The China Vortex

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

• Politburo to convene urgent economic meeting
• Chinese Domestic Olympic Travel Falls Lower Than Expectations
• Unsold inventories climbing
• Shanghai Vanke first to lower real estate prices in Shanghai (in Chinese)

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.

On June 11, I attended an event in Beijing where Jack Perkowski, author of the book Managing the Dragon talked about his experiences doing business in China and on the Chinese economy. He also keeps a blog where he talks about China-related topics. In March, I had read the book and wrote an online review which you can read here.

During the dinner talk, Mr. Perkowski talked in greater depth about some of the issues he talked about in the book. Most of the audience of 20+ people were people who had considerable experience living and working in China.

He talked about how he saw China as having two different economies, which he calls the “local foreign economy” and the “local local economy”. He sees the local foreign economy as being made up of 400M people who have average annual income of US7500. The other 900M people have an annual average income of US2500. Right now, these are almost separate economies in the same country. The existence of the local local economy, which is very cost- and price-sensitive, means that there is a large part of the economy which needs modern things, but cannot afford western prices. Many Chinese companies are looking for new ways to reach this audience. This means that manufacturers are always looking for new ways to constantly cut their costs to reach them, which in turn leads to a very high rate of innovation.

An example he mentioned were piston rings. There are six global piston rings makers in the world, but there are 400 in China. The reason for the China discrepancy is because there is demand for cheaper solutions from the local local market, who are always looking for cheaper and more competitive components. While they have the same need for transport as the foreign local market, they cannot afford the expensive brand components.

In contrast, the foreign local economy accepts a higher level of costs, and is less sensitive to pricing pressure. These are mainly export manufacturers which have come to China from the US or Europe and come to manufacture auto parts first for their home markets and then later, other markets. Mr. Perkowski believes that in order to survive, it’s essential to reach down into the local local market. Unfortunately, many American car makers were unaware of this market, and wanted to sell only into the foreign local market. In the meantime, the toughest Chinese makers which have prospered and survived, claw their way into the local foreign market, where they are much leaner, meaner and smarter than the major US makers.

It made me think that in reality, China has a domestic market and an export market. The domestic market can be thought of as the local local market, and the export market is the local foreign market. Eventually, the two markets will merge, but it will take some time before that happens.

Mr Perkowski mentioned that the US “makes” 16M vehicles annually, of which 5M are imported from other countries. This means that in reality, the US makes some 11M vehicles annually. According to him, American makers are not able to make money on small cars, only on larger vehicles such as SUVs, which Americans are no longer buying because of high gasoline prices. The Chinese auto makers, in comparison, are able to manufacture small cars profitably. This year, Chinese makers will make some 10M+ vehicles, putting Chinese manufacturing capacity on a par with US makers. He believes that China will overtake the US economy in size, and Americans will have to get used to the idea of having the second largest economy in the world. (My note: Of course, it will take some time for India to take the world’s second largest economy position away from the US.)

He believes that the place where the US will continue to be dominant will be in efficient capital markets. This is a place where America will continue to be the world’s leader.

Mr. Perkowski does not speak Chinese, but his good common sense about doing business in China showed that he had a good deal more knowledge about China than many of those who speak the language. In his case, common sense and a good attitude have more than compensated.

One phrase I have heard frequently from well-to-do Chinese business people is 钱无祖国. Roughly translated into English, this means that “capital has no homeland”; it largely goes wherever it can get the best return for its owners.

The flip-side of this statement is that the nation-state, this political entity which has been so important for the past 500 years, is gradually losing power and influence. As technology enables individuals more and more, governments and large organizations lose power, influence and attraction.

How many bright young people have you met who said “I want to work for a large organization?” In the tech sector, the number is small; most prefer to work at startups. I predict that this trend will soon spread to media and other fields. It’s just easier to get things done and you don’t need to share the profits among as many people.

This is what those who criticize the article about sovereign wealth fund stakes in Google and Apple don’t understand. When a corporation’s shares are traded on the open market, a corporation is no longer just a national entity, it is a global entity. Apple and Google are global corporations, not American corporations. Their owners, shareholders and employees are global, not just American. They just happen to have their main domicile in the US and were first incorporated in the US and are subject to US laws, but that’s it. Only if capital restrictions are put in place can you prevent anything like the scenario I have put forward from taking place. If the US were to do that, it would amount to the US government admitting that globalization, a policy that all US administrations have pedaled to the American people for the past 50 years is wrong and is bad for America.

Doug Rediker has an excellent article about the difference between how national banks and investment banks see this trend.

If there is one area where many Americans have fallen woefully short it has to do with educating themselves about the importance of managing your finances in a smart manner. Roger Ehrenberg draws an excellent picture of how the subprime mortgage mess grew, and how most Americans are responsible.

The same rules of economics which apply to individuals also apply to countries and nation-states. Foremost among these is the rule that if you remain a debtor over a prolonged period of time, you lose control of your own destiny, and become subject to the whims of others.

The pendulum has now swung in China’s favor; in the 19th century and first half of the 20th century, China was the economic basket case. For the most part, Chinese have learned the importance of savings and not going into debt. Will the next generation of Chinese remember this lesson? Time will tell.

Americans need to face up to this unpleasant reality, and the sooner the better. The first step to recovery is to recognize that one is in trouble and needs to change current behavior.

The old ways just don’t work anymore.