Market Edge Market Summary
Soothing comments from Fed Chairman Bernanke concerning inflation worries fueled stocks last week as several of the major indexes posted record highs. The DJIA, which had been languishing in the 12500 - 12600 area for over a month perked up on Tuesday gaining 102 points. It added another 87 on Wednesday to close above 12700 for the first time in history (DJIA 12741.86). Thursday saw some minor follow through as did Friday despite a lousy housing start report which showed that new home construction had plunged to a ten year low. For the period, the DJIA gained 185 points (+1.4%) closing at 12767. The NASDAQ, which had been down for three of the last four weeks, found some footing as it made a run at 2500, a level not seen since 01/12/07 (NASDAQ – 2502.82). For the period the NASDAQ gained 36 points (+1.4%) and closed at 2496.

Navarro’s Big Economic Picture
So back I went to D.C. last week in the middle of a snow storm and a nightmarish Jet Blue flight home that stretched almost 24 hours. Still, it was worth it. The hearing I testified at was before the House Ways and Means Trade Subcommittee, and my fellow witnesses were very interesting to listen to. Lots of “war stories” from the front line of Chinese mercantilism – and the devastation it is causing in American industry. In addition, Congressman Sandy Levin (D-MI) looks serious about introducing a series of bills that may finally begin to fight back against China’s ubiquitous unfair trade practices.

My value-added in the hearing was to provide a comprehensive accounting of the various sources of China’s competitive advantage and to illustrate how much of this advantage is linked to direct, indirect, or hidden subsidies.

The full testimony is tacked on to the end of the newsletter after the ETF hightlights as I don’t want to step on Andrew Vaino’s fine column this week. You can read the testimony of the other participants at http://waysandmeans.house.gov/hearings.asp?formmode=detail&hearing=525 I particularly recommend that of Goodish, Vargo, Bassett, and Tyrone.

This Week’s Big Market Movers
The CPI and FOMC minutes promise to be the highlight of an otherwise light week on the macro calendar. With the CPI, it’s always about any nasty upside surprise.

Vaino’s Biotech Corner: Biosante!
An insightful reader emailed me (which I highly encourage!) last fall suggesting I look further into Biosante (BPA), a small company devoted to improving drug delivery. This is an excellent example of a missed opportunity by me, as the stock is up more than 50% since then.

Biosante is a tiny (according to their most recent 10-K they have fourteen employees) company working on transdermal delivery of hormones. In December of last year, they received FDA approval to market Elestrin, an estradiol gel designed to be rapidly absorbed through the skin. It is meant to be applied daily to the arms, shoulders, abdomen, or thighs. A gel or cream is less invasive than a patch that needs to be worn continuously.

In a Phase 3 study Elestrin demonstrated significant decreases in incidence and severity of hot flashes in menopausal women, but at a substantially lower dosing level of estradiol. Lower estradiol levels can decrease undesired side-effects in hormone replacement therapy. Elestrin will be marketed by Bradley Pharmaceuticals (BDY). A launch is expected in mid-2007. Bradley Pharmaceuticals has experience selling specialty pharmaceuticals, so this is a good way to market their product.

In addition, Biosante recently announced they had begun a Phase 3 clinical trial of a similar product, to deliver testosterone, to treat female sexual dysfunction (FSD). There is precedent in the scientific literature that administering testosterone indeed treats FSD. They also announced positive preclinical results on delivery of a vaccine to prevent bird flu. While both these products have potential (I’m not overly impressed by preclinical data), I think the main value-driver of this company is Elestrin.

As an aside, there are 493 literature references to clinical trials for FSD on “Pub Med” (a website that searches the medical literature) compared to 1,121 for erectile dysfunction in men.

In an article in “The Motley Fool”, Brian Lawler questioned just how much of the estrogen market Elestrin will actually capture. This is a critical issue. Novavax (NVAX) sells Estrasorb, also a transdermal estradiol delivery system, and has not gained any real traction in the market.

