The China Vortex

More stories come out every day about how China is favoring state-owned enterprises (SOEs) at the expense of China’s private sector. Every day there are stories about SOEs advancing and the private sector in retreat or 国进民退 as it is called in Chinese。Seemingly, the Chinese leadership has embraced the view that China was able to save its own economy in the fall of 2008 by rapidly injecting a stimulus package into the Chinese economy, which meant state-owned enterprises through its own state-owned banks. By doing this when the US government was not able to react so quickly, China was able to fire up its own economy and maintain production and employment when the rest of the world was left on life support.

It sounds good as a story, but is it really true? Certainly the Chinese government is doing some of the right things by getting foreign manufacturers to raise wages, but is the conclusion that SOEs are the right way to go for the Chinese economy the right one?

My argument is that it’s not; it’s actually a return to a corrupt version of Gosplan which the Soviet Union had in the 1980s, and led to economic stagnation.

But first, let’s talk about the Chinese government reaction to the Wall Street financial crisis of 2008. The conclusion which the leadership has drawn is that some companies should be “too big to fail” because they employ such huge numbers of people. Since the single overriding issue for the Chinese government is social harmony (low unemployment + less social incidents), then yes, SOEs do prevent this. But this comes at the price of business efficiency for the whole economy, since, for the most part, they are large inefficient behemoths. And because they receive money from the state-owned banks on a policy basis, as opposed to business criteria, they can continue to do so. The price China pays for this inefficient allocation of capital is high; it means that Chinese consumers have less money to spend on discretionary items, which means that consumer spending is kept artificially low. All because the government is subsidizing its own kind in the name of social harmony.

The greatest single misreading of the situation is that the Chinese government believes that they were able to act quickly and decisively, when in fact, it had more to do with the US’s decision to bail out the financial industry, and then presented the bill to not only today’s Americans, but future generations of Americans. Up until this crisis, the US had the reputation for practicing the most efficient form of capitalism, sometimes with harsh social results. More than Europe, the US has allowed new industries to replace older outdated industries. For the first time this time, the US stepped in to bail out the banking industry at the cost of the whole country. This time, the US government decided that the unadulterated version of capitalism was too much.

China didn’t come out better because of its stimulus package; it looked better because the US betrayed its own economic values and policies.

The right conclusion for the Chinese leadership to draw from the crisis would have been that the 2008 stimulus package was a necessary one-time fix to save China’s economy during a global crisis. But then expanding that to say state capitalism is the best form of capitalism for China’s situation is exactly the wrong conclusion.

Now Beijing has ended up with a bunch of state-owned enterprises at the trough talking about how brilliant the Chinese version of state capitalism is, while Chinese private-sector companies are starved of capital and cannot compete against larger SOEs. Not only that, but the Chinese leadership has bought the line, and is reselling it as some magic fix for turbulent economic times.

Pushed to its logical conclusion, China will end up with:

• Large companies which are less efficient and less innovative, just when Chinese companies need to move up the value chain;
• The most talented young Chinese will continue to emigrate because they know that China does not reward innovation and individual initiative;
• Chinese entrepreneurs will stay in China only long enough to get experience and develop their ideas, then will emigrate because they want their child to enjoy a brighter future;
• The rich/poor gap, already large, will worsen because of widespread power abuse;
• The SOEs will get fatter and dumber because they enjoy a monopoly;
• By showing that they have so much sway over government policy, they risk becoming a target for government and policy criticism, and the Chinese government will largely be seen as a shill for the SOEs;
• Needed political reforms, such as those recently mentioned by Premier Wen Jiabao, may be pushed back even further into the future;

Judging from the debate going on in China, it looks like the supporters of state capitalism want this to become a stated policy goal. If this were to happen, it would be a betrayal of Deng Xiaoping’s economic policies, which were about putting pragmatism over ideology. Putting state capitalism on a pedestal as if it were the single answer to all of the world’s economic problems would not have been a policy which he would have approved of.

If this were to happen, it would be a tragedy for China, its people and its aspirations. And for the rest of the world.

