The China Vortex

While there has been much heated discussion in recent days about what Apple plans to announce on January 27, almost all of the comments, some of which are very good and offer intelligent insightful analysis, focus on what Apple is famous for, the front-end user experience.

In this article, I would like to focus on what I think is just as important but talked about much less, the business angle for the Apple Tablet. Beginning with the iPod, while Apple focused on changing the consumer digital experience, it has worked just as hard on changing broken business models, starting with the music industry. In 2001, when the iPod was first launched, many people listened to their music on recordable CDs and CD players. The music industry’s major labels had fought and won against Napster, but the digitally savvy were distributing songs and music for free on the Internet.

Then Apple updated iTunes, and continuously added more power and features, first on the Macintosh platform for its loyal user base, then when it had reached a degree of stability, pushing out to the dominant Windows platform. At the same time, Steve Jobs negotiated with the music labels to get them to accept music sales for .99 per single song. There was strong initial resistance to this because the labels were used to selling CDs, and even though CD sales were falling, they stubbornly stuck to this model. That is, until reality stepped in, and someone had to point out the obvious, after which one broke rank and reached a deal with Apple. Then the others fell in line.

Before the iPhone, there was the same problem with applications on mobile phones. Except in this industry, the role of the music labels was replaced by the carriers. As Steve Jobs himself said (paraphrasing him here); they found an industry which was broken and didn’t make sense, and Apple’s engineers came up with a new solution combining a phone, a computer, and gaming device all into one elegant solution based on OS X technology with the Apple interface. The result has been the iPhone which has become popular, breaking sales records worldwide.

It would be all too easy to say that the success of the iPhone is based on device and user experience alone. That would take an oversimplified view of what Apple has been doing since the iPod: it creates new devices which at the same time, create new business ecosystems which increase and diversify the revenue streams for Apple, while making things easier for publishers. The design sexiness means that the new device can sell for a premium price which Steve Jobs (and his shareholders) love, while the backend store and ecosystem builds out, becoming an important distribution point for Apple services and locking in publishers.

I accurately predicted this with the launch of the AppStore for the apps which users can download/buy for their iPhones, giving them the power to customize their phones with their own selection of application software. For developers, the model, while not perfect, is simple to understand: developers set the sales price, and Apple takes 30% for hosting and billing while the developers keep the remaining 70%. The result has been outstanding sales success, even beyond what Apple predicted.

Looking at the book publishing industry today, it is a broken business model. From the author’s point of view, while writing a book is hard enough, the business side is even worse. First of all, in the US, one must find an agent and complete a draft and book proposal. The agent then shops the book to publishers, and then negotiates a deal with the book publisher, which usually involves the agent taking 10-20%. The publisher then may pay an advance (becoming increasingly rare), and then the author is paid a portion based on royalties for the books sold, which is usually 5-10%. The book publisher makes sure that the book is edited and makes its way into the book distribution system (dominated by 2-3 players) which gets it into book stores. However, the author is largely responsible for promotion. To make things even worse, bookstores in the US don’t really buy books; they sell on consignment. This means that they can return unsold books to the publisher, and get a refund, which cuts back even more on how much the author gets.

When you figure all this in, it’s amazing that there are any authors who make money at all! Now, let’s say that you are writing a book on a fast-changing field. In my case, my main subject is China and technology, both of which are fast-changing fields. By the time you go through the whole book publishing process and your book hits the shelves, everything has changed! Information which was current 18 months ago has been completely superseded by changes in Chinese government policy, changes in business conditions and changes in technology.

Please tell me: “How can an industry get more broken that that?” No wonder smart people are choosing to get their information from the Internet in preference to books!

If I were Steve Jobs, I would look at this and say: “If I have a good device which offers superb user experience, leverages off the current Mac user base (which now includes iPhone users), and ties in on the back end with a new business ecosystem which gradually sweeps aside the current broken publishing ecosystem, we might have something.”

Now, in order to make the Apple Tablet a real success, it has to have certain functionality which will not cannibalize iPhone and Mac notebook sales. This is why it’s point of attack will have to be on books, magazines and the publishing industry. It will offer developer tools for Apple’s digital publishing solution. Already there is talk about Apple’s new SDK for this new platform.

