The New Investment Rules For China

October 5th, 2008

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.

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Chinese Economy: Early Signs of Rapid Deceleration

July 23rd, 2008

Some signs point to a rapid deceleration of the Chinese economy:

The whole idea of an urgent politburo meeting just three weeks before the Beijing Olympics is a strong indicator of how serious the ruling levels of the Chinese government see this situation and would, in my opinion, be an ominous sign.

All of the signs point to an economy which is rapidly deflating, following on the falling performance of the Shanghai stock exchange, which has fallen more than 50% in the first half of the year. A lot of money which people thought they had made, and did not think of converting into cash thinking that it would go higher, is no longer there.

In China, this is always a warning sign of potential social instability. It also explains a lot about why the Chinese government has introduced new licensing regulations for online video and other communications means where people can communicate quickly, spreading views contrary to the official line, and events can quickly spin out of control.

If the Chinese economy deteriorates, as signs suggest, then it would be safe to say the government controls would tighten further. This would especially be the case in areas where foreign investment capital has gone into sensitive media sectors, which is always viewed with some degree of suspicion by the Chinese government.

Business and Social Context Isn’t Important; It’s Everything

February 10th, 2008

One of the most popular cliches in the west about China is that Chinese are generally good and reasonable people, but when it comes to nationalism, they are unreasonable. On the political level, national sovereignty is not negotiable, and when it comes to business, you need to realize that nationalism is a wildcard, and can throw a monkey-wrench into your best-laid plans. Put into this context, the 2008 Beijing Olympics is all about righting past wrongs, and showing that China is now an equal, maybe even a leader, in the world stage.

Like all bad cliches, this cliche contains a kernel of truth.

In my previous article, I mentioned why it’s so important for any business to be successful in China, decisions must be made locally by local management; it cannot be micromanaged from the US or anywhere else. Established business sectors such as finance, banking, retail, and fast moving consumer goods (FMCG), all understand this very basic rule of international business.

In the venture capital field in China, there has been a large influx of companies and partnerships which have opened offices and partnerships in Beijing and Shanghai. These companies understand that good investment decisions must, for the most part, be made in China where the local partners can understand the business environment, the competition and perform the due diligence to make the right decisions. Smart decisions cannot be made outside China.

And even that is not necessarily enough. Now more companies are going into the Chinese tier 2 and 3 cities and they are realizing that Beijing and Shanghai have more in common with New York, London or Tokyo than with other Chinese cities.

So why do so many US technology companies continue to try to second-guess and micromanage their China local management?

This is a mystery to me, and I continue to be befuddled by it. How can intelligent people continue to make and repeat over and over again mistakes which others have made before?

And then, when the Chinese local management complains that they are not empowered, sometimes they dismiss it as the Chinese “going nationalistic”. Never mind that the people questioning the Chinese management in the US do not speak, read or write Chinese; never mind that the people coming into China spend only a few days on the ground in China and think that they have China “all figured out”, yet they continue to do this over and over again.

Does this make sense? Any sense at all? And should there be any surprise that leading US companies including Yahoo!, eBay and AOL have failed in China?

And yet, these people control the budget and resource allocation for China. Should there be any surprise at all that US Internet companies have not been able to be successful in China?

What value do these people contribute to the success of the business in China? I can’t see any. Then when the company fails, it isn’t because headquarters slowed down the decision loop; it’s because of “poor performance by local management”!

They have set up Chinese local management to be the fall guy even before they started!

If this thinking were only confined to Internet companies and startups in China, it would be bad, but in the overall economic picture, it wouldn’t be that important.

The problem for the west is that it isn’t.

It has affected the west’s popularity in Africa because China offers aid without strings attached. In the mainstream media in the west, this is depicted as a cynical attempt by the Chinese to curry favor with regimes which behave badly.

But could there be more to it than meets the eye?

Could it be that the Africans don’t like to have someone dictate loan and development terms from Washington DC, London or Paris, and setting performance benchmarks for them without understanding the context of development in their own countries and region?

And could it be that the real reason for the popularity of the Chinese is that for better or for worse, they have gone local, setting up their own businesses and factories in Africa instead of trying to dictate terms from Beijing?

Definitely this is something worth pondering…