Novavax published data from a Phase 3 study in the journal Menopause. The lowest daily dose of Estrasorb was 8.6 milligrams of estradiol. By contrast, according to Phase 3 clinical data, dosing of Elestrin was found to be effective between 12.5 and 64 micrograms. For readers less conversant in the metric system, there are 1000 micrograms in a milligram. That is, the amount of estradiol dosed with Elestrin is a tiny fraction of that dosed in Estrasorb. Given there are known health risks associated with estradiol, the ability to give a significantly lower dose, I believe, makes for a superior product that should gain market share.

Current U.S. estrogen therapy sales are estimated at $1.3B annually. Transdermal delivery accounts for about $250M, so it’s definitely a big potential market. According to the US Census Bureau, total US population should still hit almost 400M by 2050, and, the median age of that population will be older. As estrogen therapies are targeted at 50+ women (also according to the US Census there are more 50+ women than men) the potential market is increasing.

Now, Biosante’s balance sheet is troublesome. As part of their deal with Bradley there are to receive $10M within the year. In addition, terms of the deal call for milestone payments and royalties. Triggers for sale-base milestones, which can reach $30M, have not been disclosed.

While I would prefer more transparency in Biosante’s deal with Bradley, I do think they have a good product in a growing market. As always, proof will be in the execution and this certainly is not risk-free. This is a nanocap stock with a small (<20M shares) float and will be subject to volatility. While numbers like $1.3B are pie-in-the-sky, this is a small company. Even capturing 5-10% of the estrogen replacement market will send the stock skyrocketing. (Be careful on the entry, however. The stock is showing some signs of a retracement.)

Testimony of Business Professor Peter Navarro before the House Ways and Means Trade Subcommittee, February 15, 2007
Mr. Chairman and members of the Subcommittee. My name is Peter Navarro, and I want to thank the members and staff of this subcommittee for the opportunity to testify today on the crucial issue of U.S.-China trade relations – specifically the role of a complex web of mercantilist export subsidies in providing China with an unfair competitive advantage over U.S. manufacturers.

As a biographical note, I am a business professor at the University of California-Irvine and hold a PhD in economics from Harvard University. My research has appeared in academic journals ranging from the Journal of Economic Perspectives, the Journal of Business, and the Rand Journal to the Harvard Business Review and China Perspectives. I am also the author of a number of books on economics and public policy, including The Coming China Wars: Where They Will Be Fought, How They Can Be Won (Financial Times, 2006).

My value-added in this proceeding will be to provide members with a conceptual framework with which to understand the broad scope of Chinese mercantilist practices as well as to provide a more expansive definition of what constitutes an unfair “mercantilist export subsidy.”

In this testimony, I will identify the eight major drivers of the so-called “China Price,” which is a short hand term for Chinese competitive advantage in world markets. Most importantly, I will illustrate how fully 7 of these 8 China Price drivers are, in turn, driven by a complex web of direct, indirect, and hidden mercantilist export subsidies.

I shall conclude this testimony by urging Congressional policymakers not to compartmentalize the various factors contributing to China’s unfair trade practices nor deal with them in piecemeal policy fashion. Instead, I urge Congressional leaders to address Chinese mercantilism in a comprehensive and integrated fashion that hits all mercantilist points of the China Price compass. The framework offered in this testimony may be helpful in the policy architecture and design.

China’s Clear and Present Danger to America
By practicing a highly evolved form of 18th century “beggar thy neighbor” mercantilism, China is emerging as a 21st century economic superpower. While consumers around the world have benefited from the flood of cheap goods, China’s broad portfolio of unfair trade practices has resulted in the loss of millions of jobs in countries ranging from the United States and Mexico to Brazil and Lesotho. Chinese mercantilism is also depressing wage and income levels worldwide while China’s exploitation of lax environmental and health and safety standards as competitive drivers is killing millions of Chinese workers and citizens and generating significant regional and global pollution.

To understand both the breadth and depth of Chinese mercantilism and its far ranging effects, it is essential to first understand the mercantilist roots of the so-called “China Price” and the complex web of direct, indirect, and hidden export subsidies that have so sharply honed China’s global competitive advantage. The China Price refers to the ability of Chinese manufacturers to undercut global competitors by as much as 50% or more over a wide range of manufactured goods. Today, as a result of this powerful “weapon of mass production,” China has emerged as the world’s blue collar “factory floor.”