As a consultant in software product development, I have followed trends not only in software development, but in other businesses as well. Software is one of those businesses which changes fairly quickly, since its main output is code. When software engineers decide to retire code or a standard, that code is said to be deprecated. In short, it is no longer supported in the current version, though it may be in previous versions. One of the major reasons for poor performance in consumer software is the support for deprecated systems and code; this causes a performance hit.

With the rise of the Internet, more service work is easily done in remote locations and time zones. This change is most common among software developers, many who work in other locations and are never seen in any office, but continue to contribute. It is also happening in the field of writing and reporting; I write for Forbes.com The China Tracker and Business Insider; but I have never stepped inside their offices. There simply is no need to.

Michael Pettis, an economist and observer of the Chinese economy, has made the criticism that China’s party, government and technocrats have invested too much in export production capacity, while Chinese consumer spending is actually shrinking as a percentage. This is all happening at a time when the rest of the world is looking to the Chinese consumer as the last hope for the global economy. Definitely, this is not a good sign.

The intrinsic problem is that China has become too dependent on its own state-owned enterprises to maintain growth and employment at all costs following the events of September 2008. Because they were so huge and had ready access to capital from the state-owned banks, they were able to keep China’s economy growing, even while the rest of the world headed into a funk. Nearly two years later though, cracks in the dike are beginning to appear.

For one thing, China’s economy has become too dependent on the large corporate enterprise. Both the US and China have been trying to do the same thing: trying to save large corporations at a time when they should be deprecated. This article from the Wall Street Journal, The End of Management, says it best:

Corporations are bureaucracies and managers are bureaucrats. Their fundamental tendency is toward self-perpetuation. They are, almost by definition, resistant to change. They were designed and tasked, not with reinforcing market forces, but with supplanting and even resisting the market.

In the US, government has become too closely aligned with the financial industry and its interests, and in China, the party exercises dominance and control of the economy through state-owned enterprises, many of which have become dependent on real estate speculation to be profitable. The WSJ article goes on further to say:

British economist Ronald Coase laid out the basic logic of the managed corporation in his 1937 work, “The Nature of the Firm.” He argued corporations were necessary because of what he called “transaction costs.” It was simply too complicated and too costly to search for and find the right worker at the right moment for any given task, or to search for supplies, or to renegotiate prices, police performance and protect trade secrets in an open marketplace. The corporation might not be as good at allocating labor and capital as the marketplace; it made up for those weaknesses by reducing transaction costs.

Mr. Coase received his Nobel Prize in 1991—the very dawn of the Internet age. Since then, the ability of human beings on different continents and with vastly different skills and interests to work together and coordinate complex tasks has taken quantum leaps.

Most of the reasons which Coase outlined for the creation of the corporation in The Nature of the Firm no longer exist. Thanks to Google and other tools, small organizations can resolve all of these issues for almost no costs at all. Isn’t it time we start thinking and talking about deprecating large corporations?

Of course, many in the US and China would argue that only a very small and select minority would be able to work on different time zones and in remote locations with minimal supervision; I would beg to differ. For many service jobs where key personal relationships are not important, this will become the norm within 20 years. It’s just that the US and Chinese government haven’t figured it out yet.

In China’s case, this change is particularly disturbing. Most outside observers of China don’t understand that the main metric which drives China’s economic decision-makers is job creation and employment, not company profitability. Recently, I was pointed to a long article by Daniel Cloud called Ghost Money. In the article, Cloud says:

Simply endlessly printing more money is more likely to lead to catastrophic failure – devaluation, inflation, default, or all three – than to any permanent rescue of the situation. That, in an open economy with large cross-border trade and capital flows, debasing your currency is not a long term solution to any real economic problem is something we’ve known for a rather long time. A one-off devaluation is sometimes useful, but the endless abuse of segniorage has not traditionally been viewed in a very favorable light. Someone will pay in the end; now we are beginning to see who it is. Anyone who holds a lot of sovereign debt is at risk of eventually discovering that it is fairy gold, ghost money, mere joss paper that didn’t ever correspond to any pile of goods and services actually available in this world. (Imagine an endless stream of ships leaving America full of cargo and returning from China empty, as if we were paying war reparations, individual Americans making terrible personal sacrifices to make sure the debt was paid…. The scenario is just so implausible.)

