The China Vortex

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 of the things past experience has taught me that while it is possible to guess that some business will take off in China, it is almost impossible to tell when. The most common scenario is that for many years, a western business will devote its people and resources to making its business popular with Chinese, it will not show results. Frustrated, it will depart China with nothing to show for its hard work and investment. (This happened frequently in the eighties and nineties; now it is much more rare.)

This rule does not just apply to business; it even applies to Chinese government policy. For years, the Chinese government actively urged the Chinese people to travel more; it even increased the number of public holidays, creating the Golden Week holiday around the May Day holiday in the late 90s to get Chinese to travel more, and spend some of their savings. For years, the policy yielded no solid results.

But later it worked, and beginning this year, the May Golden Week holiday will be abolished. Put simply, it’s no longer needed. Chinese now travel freely, are willing to spend their savings, and the incentive is now no longer needed.

The same phenomenon occurred in the auto industry. For years, local Chinese automakers were unable to get Chinese to spend money on automobiles; most of their production went to taxis and to Chinese government ministries and officials. These habits changed suddenly with the SARS crisis in 2003. All of a sudden, Chinese were afraid to take public transport and started buying cars. And unlike in the west, they paid for their cars in cash.

This trend, which started in 2003, has continued to this day. Now, if a young man in China’s cities wants to get married, more and more young brides are expecting an apartment and car to go with their husband-to-be. Today, in Beijing, 1,000 new cars are being added daily to the city’s traffic woes.

This creates a phenomenon which I call the “Chinese hockey stick”. In simple terms, this means that “It is likely that a new business/service/product will take off in China, but it is hard to say when.” This can be endlessly frustrating for businesses which need to plan their expenditures on an annual or quarterly basis. When are they going to see some of their investment money come back? Country heads need to tell their head offices when the hockey stick will finally take off, and more often than not, it is very hard, if not impossible, to tell.

Part of my rationale for the Chinese hockey stick is that Chinese consumer spending patterns will track more closely to the spending habits of their Asian neighbors in South Korea, Japan, Hong Kong and Taiwan, than to the west, as Chinese society becomes more prosperous. If you want to understand how Chinese spending habits are likely to develop, take a close look at these places. You will learn a lot. In culture and language, these places are closer to how Chinese think, act and behave than the societies of North American and the EU.

Most frequently, the businesses which are able to time the rise of the hockey stick are local Chinese entrepreneurs. Unlike western companies which try to sell their foreign-designed products in China; these Chinese entrepreneurs stand in the wings, just waiting to swoop in at just the right moment. Unlike western corporations, these companies do not have the big budgets of western companies, but their knowledge of their countrymen’s thinking and spending habits more than compensates for this. This is why many leading Chinese Internet companies such as Tencent, Baidu and Sohu have been able to prosper, while their much larger and richer western competitors have been unable to gain traction.

With the dramatic growth of the Chinese consumer market in the past five years, you would think that western observers would learn to be quiet instead of sticking their necks out and betting against the spending power of Chinese consumers.

Apparently not.

David Wolf’s Silicon Hutong has pointed to an article by Donald dePalma in which he claims that China’s buyers account for only 1.1% of what he calls “online GDP”. Unfortunately, he does not explain his methodology as to how he gathered his numbers.

In the west, the Internet led to the creation of some whole new businesses, with Amazon and Google being the best examples. In China, many Internet companies are front-ends for established brick and mortar businesses. For many Chinese consumers, the Internet is like a shop window; when they buy, they still prefer to buy from a person in a store.

These fundamental differences in consumer spending habits make me question the value of even measuring something like “online GDP”. And as David Wolf alludes to, the eGDP is a static number; it does not capture or reflect trends. It is like trying to understand a movie storyline from a still photo.

That’s why I’ll stick with my analogy for the Chinese hockey stick, at least for the time being.