DeWeaver []
  17. China’s airport overkill from Financial Times []
  18. More than 70% of Chinese airports lost money in 2011 from Want China Times []
  19. China Airport Boom: Will There Be a Bust? from TIME []
  20. 82 new airports to be built from GlobalTimes []
  21. See China Plan Seeks to Bolster Airports, Locally-Produced Airplanes from Bloomberg and 我国5年投资4200亿建设支线机场 或大面积亏损 from Sina []
  22. Air rage: Chinese screaming mad over delays and Reuters []
  23. China Tea Leaf Index: Look to the skies from Retuers []
  24. Airlines fly into headwinds from high-speed trains from South China Morning Post []
  25. See Performance-Based Navigation Implementation Roadmap from Civil Aviation Administration of China and Surveillance accuracy analysis of ADS-B supporting the separation service in western China from IEEE []
  26. See China nears approval of $16 billion domestic jet-engine plan from Reuters and Unable to copy it, China tries building own jet engine from Reuters []
  27. China sells jets, dabbles in Eastern Air revival from Reuters []
  28. Chinese aerospace firms have made progress in other areas including military jetcraft such as the new Y-20 strategic transport aircraft that recently made its maiden flight in January 2013.  See The Y-20: China Aviation Milestone Means New Power Projection from The Wall Street Journal []
  29. Boeing Raises China 20-Year Plane Demand Forecast 5.2% from BusinessWeek []
  30. See Chinese airlines seek elite foreign pilots from China Daily and Skies too friendly for foreign pilots, key document says from China Daily Asia Pacific []
  31. Sky’s the limit for booming general aviation sector from China Daily []
  32. US Civil Airmen Statistics from the Federal Aviation Administration []
  33. China says top 10 steel mills to control 60 percent of capacity by 2015 from Reuters []
  34. The domestic steel industry – despite subsidies – has collectively been operating at loses due to slow demand and as a consequence many participants have been unable to pay back loans.  See Loans to Steel Traders in China Pose Risk from The Wall Street Journal, China’s steel industry in trouble: association from Xinhua, Steel demand to slow over next two years from Financial Times, Central Gov’t Reshuffles a Bad Deck at Steel Services Firm from Caixin, China faces steel-production paradox from MarketWatch, Baosteel’s sell down could signal start of rethink by state-owned enterprises from South China Morning Post, China’s steel makers set for two more years of poor profits from South China Morning Post, Steel producers prepare for difficult months ahead as property sector slows from China Daily and Deal Journal China stimulus won’t work this time, says Citigroup analyst from The Wall Street Journal []
  35. Cementing a strong business in China from China Daily []
  36. Behind China’s Green Wall: Special Report from The Tyee []
  37. See 2015年环保产业总值或超3万亿元 成市场新动力 from Sohu and Environmental protection industry to reach 3 trillion RMB by 2015 from China Green News []
  38. Despite the aggressive timeline for hydrocarbon extraction, another hurdle is a lack of experience.  None of the 16 firms awarded drilling rights at a recent auction has ever drilled a hole.  See China’s ragtag shale army a long way from revolution from Reuters, Environmental Frets as Frackers Move In from Caixin and China’s “Ultimate Goal Is a Huge Fracking Industry” from Mother Jones []
  39. TravelSky Announces 2011 Annual Results from Strategic Financial Releations []
  40. Ctrip []
  41. Without an organic price mechanism that arises via market participants (e.g., interaction between entrepreneurs, investors and consumers) central planners – lacking this mechanism – must arbitrarily pick coefficients for their models and equations.  In other words, they cannot rationally calculate away from net losses and towards profitable (and efficient) solutions.  Thus a priori their plans lead to inefficiencies and disarray.  See Economic Calculation In The Socialist Commonwealth by Ludwig von Mises []
  42. Japan Inc shoots itself in foot on bullet train from Financial Times []
  43. China’s Railway Minister Removed from Position from Caixin []
  44. Former rail minister expelled from Party from China Daily []
  45. Boss Rail by Evan Osnos []
  46. China’s New Wealth Spurs a Market for Mistresses from The New York Times []
  47. Chinese rail crash scandal: ‘official steals $2.8 billion’ from The Telegraph []
  48. These were not isolated incidents as Luo Jinbao, former chairman of China Railways Container Transport also received a variety of bribes.  See State firms paid half the bribes rail executive Luo Jinbao received from South China Morning Post []
  49. See China’s Ministry of Railways debt: Three ways out of the mess from Institute for New Economic Thinking and Local Gov’ts Angle for Slice of Rail Projects from Caixin []
  50. China’s Railway Ministry Posts $1.4 Billion Loss from The Wall Street Journal []
  51. According to a November 2012 report from the Global Times, the NDRC recently approved an additional $7.87 billion of new railway projects.  This is on top of the $110 billion for 25 other rail projects.  The Railway Ministry spent 506.9 billion yuan ($81 billion) in the first 11 months of 2012.   And according to another November 2012 news story, the Railway Ministry is planning to spend 612 billion yuan ($82.6 billion) on capital expenditures related to the railway system this coming year.  However in January 2013 it was announced that $104 billion would in fact be spent on railroad construction.  See China approves $7.87 billion in railway projects to jumpstart economy from Global Times, Ministry Spends More than 500 Bln Yuan on Railway Fixed-asset Investment from Caixin, 铁路基建投资又迎新高潮 明年将超5160亿 from Jin Ji Can Kao Wang, Railway Investment to Increase Next Year, Ministry Says from Caixin and Funding set for renewed railway boom on horizon 2013 from Global Times []