So what can China do? Cloud goes on:

Export-led growth works well in a world where the price elasticity of demand for the exported goods is effectively infinite, where any decrease in costs will always lead to an expansion in sales. Even in a world like that, though, sooner or later the very development it brings about will put upward pressure on export prices. So even in a world where the first condition continues to hold indefinitely, sooner or later it will be necessary to switch to growth driven at least partly by domestic demand. But large countries like Japan and China are bound to run into another barrier as well. Eventually their exports will become so big relative to the economies they are exporting to that people in those countries will not be able to afford to continue increasing their purchases of the exports at the same rate year after year. A country the size of Singapore can afford to ignore the limits of their customers’ purchasing power. But both Japan in the ‘80’s and China in the last decade found themselves having to lend their export earnings back to the countries they were exporting to, to keep the growth in exports going.

Once you get to this point, it should be obvious to the exporter that he is never going to get paid back at today’s prices. (Where would the money come from?) The importer is likely to try to avoid bankruptcy by forcing a revaluation on the exporter, which is politically easier for him than persuading his own voters to adopt the necessary austerity measures would be. The exporter, seeing this risk, will frantically try to switch over to an economy based on domestic demand. Whether or not he can do this depends on the condition of his political system.

Basically, Cloud’s argument is the same as Pettis’, that there is way too much capacity for the Chinese consumer to absorb, and if the Chinese consumer doesn’t spend, we are all effectively screwed. According to an article in the Financial Times, Chinese retail consumers are reluctant to spend. Cloud says that the only way out is for political reform to come to China.

If that is indeed the case, then the Chinese government will continue to fund Chinese money-losing state-owned companies until it can no longer do so. The Economist has a recent article on how the Chinese government has introduced a new circular bail-out for SOEs.

Hmmm. Looks like short-term thinking to me. Short-term bailouts do not resolve long-term structural issues.

For this reason, an article by Perry Link, a long-time China authority, in the the New York Review of Books drew my attention. This article was titled “Waiting for WikiLeaks: Beijing’s Seven Secrets” goes into some detail about the seven closely guarded secrets which are closely held in the party’s archives. I won’t go into detail about those secrets here, but what grabbed my attention about the leaked story was the final paragraph:

The anonymous reporter who leaked the contents of the July 21 meeting commented on a looming atmosphere of demise at the meeting. The underlying mood, he suggested, was, We had better get control of these archives, and perhaps destroy them, before a day of reckoning is upon us.

Does this sound like the confident leadership of the world’s fastest growing major economy? You can draw your own conclusions.

At the same time, there is an article in the People’s Daily titled “Chinese leaders vow to make Party affairs public”.

Hmmm. Interesting.

There is a point which western critics of China and the Chinese government have not pointed out. To a large extent, China is where it is now because it has followed the western model of economic development for developed economies, while retaining its own political system. Critics like Cloud say that this is why China is doomed to failure; it has followed the economics, but did not follow the political model.

I don’t think that it’s that simple.

The real problem in the Chinese model is an over-reliance on state-owned enterprises and since 2008, state-created employment. In fact, what the Chinese government should do is increase lending to Chinese private companies, and allow them to compete on a level playing field with Chinese SOEs. Instead, the Chinese government has focused all its attention and capital on Chinese SOEs, while pretending that the Chinese private sector doesn’t exist. At best, the party has treated China’s own private sector as the wife’s red-haired son from her first marriage.

For a long time in the US, private companies have been the main engine of growth and job creation. But unfortunately, Americans are not as good at entrepreneurship after they have been in the US for several generations. In the US, the best entrepreneurs have historically been the immigrants who have opened restaurants, groceries, laundries and other small businesses. They would then save money, sending their children to the best schools, so that they could become managers, doctors and lawyers. This has been true of every immigrant wave to the US, and is why the US is so dependent on new immigrants. Then, when their kids go into the mainstream, they become the new white-collar class of doctors, lawyers and managers. The problem now for blue collar workers, is that they look for jobs at corporations, and when they can’t find any, they go on welfare. But the problem is that the system is broken, and most state governments are broke.