My prediction is that this new SDK will make it apparent why Apple has not been friendly about offering Adobe’s Flash access to the iPhone, since Apple’s solution will offer much of the same feature set as Adobe Flash, but will be more tightly bundled in on the front and back ends to the device and to the store. (Steve Jobs likes closed ecosystems where he controls the whole experience.) Tough times for Adobe’s Flash and Microsoft’s Silverlight: all dressed up and nowhere to go.

So what about Amazon’s Kindle, which have already outsold print books in distribution this past Christmas? Ironically, the Kindle will help Tablet sales since many Mac users have held back on buying a non-Apple device, waiting for Apple to come up with their solution. When they see the Apple Tablet, this pent-up demand will be released, because the Apple UI design and interface will offer something to them which the Kindle, in its current iteration lacks. Amazon will get a new competitor for online electronic distribution, which will cut into their Kindle sales and profits.

Speaking to a few book publishers (yes, they still exist), I have heard complaints that they are not able to make money on their Kindle editions; print distribution is still more profitable with them, even though sales are tracking down. Apple and Steve Jobs don’t have to do much to bring them aboard. My prediction is that the business model will be like the App Store offering for developers: “You set the final sales prices, we take a percentage on each sale.”

As for Google, they seem to be focusing most of their efforts on the Google Android platform, which will make inroads this year. This year, Google won’t be able to do much in the publishing field, and if and when Google does enter this field to compete with Apple, they need to undo much of the bad feeling with authors and publishers over copyright which started with Google Books to the point where a Chinese author has sued Google! (Hmmm… What’s wrong with this picture?) This will give Apple at least a two-year lead over Google in this field and Google will have to fight a tough uphill battle when it comes in.

About this time, Apple will be getting into the advertising field. I mean, who is still impressed with small text box ads on their web page, and doesn’t find them at least a little annoying, even though they may be relevant? My guess is that Steve Jobs is thinking about applying some magic sauce to make them better, sexier both for advertisers and content syndicators, and in the process, getting more revenue, and a new revenue stream, for Apple. I find it hard to believe that Apple is investing so much in a new data center without new revenue streams. My guess is that it will include advertising, and if correct, then Google will be on the defensive. It may take the form of a free service Apple TV with ads, and subscription form without ads.

No wonder Steve Jobs is feeling extremely happy, life just keeps getting better and better.

It has been a long time since I last posted, for which I apologize. I won’t insult your intelligence by offering some excuses, but I will try to get back on a more regular schedule. I thank you for your understanding. If you would like to follow an unadulterated distilled real-time version of my thoughts, then I’d encourage you to follow me at twitter.com/pdenlinger

Today is the first year anniversary of the May 12 earthquake which killed an estimated 100,000, mostly in Sichuan, and causing untold damage and suffering. It also awakened the Chinese government and people to the suffering of ordinary Chinese in a way which did not happen before. I don’t have anything to add which I have not already said in the previous year, so I will offer a few links which I wrote last year.

In previous articles, I have voiced some of my criticisms and predictions re globalization here, here, here, and here. Unfortunately, it is becoming clearer by the day that globalization was largely a fraud where Americans could endlessly consume and Chinese factories could endlessly manufacture without any adherence to economic fundamentals and creating a false and bloated version of prosperity and rising living standards. The brilliant minds of Wall Street came up with “risk management strategies” (irony alert) so that derivatives could endlessly build a never-ending Ponzi scheme which would go on forever and ever.

We are now entering a very painful period of unwinding of what economist Niall Ferguson called “Chimerica”. Now, China and America are entering a dangerous period of deglobalization, where they have come to the realization that after the bubble pops and the deleveraging begins, their interests are really quite different. Instead of China and America being two sides of the same economic coin, they need to play or pander to their own constituencies. The blame game will begin.

And their native constituencies are confused, hurt and angry. But they are not nearly as angry now as they will be in the near future when they have figured out what has happened to their wealth. When that happens, there will be hell to pay, and there will be blood in the streets.

The reason for this is because the leveraging which occurred is simply too big and too complicated. Taking all the bad leveraging out of the system and replacing it with cash and credit liquidity is like trying to rebuild the engines of an aircraft in flight. It cannot be done. This means that there can only be a crash.