The rapidity with which China has captured a wide range of markets is breathtaking: Already, China controls over 70% of the world’s market share for DVDs and toys, more than half of the share for bikes, cameras, shoes, and telephones; and more than a third for air conditioners, color TVs, computer monitors, luggage, and microwave ovens. It has established dominant market positions in everything from furniture, refrigerators and washing machines to jeans and underwear (yes, boxers and briefs). As it moves inexorably up the value chain, China is now even making rapid inroads into the global auto market.

In wielding the China Price to capture these markets, China has all but gutted many segments of blue collar manufacturing in countries around the world. In this regard, it’s one thing for America to lose much of its blue collar manufacturing base to China. If the U.S. loses its white collar science and technology base too, it will be Americans living the peasant life rather than the Chinese.

Alarmingly, under the catalyst of Chinese mercantilism, the shift of America’s white collar science base has already begun. For example, the American biotech and pharmaceutical industries are already well on their way to offshoring much of their research and development and production to China. Indeed, today, there are more than 300 biotech companies in China, and nearly every major pharmaceutical company has built, or is building, a research center in China.

An Expanded Definition of "Export Subsidy"
Given current trends, it is crucial that U.S. policy makers cultivate a much more sophisticated understanding of the phenomenon of the China Price – as well as its mercantilist foundation and roots. In cultivating this understanding, it is equally essential for U.S. policymakers to use a broad definition of what truly constitutes an unfair “mercantilist export subsidy.” The clear danger of using an overly narrow definition is that policymakers will compartmentalize various aspects of Chinese mercantilism, e.g., currency manipulation, IP protection, and then attempt to deal with these issues legislatively in a piecemeal fashion.

In this regard, while there are various legal and technical definitions for what constitutes an illegal or prohibited export subsidy in forums like the GATT and the WTO, the most useful economic definition for policymaking purposes is an expansive definition of a mercantilist export subsidy that includes any direct or indirect government action or inaction that unfairly stimulates export activity at the expense of trading partners.

For example, a direct government action would be the use of tax rebates for exporters while an indirect action would be currency manipulation, which is designed to undervalue a country’s exchange rate and thereby gain competitive advantage. More subtly, a government inaction would be the sanctioning of counterfeiting and piracy despite laws established to prevent such practices. Each of these direct and indirect government actions and inactions may be thought of most broadly as “mercantilist export subsidies” because their intent is to encourage the country’s export trade in ways which are clearly outside the bounds of free and fair trade.

The table on the next page provides an overview of the eight major drivers of the China Price and the various direct, indirect, or hidden mercantilist export subsidies used by China to capture markets in world trade. This table is based on a research project I conducted with a large team of MBA students over a year long period at the University of California-Irvine (Download The Report of the China Price Project at www.peternavarro.com ). The purpose of that project was to answer these two questions: What are the major sources of Chinese competitive advantage in world markets and to what extent is Chinese competitiveness driven by fair versus unfair trading practices.

Column One of the table on the next page identifies the various “Pure Mercantilism” and “Mixed Mercantilism” drivers of the China Price while Column Two indicates their relative importance in the China Price equation. The third column may be of most interest to this subcommittee. It identifies the array of mercantilist export subsidies associated with each China Price driver.



The first five China Price drivers represent a very pure form of Chinese mercantilism and account for over 40% of China’s competitive advantage. These drivers include a pervasive system of subsidies and tax preferences designed to stimulate the export economy, currency manipulation which distorts the dollar-yuan exchange rate relative to market forces, government-sanctioned counterfeiting and piracy, and a set of lax, and laxly enforced, environmental and health and safety regulations that fall far short of international norms and standards.

The sixth and seventh Chinese Price drivers are Foreign Direct Investment and Low Labor Costs. These drivers may be characterized as “Mixed Mercantilism” because of various mercantilist elements which enhance what would otherwise be a fair comparative advantage. (The final driver, not pictured in the table, is a very sophisticated form of industrial network clustering. See Report of the China Price Project for details, www.peternavarro.com .)

China Price Driver #1: Subsidies, Tax Preferences, and Other WTO Violations Under State Control
Many Chinese state-owned manufacturers are operating with the benefit of state-sponsored subsidies, including: rent, utilities, raw materials, transportation, and telecommunications services. That is not how we define a level playing field. -- Former U.S. Department of Commerce Secretary Donald Evans

The first China Price driver encompasses a wide, but often difficult to detect, array of mercantilist subsidies and tax preferences that provide Chinese exporters with reduced costs. This array includes subsidized energy and water as well as preferential access to free or cheap land or rent.