Compared to the US, China is more fortunate. It has always had a large population of entrepreneurs. But many have had trouble finding capital to start their own businesses, or feel discriminated against by the government, which is why so many continue to emigrate to Australia, New Zealand, Canada and the US even though they have been able to achieve some degree of success in China. The end result is that many of the best remaining entrepreneurs are government bureaucrats, who abuse their privilege to become wealthy. Then the Chinese government goes after some of those, putting them on trial for corruption, and serving them up to the people as examples of how the government is helping them.

But doesn’t it make much more sense to help China’s own private sector by providing them needed capital for growth at critical moments? Why should China’s own private sector continue to be treated as the red-haired stepson by the government?

The best way for China to stimulate real consumer growth and spending is to remove the barriers to growth for the Chinese private sector, so that they obtain needed capital to grow at home in China. This will work much better than any slogans about Chinese global brands, innovation and creativity for large Chinese SOEs.

Most likely, these new businesses will start small. At the beginning of this article, I talked about how there is less need for large numbers of people and large corporate organizations anymore. This is what Schumpeter’s creative destruction thesis was all about.

Through its control of the financial sector, the Chinese government and party has the basic tools to help China regenerate itself more, much more, than it has up until now. It has long been my view that China is a nation of small business people, farmers and engineers. The problem in today’s China is that there is not a good balance: the engineers have too much power and influence on policy, and the small business people and farmers have suffered at their expense. The engineers are good at producing, but are less good at profitability. This has led to severe imbalances in China’s economy and society.

The Chinese government has, within its own hands, the power to unleash China’s small business sector and private entrepreneurs not only as a force for change inside China, but as a force which can change the world for the better. So far, it has not given them that power.

Historically, China has had major social disruptions when the rural and urban gap widened too much, and the rural population felt that they were ignored by the central government. The Chinese Communist Party came to power in 1949 based on widespread rural support for what was seen as a largely corrupt urban Kuomintang leadership. Yet this is what is happening now in China; except this time, the gap is widening at a much faster pace. The leak from the party archives meeting shows that the party is aware of this imminent danger at its most senior levels, yet has no way to deal with it.

Now, the Chinese government is trying to build an urban middle class while retaining a dominant public sector. This has never been done before, and the leak from the party archives meeting suggests that even the government leadership has its doubts about whether it will succeed. It is time to rebalance Chinese society so that the private business sector and farmers have a greater say in China’s future. This is all the more reason for China to build a REAL urban middle class; one which is based like Taiwan’s, Hong Kong’s and Singapore’s, on a vibrant, healthy and growing private business sector.

It is time to let a hundred flowers bloom in China’s private sector.

Foreign Policy magazine recently published an article on Chongqing, Sichuan’s largest metropolis and China’s fastest growing city, as Chicago on the Yangtze. For many Americans, the rise of China, and of huge metropolises which many have never heard of, let alone pronounce, comes as a surprise.

The sad fact is that it shouldn’t have come as a surprise. The rise of China did not happen overnight. To a large extent it was planned, and in some instances, it also took advantage of circumstances. For me, this raises the bigger question of why it should come as a surprise for Americans? Doesn’t the US have a free press, and shouldn’t they know about these things? Or did they just refuse to see, being pre-occupied with other events which seemed more important at the time?

Back to Chongqing. I visited the city in 2007 for several days, and it seemed to me like a mess, growing in all directions but with seemingly not much planning. In 2008, I wrote an article which was somewhat critical of Chongqing’s chances for success. Like many fast-changing industries, it’s easy to overestimate the effects of change in the short-term, and underestimate the effects of change in the long-term when it comes to China.

In the case of Chongqing, the appointment of Bo Xilai as mayor has been politically significant. Previously, Bo Xilian had served as mayor of Dalian, where he had successfully started the modernization of that city, and was then appointed to the Ministry of Commerce, where he also had a successful tenure.