The bright side is that crashes can be managed. You can go into a death spiral which is impossible to pull out of, but a smart pilot will look for a stretch of land and try to glide in for a crash landing. So far, the political leadership worldwide is pursuing policies which more closely follow the former path of the death spiral. This is because everyone is acting in what they perceive in their own interests, instead of keeping their heads and thinking through what needs to be done. It is a deadly panic move.

The problem is that we are now entering a phase where the crisis has spread from subprime mortgages, to derivatives, and then on to currencies. In the beginning the patient suffered from a lack of credit liquidity (constipation), so the central banks are going to provide liquidity (the enema). This did not work, and the patient has become bloated. There is the very real chance that this will eventually cause runaway inflation (dysentery) and the patient will then die of dehydration. When this happens, the currency becomes worthless and society falls apart until a new dictator imposes his will on the society, as Hitler did at the end of the Weimar Republic in Germany. In China’s case, runaway inflation led to the Kuomintang and Chiang Kai-shek’s loss of support in the cities, and directly contributed to the establishment of the People’s Republic.

Sounds really really really bad, doesn’t it? That’s because it is.

But there are survival and prosperity strategies. I will talk about them in 2009. But you will have to be really really tough.

Gladiator movie poster

At the end of my previous post, where I painted a generally pessimistic picture of the near future, I mentioned that I would write about the businesses which would do well in this downturn.

In my opinion, they are bread and circuses.

During the decline of the Roman empire, the Roman emperors realized that in order to prevent uprisings, they needed to feed the people (bread), and to entertain them (circuses). Life was grim, ugly and short. People lived for the day. People were reduced to their most basic needs, food, sex and entertainment. Everything else was unnecessary, and most likely, did not do well as a business.

The most popular entertainment of the time in Rome were massively staged gladitorial spectacles which were fights to the death for the gladiators. When people were this miserable, they wanted to have power, if only for a moment, to see others fight to live. People were not happy, and they got pleasure and enjoyment out of what some would call sadistic entertainment (in happier times).

The Roman emperors provided a huge spectacle as an outlet for this frustration in the form of gladiator fights at the coliseum. Instead of trying to resist this angry urge, they saw that the only way out for them was to channel the urge away from them. The state rode this wave, and brought Hollywood production values and state funding to this entertainment to keep the sheeple happy. That is how they were able to extend the period of decline in the Roman Empire to 400 years instead of being overthrown much earlier.

Bread and circuses.

The times we live in will be very similar.

In China, where entertainment is already a large part of what makes up the Internet, there is already a very large entertainment component.

Historically, Chinese rulers have been experienced at putting down rebellions and uprisings, but when it came to entertainment for the masses, they could not hold a candle to the Roman emperors. On the other hand, they did not produce characters quite as twisted as Caligula and Nero either. The Roman emperors were in a league of their own.

Now, how to get state funding and production values for huge epic productions which recreate the smell, blood, excitement and drama of a real gladitorial spectacle as was captured in the movie Gladiator? Whoever can answer that question and can figure out how to bridge online games and the real world drama of life and death gladiator fights, creating a whole new experience, is in the money, not only in China, but globally.

Plus ca change, plus c’est la meme chose.

One of the big problems with the present economic crisis is that we really do not know how big the problem is. We know that our problems have been caused by the creation, then over-leveraging of debt. But we don’t know how much debt was created, then sliced into derivatives multiple times which were then sold on to financial institutions all over the world.

But no one knows how much debt, then derivatives, were created by this whole process. That is the big elephant in the room which no one wants to talk about.

That makes it a good reason for me to talk about it.

We now know that a great deal of what passed for growth in the US over the past 20 years, starting with the Reagan administration, was financed by the creation of debt. Debt, by itself, is not a bad thing. In fact, it is needed for healthy growth. Companies, and countries, frequently reach stages in their growth when they need to borrow in order to reach another level of growth. When they get return from this new level of growth, they pay back and retire the debt. That is the way debt is supposed to be used.