Despite alleged reforms, China’s state-owned banks also continue to hold a large portfolio of non-performing loans. These NPLs often have been issued in a preferential manner and without expectation of repayment, providing many Chinese enterprises with essentially free money. Despite numerous WTO-related complaints, China also continues to use an extensive tax rebate system for its export industries.

China Price Driver #2: Currency Manipulation
To maintain its undervalued currency – and thereby sell it exports cheap and keep foreign imports dear – China maintains a fixed currency peg between the U.S. dollar and the yuan. To maintain that peg, China must recycle large sums of its surplus U.S. dollars gained in the export trade back into the U.S. bond market. Through such activity, China has become the de facto “central banker” of the U.S., with its net capital inflows roughly equal to that needed to finance the U.S. budget deficit.

Chinese currency manipulation is an indirect export subsidy because it artificially depresses the price of Chinese exports while inflating the price of exports from the U.S. This is not the only effect of Chinese currency manipulation, however.

More subtly, China’s massive recycling of its surplus U.S. dollars back into the U.S. bond market has helped keep long term interest rates and mortgage rates artificially low. This, in turn, has helped transform the typical U.S. home into an “ATM machine.” Indeed, many Americans have become “serial refinancers” of their homes. By taking equity out of their homes, they have managed to boost their consumption in the short run, and much of what these serial refinancers spend is on cheap Chinese imports. The practical effect has been a short run boost to the economy. Longer term, this is a dangerous situation because it is saddling U.S. consumers with more and more debt and U.S. homeowners with more and more risk of defaulting on their mortgages.

China Price Driver #3: Counterfeiting and Piracy
China is the piracy capital of the world. It accounts for 2/3ds of all the world’s pirated and counterfeited goods and fully 80% of all counterfeit goods seized at US borders.

Chinese counterfeiting and piracy help lower production costs for Chinese manufacturers relative to competitors in a number of ways that vary in degree by industry. For example, Chinese counterfeiters don’t have to pay for R&D costs. This has been a particular stimulant to sectors like autos and pharmaceuticals. Nor do Chinese pirates who steal software have to pay for IT costs while Chinese counterfeiters save on marketing costs because they don’t have to build brand.

Chinese counterfeiting and piracy is a classic example of how government inaction leads to a mercantilist export subsidy. Despite highly publicized periodic crackdowns on counterfeiting and piracy by the Chinese government, much of it remains state-sanctioned. Indeed, stripped of Chinese rhetoric, counterfeiting and piracy represent a cornerstone of the country’s discretionary macroeconomic policies.

In this regard, it has been estimated that anywhere from 20% to as much as a third of China’s GDP is derived from counterfeit and pirate activity. This intellectual property theft generates tens of millions of jobs while keeping prices and inflation low. That’s why, absent outside pressure from the U.S. and other members of the global community, China will continue to merely give lip service to IP protection.

China Price Driver #4: Lax Health and Safety Standards
Lax health and safety standards represent an important hidden mercantilist export subsidy. Under China’s lax regulatory regime, China has become one of the most dangerous places to work in the world.

The highest risk industries in China include building materials, chemicals, coal production, machinery manufacture, metallurgy, plastics, and textiles. Diseases ranging from silicosis and brown lung to a variety of cancers caused by the ingestion, inhalation, or contact with toxic chemicals and waste are endemic. Workplace injuries are endemic.

The cost advantages to Chinese exporters derived from this lax health and safety regime range from the use of cheaper equipment for workers and fewer safety-related expenses to savings on training and safety-related large capital expenditures. For example, Chinese textile companies are unlikely to invest in anti-noise or dust control equipment. Chinese coal mining companies tend to skimp on masks, goggles, and emergency rescue facilities while a wet drilling system costs as much as 60% more than a dry drilling system but significantly reduces hazardous dust emissions.

In addition, the compensation of Chinese workers who are maimed or dismembered in the production process is often reduced or withheld by companies in China. This callous behavior results in a reduction in liability costs for Chinese exporters relative to global competitors.