Bo’s appointment to Chongqing is politically significant because it is one of the few cities in China which does not report to its own provincial government of Sichuan; it reports directly to Beijing. Before Bo’s appointment as mayor, Chongqing had a reputation for being rowdy and corrupt, with the police in collusion with local gangs. After Bo became mayor, he brought in many of his own people, some of whom had worked with him at Dalian and at MOFTEC, and proceeded to clean up. Corrupt officials were tried, and in a few instances, executed, including the former chief of police. There could be no mistake; this was no cosmetic cleanup, this was the real thing. In Chinese politics, one of the ways a politician establishes a tough reputation is to have someone who was part of the old order tried and executed. This shows that the politician is a “tough guy” and will not compromise. Even more, it means that the corrupt old guard won’t come back, and if they try, it will literally be a fight to the death. When this happens, support for the ancien regime usually collapses.

There have also been reports that Chongqing plans to introduce a property tax, which would be a first in China. While there has been widespread discussion about the introduction of property taxes in China, it is politically difficult to do so, especially in the major cities of Beijing, Shanghai, Guangzhou and Shenzhen, which like Chongqing, are direct municipalities which report directly to the central government. Unlike Chongqing, they do not have a mayor who was given a free hand to clean up, and tried, jailed or executed the former clique which ran the city.

Bo Xilai is widely known to be politically ambitious, and there has been discussion that he may want a seat on the Politburo’s Standing Committee of the Chinese Communist Party. Looking at it now, there are two ways it could go: he may be quickly appointed to the Politburo Standing Committee and go back to Beijing, but another scenario which may be more likely is that he is being asked to introduce the property tax in Chongqing and make it a success before being asked to take a major leadership role in Beijing, which may be higher than the Politburo Standing Committee role. If Bo Xilai can make a success out of the introduction of a property tax in Chongqing, and then goes to Beijing in a major role in the central government, he would be in an ideal position to introduce the property tax nationwide.

In all of China’s cities, the major developers have a tight relationship with municipal governments, and their resistance to a property tax makes implementation virtually impossible. But Bo’s actions in Chongqing show that he means business, and that he has the team to make things happen.

In another article, I talked about how the Chinese government liked to try new policies on a trial basis. For Chongqing and Bo Xilai, it is an ideal place to try and experiment to do new things in new ways.

For businesses, it is often wise to ally politically with a rising star. Chinese pay attention to timing; it not only matters that you ally with a rising star; what is even more important is when you ally with them. Chinese government officials give special preference to companies which came to China when it was dirt poor, and when western countries had sanctions against China. These companies are generally considered to be “old friends of China” and tend to be given special preferential treatment on an unofficial basis. The later you come in, the less special you are.

If you company comes to China now, they will look at it purely in terms of how much investment money and technology you bring in, and then they will negotiate the degree of market access you get. This is of course, a generalization, but you get the idea.

The same goes for individual politicians who are rising.

The Chinese definitely prioritize their friends, and if you’re smart, you’ll know where you stand in that priority.

I recently did a podcast interview with Eric Garland of Competitive Futures. Eric was until recently based in Washington DC, and recently moved to St. Louis, Missouri. His company is a strategic analysis firm which advises companies on global strategy related issues.

Our conversation was about how China sees the US, especially in the period following the Wall St. meltdown of September 2008. I’m pleased to say that the podcast has been very well received, and Eric and I have started talking about doing more podcasts about China in the near future. Please tell us if you like it, and we’ll do our best to make things happen.

This podcast can be listened to on the Internet, or as part of Competitive Future’s new iPhone app.

I recently conducted a phone interview with Handel Jones, the author of Chinamerica: The Uneasy Partnership That Will Change the World which is published by McGrawHill.

You have worked as a consultant for many years in China and the west. What motivated you to write this book?

Many Americans don’t know much about how China works, except for those who are in the business sector. Now that China has become economically powerful, it is important for more people to understand how the Chinese government and people see themselves, and their role in the world.

In your book, you mention that China needs and respects a powerful US, but if the US becomes weaker, then the relationship would become unstable and even dangerous. Why?
China has looked up to the US for a long time as a world leader, and setting the rhetoric aside, continues to have a deep respect for many things which the US has done. For example, in the area of graduate university education, Chinese continue to choose the US as their most popular destination.

In your book, you express some frustrations at recent US government policies. What are they?
Domestically, with the change in administration, we were expecting more support in the business sector. However, for small businesses, there has been more regulation and more taxation. This has hurt the overall competitiveness of US businesses. This is in comparison to the Chinese government’s policies, which have been to support Chinese businesses and exports, especially state-owned enterprises.