  52. According to an estimate from a Citigroup analyst, the Railway Ministry will buy 300 to 400 train sets within the next two months financed by $6.2 billion in ‘tenders.’  See China May Make First High-Speed Train Orders Since Crash from Bloomberg []
  53. In November 2012 another $12 billion has been approved for railway projects.  And in December 2012 it was announced that 500 billion yuan ($69.9 billion) “will go into infrastructure investment next year [2013].”  See NDRC approves 75b yuan rail projects from China Daily and Ministry Spends More than 500 Bln Yuan on Railway Fixed-asset Investment from Caixin []
  54. See Railway ministry loses powers from Global Times, China Takes a Slow Train to Railway Reform from Caixin and 全国铁路法院全部改制移交地方 from the Supreme People’s Court of the People’s Republic of China []
  55. See China to dismantle bloated rail ministry from Reuters and China’s Leaders Plan Government Revamp as Xi Set to Take Reins from Bloomberg []
  56. ‘Big Hairy Audacious Goals’ is a term that comes from a popular business management book called “Built to Last” by James Collins and Jerry Porras. []
  57. Inside China’s High-Speed Rail Triumph from The Daily Beast []
  58. China Cities Value Land at Winnetka Prices With Bonds Seen Toxic from Bloomberg []
  59. As a matter of fact, hosting the Olympics typically leads to an unsustainable boom of unnecessary construction nearly every place they are held – in fact few Olympiads have ever turned a profit.  For example, the multi-million Wukesong baseball stadium was demolished and turned into a shopping mall.  See Beijing’s Olympic building boom becomes a bust from Los Angeles Times []
  60. Another argument has been made that Olympiads act as unsustainable booms, creating unproductive assets that in the long run creates economic dead weight.  For example, the 2004 Athens Olympics is considered in retrospect as having spurred part of the debt problem that contemporary Greeks currently face.  See Did the 2004 Athens Olympics contribute to the Greece financial meltdown? from Examiner and The Stadium Gambit and Local Economic Development by Dennis Coates and Brad R. Humphreys []
  61. For Subway Projects, a Costly Ticket to Ride from Caixin []
  62. This is not a phenomenon found only on the mainland as very few subways are profitable in other countries.  The Hong Kong MTR and Japanese counterparts are a few notable exceptions.  See Why Subways Suffer Losses from The Economic Observer and Japanese Private Railway Companies and Their Business Diversification from Japan Railway & Transport Review []
  63. Why China’s Subway Boom Went Bust from The Atlantic []
  64. Amid poverty, Chinese officials splurge on lavish vanity projects from Los Angeles Times []
  65. See Building the American Dream in China from The New York Times and Copycat Architects in China Take Aim at the Stars from Spiegel []
  66. Recreating iconic landmaks and villas probably will not stop anytime soon thus there are continual opportunities for Western architects to literally bring the West to the East.  See Eight Questions: Bianca Bosker on China’s ‘Original Copies’ in Architecture from The Wall Street Journal []
  67. “China is a dream scenario for a designer” – Michael Young from de zeen []
  68. Another illustration of the irrational exuberance of “face projects” that dot the mainland is the 328-meter New Village Building in Huaxi.  At the top of the £300 million skyscraper is a one ton 24k gold bull.  What are the alternative opportunities foregone in consuming resources towards this project?  What are alternative industrial uses for $54.4 million of gold (at 2012 prices)?  See China’s richest village opens its own skyscraper from The Telegraph []
  69. According to Shang Fulin, chairman of the China Banking Regulatory Commission, as of September 2012 the local government debt collectively amounted to $1.48 trillion.  See High local debt levels coming under control from China Daily.  Other higher estimates can be found in China tells banks to roll over local govt loans: report from Reuters and Are Chinese Banks Hiding “The Mother of All Debt Bombs”? from The Diplomat []
  70. Other investment vehicles also include wealth management products (WMPs) such as trust companies which are a type of wealth management service that amounts to more than $1 trillion and is considered to be part of a “shadow” banking system (e.g. off-balance sheet transactions).  According to Xiao Gang, chairman of Bank of China, there are 20,000 WMPs in circulation currently.  See Examining China’s ‘Shadow Stimulus’ from The Wall Street Journal, In China, Hidden Risk of ‘Shadow Finance’ from The Wall Street Journal, Regulating shadow banking from China Daily, Uncertain foundations from Financial Times, China to tighten shadow banking rules  from Financial Times, China’s brokerages turn shadow banks from Financial Times and Don’t Worry About Wealth-Management Products, Regulator Says from The Wall Street Journal []
  71. Impending Bad Debt Headache Likely Bigger Than Expected from The Wall Street Journal []
  72. China’s booming fake muni bonds from Financial Times []
  73. Back in Fashion: China’s Bad Debt from The Wall Street Journal []
  74. Siemens to support the development of mass transit in China from Siemens []
  75. Siemens to supply signaling for new metro lines in Suzhou, Qingdao and Chongqing from Siemens []
  76. Siemens Reported Revenue Of EUR6.35 Billion In China In 2012 from China Tech News []
  77. See Train Makers Rail Against China’s High-Speed Designs from The Wall Street Journal and A Problem with California Plans to Tap Chinese Tech from The Wall Street Journal []
  78. See Siemens transfers low-floor tram technology to Chinese manufacturer from Xinhua and Bombardier to share railway technology with Chinese from The Globe and Mail []
  79. See China Technology Licensing. Sometimes It Makes Perfect Sense. by Dan Harris and China’s Awkward Quest for Bullet Train Technology from Knowledge@Wharton []
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