China Price Driver #5: Lax Environmental Standards and Enforcement
China’s lax environmental regulations and weak enforcement likewise provide Chinese exporters with a hidden mercantilist export subsidy. There is, however, some irony in using the term “hidden” here. China’s air and water pollution are highly visible within China – with Beijing, Shanghai, and China’s industrial heartland often enveloped in a toxic shroud. Meanwhile, America’s air basins are also being despoiled by Chinese “chog,” an equally toxic combination of smog, particulate and hazardous substances like mercury, while much of the acid rain falling in both Japan and South Korea is “made in China.”

China lax environmental regime provides a variety of cost advantages to its industrial sector. Enterprises save money on protective equipment for workers. Many don’t have to invest in pollution control technologies while those that do invest save money by not operating the equipment. Waste disposal costs are also considerably reduced. The net result is a significant reduction in compliance costs relative to competitors.

China Price Driver #6: Foreign Direct Investment
Among developing nations, China has become the leading destination of Foreign Direct Investment (FDI). Since 1983, FDI has grown from less than $1 billion a year to over $60 billion. 72% of China’s FDI targets manufacturing.

This China Price driver fits into the category of “Mixed Mercantilism.” This is because that while much of FDI is attracted to China because of China’s comparative advantage in labor and the promise of a burgeoning new market, FDI is also arriving on China’s shores because of various mercantilist aspects of the Chinese economy.

For example, both the aforementioned lax health and safety standards and weak environmental laws and enforcement have helped attract FDI from countries like Japan, South Korea, Taiwan, and the U.S. where standards are much higher. This observation illustrates an undesirable synergy between China’s mercantilist policies and the attraction of FDI.

Equally troubling is the pervasive practice of the “round tripping” of Chinese capital. In particular, 20% to 30% of China’s FDI is estimated to be of domestic origin. It is the result of the “round tripping” of mainland Chinese capital, primarily through Hong Kong (and also the Virgin Islands). This round tripping of capital is clearly mercantilist in nature and quite contrary to the spirit and tenets of the WTO. This is because it is driven by the special preferences awarded to FDI in the form of lower tax rates, land use rights and subsidies, administrative support, and other subsidies as well as by a desire to evade foreign exchange controls.

China’s catalytic FDI provides a variety of competitive benefits. It finances the transfer of the most technologically advanced production and process technologies. It has brought with it managerial best practices and skills as many FDI-financed enterprises are managed by foreign talent. FDI is also often tied to the improvement of both marketing and distribution skills. When all of these attributes are tied to one of the least expensive labor forces in the world, FDI becomes a powerful competitive driver. To the extent that a significant component of FDI is driven by mercantilist elements, it represents a hidden mercantilist export subsidy.

China Price Driver #7: Low Labor Costs
The China Price driver of low labor costs likewise fits into the category of “Mixed Mercantilism.” While China has an undeniable comparative advantage in its well-disciplined and well-educated workforce, China’s low wage costs are also driven by significant mercantilist elements.

The aforementioned lax health and safety standards represent one such element. In addition, there are the well-known problems of the use of slave labor, the specification of labor contracts in a manner which constitutes indentured servitude, the failure to pay the minimum wages specified under law, and the lack of any right to freely associate or organize into bargaining units or unions. Together, Chinese mercantilism in the workplace provides Chinese exporters with an additional unfair advantage over competitors.

Summary and Conclusions
The picture that emerges from this analysis of the China Price and its economic drivers is that of a picture of a country singularly intent on export-driven growth that uses a complex web of direct, indirect, and hidden mercantilist export subsidies to beggar its neighbors. The policy framework strongly suggested by this China Price-Mercantilist Export Subsidy analysis is one that requires a comprehensive, rather than piecemeal, policy approach.
In particular, rather than deal with each of the various aspects of Chinese mercantilism such as IP protection or currency manipulation or labor abuses with separate pieces of legislation, it may be far more useful to develop an comprehensive, omnibus bill that hits all points of the mercantilist China Price compass. It is to this goal that I urge this subcommittee to direct all possible energies.

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at pn@peternavarro.com. Andrew Vaino is a Ph.D. chemist currently teaching at The University of Maine.

DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.