What is your feeling about the competitiveness of US businesses?
I believe that US management practices, generally speaking, are the best in the world. It also has the best business managers in the world. This is why the US has world leaders and brands such as HP, Apple, Boeing, just to name a few. However, there is little understanding on the government policy level as to how to leverage these American strengths as most US politicians are too absorbed with domestic issues so that they can win the next election.

How is this different from the Chinese government’s worldview and their policies?
When China’s reforms started thirty years ago, China worked from a very weak base. Just about the only thing it had a was a large pool of unskilled labor and some smart leaders. They leveraged this base to obtain key technologies and become a manufacturer and exporter, while giving away as little as possible. To this day, it is virtually impossible for any non-Chinese company to gain access to the Chinese market without being forced to give access to key technologies, which often find their way to Chinese competitors. This is a source of frustration to virtually all non-Chinese companies.

Many US and western policymakers say that China needs to revalue the yuan upwards. What do you think?
Instead of putting pressure on China to revalue the yuan, it’s more important to put pressure on China to open up its markets to foreign-made goods, so that they are treated the same as goods made domestically in China. Non-Chinese manufacturers should not be pressured to hand over their technology to gain access to the Chinese market.

What does the US need to do to become competitive again?
Over the past few decades, US government policy has become more short-sighted, and Wall St. has reacted by creating debt instruments which were speculative in nature, instead of being investment-oriented. However, the US still has strengths in areas such as medical research, energy technology, and other leading areas. China and the US need to work together in developing these new fields of research and manufacture.

How do you see leverage between China and the US changing over the next decade?
If the US government does not wake up and change its policies to support the US business sector and investment, it will continue to lose leverage to China. This is not good for either country. This is why I wrote the book; I want Americans and the west to wake up to this real challenge, and understand the importance of our changing our own policies so that our relationship with China will become more complementary instead of potentially antagonistic. China is looking to the US for enlightened leadership, and it is time that the US government delivered, not only for its own good, but for world stability.

What hidden threats do you see to China’s leadership?
Chinese state-owned enterprises may become too powerful and greedy, leaving too little for others. This may lead to the abuse of power, which would lead to instability. So far, the Chinese government has done well at keeping these abuses in check.

In conclusion, how would you say China has performed over the past thirty years?
The Chinese government has been very smart in the way it has utilized resources to gain benefit for China. It has shown that it is not a pushover like Japan was in the late 80s. It thinks in big terms, and has a clear strategy for what it wants to do, but it is willing to be flexible in what tactics it uses to achieve those goals. I plan to write more about this in my next book on Chinese strategems.

With the increased strain in China’s relations with the west, and the west’s reliance on China for both raw materials and technology, many in the west have belatedly recognized that from China’s point of view, the west is, at best, only seen as an export market for China green energy goods. From rare earth production to processing and manufacturing of finished goods, China intends to dominate the value chain.

Funny how this largely happened without most in the west noticing it until it was too late, isn’t it?

Now, Molycorp Minerals in the US is attempting to raise more than US$500 million re-open a mine which was used up until the early 1990′s and then was shut down for environmental reasons. Part of the irony of rare earth mining is that it uses hydrochloric acid and other hazardous materials to separate the rare earth oxides out of the soil. So the process used to get these materials used in green energy are not environmentally friendly at all.

For these reasons, the US decided to outsource this environmentally hazardous mining to China, which did not have these qualms at the time. And China has leveraged that it into a trade advantage with its tight control over rare earths. In fact, North America could be completely independent of Chinese supplies if it opened a few North American mines. This is a classic case of how Chinese leadership in a sector was ceded to China by dumb policies. (Sorry, there is no other way to describe them. The Chinese just took the opportunities which were presented to them.)

The big question now is whether Molycorp will be able to raise the money needed to re-open the mine? If it is successful, it will be a sign that the US is serious about getting back into the game, and not letting China have a complete monopoly on rare earths. If it is not successful, it will send a signal of weakness to the Chinese, making the Chinese think that it is all just talk.