Now, the problem which started in the US is that there was no intention to retire the debt. This was why the US Republican party pushed “deregulation” to get votes. Without deregulation, and a necessary amount of fraud, this debt mountain would not have grown as fast as they needed it to grow. Instead, the debt was sliced to ever finer parts, and sold into the global economy. Wall Street, especially its investment banks, became a mechanism for the creation, processing and sale of ever newer varieties of debt into the global economy. As long as there was growth, the system worked fine. And this is where the problem comes in: any system which can only survive when there is “growth” and cannot withstand changes and reverses in market conditions is effectively a Ponzi scheme. “Growth” becomes a means to its own ends, and becomes a necessity. When the “growth” conditions end, the system collapses.

Which is what we are going through now.

What we are going through right now is the great unwinding or deleveraging of what has happened over the past 25 years. In simple terms, the investment bank firms, and now hedge funds, and so much of the US financial industry became addicted to leveraging. Now they cannot leverage anymore, and their business model no longer works.

This raises a very interesting question which I have not seen others ask yet. That is “If debt financing and leveraging did not happen in the US, then how big would the US and global economy be?” In dollar numbers, it would be much smaller, and financial services and outsourcing would be much less important features of the US economy. There would be more manufacturing, and China would not have grown as quickly because it would not have had such a huge US export market to sell its products to. Without such fast economic growth, it is likely that the Chinese government would have had to look at social and political reforms sooner rather than later. Faster growth would have been replaced by slower more solid and more balanced growth.

China has made this problem bigger because it insisted on keeping the yuan at a lower exchange rate in order to protect its main export market, the US, addicted to Chinese exports. As I have said earlier on this blog, China and the US are two sides of the same coin. But right now, the two sides do not enjoy the same interests. The Ponzi scheme which served both sides so well no longer exists. This means that there will be recrimination and anger as each side seeks to pin the blame on the other side.

If we are ruthlessly honest about unwinding the overleveraging, I suspect that much of the world’s growth (60-75% + compounding) since the late 70s would not exist. Obviously, that is an outcome none of the world’s governments would have an interest in.

The main problem in economics is: “What is productivity, and how do we measure it?” I do not pretend to have an answer to that very challenging question, but I suspect that most of the improvements in production over the past 30 years come from improvements in information technology. These improvements in productivity mean that it is possible to create more with less people.

The real problem now is there are too many people, and most of them are not very productive in terms of adding value to an economy.

My guess is that as the unwinding continues, people will get angrier as their standards of living fall. When this happens, governments will have to choose which is worst, deflation (caused by unwinding) or inflation. Inflation has the advantage in that it can hide the real fall in living standards by gradually debasing and eroding the value the currency, but making the general populace think that they are making more money. The downside is that inflation is notoriously difficult to control. In a worst case scenario, it turns a country into an Argentinian or Brazilian basket case, where inflation becomes a routine tool for controlling the masses. More darkly, it drives the entrepreneurial class to other countries where they can make a better living for themselves and for their children.

When it does go out of control, it becomes the most powerful and deadly destroyer of wealth there is.

And that is the current situation where we are…

In my next article, I will talk about the businesses which will do well during The Great Unwinding.

For the past five months, I have been researching about the feasibility of setting up an IAB (Interactive Advertising Bureau) in China. The IAB as a trade association was founded in the US in 1997, and has since spread to all major markets in North America and Europe where it helps to coordinate discussion and implementation of Internet advertising production standards and measurement standards for web analytics.

I have been invited as a guest of Web Analytics Wednesday to speak on the subject on Nov. 5 in Beijing. I plan to talk about what I have learned from talking to many digital companies and ad agencies, and about the progress which has been made so far. I also plan to include my own assessment of what is needed to make IAB successful in China.

If you are interested in this subject and have the time, I look forward to meeting you at the event.

UPDATE For those of you who are having trouble getting to the above link, it will be at 8PM Wednesday at Club Camp. You can get directions to Club Camp here.

I’m in Hong Kong on business, and have had the opportunity to participate in the activities related to the launch of the Creative Commons Hong Kong. Rebecca MacKinnon has done an excellent job, along with some other faculty members from Hong Kong University, in making this a very informative and interesting event. At the event, I met with Angus Lau, who is another twitterer, and has done a lot to keep the Internet a lively topic in the SAR. Most recently, Angus has been active in organizing the recent Open Web Asia event in Korea.