Let’s hope the US doesn’t send the wrong signal.

Last week I was interviewed by Chris Myrick for an article on Google in China for Wharton. The article was translated into Chinese and titled “谷歌中国新动态：胜利，失败还是僵局？” I am quoted in the article.

You can read the article here.

In China, the Chinese government is obsessed with maintaining economic growth at a high level. This is because a large part of the Chinese government’s implicit mandate with the Chinese people is guaranteeing continuing growth, which leads to a better standard of living. If growth slows down, then the whole basis of government legitimacy is challenged. This is why leading economists such as Michael Pettis, a very astute observer of the Chinese economy, believe that the Chinese government will continue their outbound investments in the US, for example.

Now for many other political observers of China, there is the widespread belief that Internet censorship is a human rights and free speech issue only, and something which is unrelated to economics. For them, this is an argument about humanitarian values which should be shared across the world. In the past few days, there has been a new crackdown on Twitter clones and some outspoken blogs in China have been deleted, according to this story in the Washington Post.

But what if economic performance and Internet crackdowns are in fact related, because the government fears outspoken criticism if economic indicators are much lower than the goals they have committed to and seek?

If that is the case, then the internal economic numbers which the government is seeing are a better indicator of how the people feel and will behave in the short-term, and bad numbers would make the government want to crack down pre-emptively, heading off potential dissent before the news becomes widespread.

When you put this into the Chinese context of domestic politics, and see that the Chinese leadership will be handed over to a new president and premier in 2012, what is happening on the Internet makes perfect sense. The current leadership of President Hu Jintao and Premier Wen Jiabao are due for retirement then, and will hand over leadership to a new leadership team. With two years left in their term, it is safe to say that world markets look unstable, with another wall of debt about to hit the US and Europe in the next year, further dampening consumer spending in the west. How can they manage a smooth handover without things getting unstable?

In China, there are early signs that there is an excess of white collar workers in the cities, and a shortage of blue collar workers in the factories, which is why factory workers have the leverage to slow down work or even go on strike. The traditional Chinese view of education is that the more educated you are, the better, but this view is being challenged now, and this view will sharpen over the next decade. China’s urbanization will mean more white collar workers will be looking for work in the cities, and they will have a harder time finding jobs. At the same time, this under-employed workforce will be aging quickly. Already, there are signs that a new subclass, the “ant people” are emerging, living in separate gated communities. Will this turn into China’s version of Brazil’s notorious favelas? This is the exactly the kind of situation the Chinese government wants to avoid. The gap between the urban rich and poor will become more marked.

As growth slows, the greatest challenge to the government will become readjusting the hopes and dreams of the Chinese people to a new reality of more moderate growth. This is an unprecedented challenge.

Is this a formula for social instability? You bet!

And where will they vent? On the Internet.

How will they potentially organize by spreading inflammatory remarks? On the Internet.

Seemingly this is a China problem, but as the world economy slows down, it will become a problem for other governments too. Free speech is taken for granted in good times, but in hard times, when social stability is at stake, it becomes another story.

Several weeks ago, I wrote an article on China’s digital advertising industry for Forbes.com The China Tracker. Now that China’s online advertising expenditure is growing, I’d like to talk more about challenges, and what I see as good opportunities in the field.

The past few years in China have seen some investment in China in combined lead-gen/traffic websites in China. I won’t name any names, but if you know this space, then I’m sure you know a few players. Basically, combined lead-gen/traffic is not viable on the long-term because there is an inherent conflict in combining lead-gen and traffic together. Either you are in lead-gen, in which you sell your leads to other sites which then try to monetize them, or you are in the traffic business, and you sell your traffic to firms which try to segment that traffic for their campaigns.

You don’t do both under one roof.

I see advertisers and publishers getting smart about this very soon, and figuring out the inherent conflict, which will cause problems for the companies which are doing this, and I expect them to change to either traffic only or lead-gen only very soon.

This will lead to healthier market development, and will help digital advertising expenditure to grow as a whole, as the industry will then grow more healthily.