Creative Commons Hong Kong

My takeaway from the Creative Commons Hong Kong event is that Hong Kong is in an excellent position to promote CC in Asia. It’s press is relatively open and free, and it really should be an excellent publishing center, especially for those connecting China and the west. In my opinion, it has not yet realized its full potential. Surprisingly, there are relatively few bridge people, who understand both the west and China as one would think. People fall into their own groups of Hong Kong people, who are interested in local gossip, westerners working for multinationals, and some Chinese from China. To a large extent, they don’t mix with each other as much as they could. This is unfortunate.

In spite of this, there are things I like about Hong Kong:

• Clean safe food
• Clean public toilets
• Real broadband of at least 200K up and down
• MOS Burger

The first three things, I’m sure you can understand.

But, what’s MOS Burger? Put simply, it’s a Japanese hamburger chain. Its hamburgers are delicious, and in true Japanese fashion, they have an eye to detail, taste and preparation which is better than McDonalds. It has stores in Hong Kong, but none in China.

If you are a computer nerd (if you read this blog regularly, you probably are more or less), then MOS burgers are to MacDonalds what Macintosh is to Windows. It’s just better, and it costs more. And I mean tastier, and sits more comfortable on your stomach after eating.

If you order a set meal, you can get a garden fresh salad as part of the C meal. (Maybe that’s why they don’t have the chain in China. Garden fresh salad in China? Ummm, I don’t know…) So, when I get to Hong Kong and after I have had my meetings, my job is to find out where the nearest MOS Burger outlet is.

BTW, if you don’t believe that it tastes better than MacDonald’s, I’d be happy to take you for a taste test.

ADMA (Asian Digital Marketing Association) is hosting an event on Thursday October 16 at Hong Kong’s Cyberport called Your Digital Day.

I will be participating in a panel talking about advertising trends and standards in China and Asia, and how they are developing. The moderator of the panel will be David Ketchum. The panel will start at 4:45PM.

If you are in Hong Kong and can make it to the event, please stop by and say hello to me. I look forward to seeing you.

Open Web Asia is a new organization founded by Gang Lu, publisher of Mobinode. Today they are bringing together some of the leading western players in China, Asia, Europe and the US to talk about web trends in Asia, and especially the trend for US and European companies to come to Asia. The venue for this event is in Korea, and brings together experienced marketers from Europe who have successfully made the transition to marketing in China and Asia, such as Web2Asia, which is based in Shanghai.

As part of the event, Open Web Asia is putting together a web survey on what companies in the west are considering coming to Asia to start companies. The survey is about the challenges western companies face when coming to Asia, including cultural, economic, and other issues. The survey starts today (Oct. 14) and will be open for two weeks.

If you are interested in China, business, economics, the Internet and technology, then I highly recommend that you take this survey. All you need to do is click on the button below.

The results of the survey will be announced on November 14, when Robert Scoble, Shel Israel and others come to China as part of the China Web 2.0 tour which is put together by the China Business Network.

I’m sure that the results will be interesting, and I look forward to seeing them.

Following on the global credit crisis, many have come to me to ask how these changes will affect China. As I have said earlier, China and the US are two sides to the same coin, and it pays to look at them as one economy, as this Newsweek article does. It goes without saying that this crisis will have a profound effect on China, and I’m not optimistic about the capability of the Chinese central government in Beijing to deal with it as quickly as it should. Michael Pettis, who lives and teaches in Beijing, has been a persistent advocate of stimulating more domestic spending from Chinese consumers, and continues to advocate that position. I agree that this is necessary; I don’t think that this will happen quickly or on an even basis. There is a simple reason for this: stimulating consumer spending depends, to a large extent, on the rollout of a national healthcare system; this is something which Beijing has tried to do since the early 90s, all without success. When it comes to the lack of a national healthcare system, the US and China are in the same boat, and the national governments are equally ineffective.

So what are some investment rules you can use? Let me list seven below:

• Avoid Shanghai and Beijing. Both have excellent universities, and Beijing has central government ministries while Shanghai is the commercial capital of China. In IT, companies have preferred to hire from Tsinghua for smart technology people. But there are major problems with both cities. First of all, staff turnover is too high, and costs are too high. In the past few years, staff have routinely asked for 20-30% raises just to stay in the same company! And with all the western companies constantly going into those cities, there has been a bidding war for staff. We are in tough times now, so do you really want to get involved in bidding wars over your local staff and deal with staff turnover issues? I don’t think so. And when it comes to Internet/IT, I say that the Internet already has become a platform and there is plenty of talent around. Do you really need expensive people from the very best universities in China who may prove a pain to manage? If you don’t, second-tier people who are reliable and don’t ask for huge pay raises are good enough, and maybe even better. When hiring local talent, look for tortoises, not hares. We are heading for much tougher times, and you need a good stable team. Beijing and Shanghai have too many hares. Your most loyal people will be the ones you hired and trained on the job. They will also be the ones who understand local market and conditions and connections.Another major issue about Beijing and Shanghai is that they are geared for exports, especially to the US. Do I need to tell you what happened to that export market?
• Instead of going to Beijing and Shanghai, look at the 20 major city markets in China if you are thinking of selling to Chinese consumers. Now is a good time to get into services for Chinese consumers. Think of cities like Dalian, Hangzhou, Ningbo, Xiamen, Guangzhou, Wuhan, Nanchang, Chongqing, Chengdu, Fuzhou, Kunming, Nanning, Nanjing, etc. If you want to get into China under the radar (in my opinion, always a wise strategy), these are places to look at very seriously. If you need knowledge workers, as in programming or game production or pharmaceuticals, pay special attention to the local universities, and partnering with them to hire their graduating students. If you show the cash and commitment, and can guarantee jobs for their students, you will get multiple offers of good deals.
• Guangdong and Zhejiang are the two largest manufacturing provinces in China. Guangdong’s factories depend on a huge pool of unskilled immigrant laborers, mostly young women, from Sichuan and other provinces. These factories and workers are going to be hit hard because of their dependency on the US market. There is too much overcapacity, too little value-added, and too little profit for most of these factories to move up the value chain. Unemployment in Guangdong and Sichuan will become a major issue. Zhejiang’s factories are mostly family-owned, and it has less reliance on immigrant workers. Because of Zhejiang’s strong private sector and private wealth, they will be able to make the adjustment in market demand from exports to domestic Chinese consumption more quickly.
• If you are a private equity or hedge fund investor, you need to think about investment horizons. In order to make up for the dropoff in exports, Beijing and provincial governments would naturally think of investing more in infrastructure. So far, most of this money has gone into infrastructure, manufacturing and real estate. The problem is that these areas are already built up and have over-capacity. They are really at a loss about what to do. If you can help and offer investments which create jobs and upgrade the skill force, you are in a good position. Be sure to get your money and profit back within 15 years (by 2023). That is because if you are selling to Chinese consumers, you are selling to the current group who are in their 20s – 40s. By 2023, China’s demographics will fall off a cliff because of the one-child policy, and they will be in savings mode instead of spending mode.
• When it comes to modernization, China is crossing a 30-foot chasm with a 20-foot rope, with each foot representing one year. China’s hardware development and infrastructure are very impressive and are the most modern in the world, as the Beijing Olympics showed. The hardest part to modernize is peoples’ mentality as the tainted milk scandal has shown. China’s aging demographics do not give it enough time to cross the chasm, so Chinese will get old before they get modern. When that happens, China will look like a bigger version of Japan, and will have all the problems Japan has today. Just hope that China has a national healthcare system in place by then.
• The wealth gap will become wider over the next 10 years between the cities and the countryside, then stabilize for five years, then shrink as the city worker bees retire in 15 years. Rural infrastructure is less developed, and so far, the Chinese government has made all the wrong moves in rural development by not supporting the development of rural collectives for the farmers. There is an excellent article (in Chinese, h/t to Stan C) about the failure of China’s rural development, and how Chinese rural development will look like the Philippines with large food processing companies employing poor farmers. This organization is partly responsible for the Sanlu tainted milk scandal, and is copied from the US. But the US has a surplus of land and shortage of farmers, while China has a shortage of land and excess of farmers! If you are interested in macroeconomic issues, this is worth more study. Its view converges very well with the view of Yasheng Huang in his new book Capitalism with Chinese Characteristics, which I have also mentioned in my previous article.
• The dumb money has already been made in China. It’s time to rebalance your portfolio to make smart money. It can be done, but it won’t be easy. Think smart, work smart, and invest for 15 years. By that time, you should be able to retire.

If you need more information specific to your fund/company/situation, you can contact me from the About page.