Many of the advertising plays in China have been laggards, as games have always generated more revenue. Growth is now slowing among game publishers, and the number of new game players is also slowing; this is a reflection of China’s aging demographics. The growth has moved from MMORPG games to casual games, which don’t eat up time and attention the same way MMORPG games do. With the growth of mobile phones, especially the Android and iPhone platforms, you can expect more mobile casual game popularity. Some of the MMORPG game publishers will move to these platforms; others will not. I expect their success to be mixed.

Blizzard and the Chinese government have all been trying to push real-name registration, for their own set of reasons. I predict that this year more people will begin using their real names on the Internet, not out of government registration threats and rules, but because they are building a following, and are becoming well-known, and even generating income from Internet referrals. This already happens for some people, but as the society becomes more digital, it is being pushed down further into society.

This will create a bifurcation of those who use multiple identities and remain anonymous, and those who use real names. Some people will become famous as leaders in their fields and will use their real names; in this respect, they will become like experts on South Korea’s leading search engine Naver.com. In this respect, I expect the Internet in China to develop along and follow South Korean lines. On the one hand, this will make the Chinese government more comfortable with its development, and it will also increase the accountability of the information.

I see the next five years in China as a kind of cleaning-up period, where content quality and reputation need to be re-examined. Let’s be honest, there is an awful lot of content on the Chinese Internet, and a lot of it is crap. Much of the content is just copied from other sites with no value added. Brands are going to advertise in China because of the importance of the market, but it would be much friendlier if it was cleaned up. This needs to be done.

As for advertising sites in China, too many of the startup ideas are content- and front-end related. This is because most of the westerners and westernized Chinese in China are content people. But content is not enough; the Internet is really about data and sorting and filtering very large amounts of data to capture insights for advertisers.

This is where the next generation of online advertising startups in China will add value. This will require REAL technology, and will be filled with terms like Hadoop, MapReduce, etc. This will replace terms like branding, China strategy, market entry, etc. In other words, the emphasis will move from the front-end to the back-end, where the real technology always is.

Google is the world’s most successful advertising company, and it is a backend data-driven business. Its front-end services are just there to drive traffic to the backend, where it is processed into useful data which generate profits.

That is something most people just don’t get.

It’s about time they did.

I wonder who will be the new VCs in this space?

I welcome your comments.

Virtually all westerners, and most western companies, embrace the belief that information should be free. This means that it should freely cross national borders and be accessible by anyone with a browser. In short, as long as it sits on a web server, it should be accessible from anywhere.

Some individuals, such as Mark Zuckerberg, Facebook’s CEO, and Google’s CEO, Eric Schmidt, have gone so far as to embrace the concept that people should have almost no secrets at all, and that if you do have secrets, you are either backward, or have something bad to hide. Basically, they put forward the view that if you want to hide something, you are old, out-of-date and out-of-fashion, and that you SHOULD embrace openness as the way of the future. Mark Zuckerberg has gone so far as to say that if he had the chance to re-architect Facebook all over again, he would make it completely open, with no privacy controls.

Many in the west, especially libertarians, have embraced this idea without even debating the merits of this argument. People in the IT sector especially are sympathetic to this POV, so much so that it has become a white god. The white god syndrome is the widespread belief is that those in the west have always known what is best for the rest of the world, and that it upholds the precious values of personal liberty and individualism. After all, hasn’t the west been the leader in the struggle for human liberty and progress, fighting two world wars and numerous small wars so that others could be free? Many in the west adhere to this point of view, forgetting to question why accountability in the west is often applied selectively, in spite of all the claims made by its proponents.

If you accept this historical narrative, then anyone, or any government, which dares to object are either ignorant or evil.

Throughout the argument for free flow of information, there is no room left for defining the role of what a government does. There is only 1) information and 2) the rights of the individual to access that information anytime and anywhere.

Because the argument is framed this way, the Chinese government’s claims for Internet sovereignty have been met with derision and even contempt by the western press. The Chinese government’s claim is simple enough: IT companies in China must adhere to PRC laws. Looking at it from the surface, there is nothing revolutionary or different about the PRC claim; other governments, including those in the west, require IT companies to follow the laws of the country they do business in. If there is a difference in China, it has to do with due process, and what the government needs to do in order to obtain data from the IT companies. This is where things get blurry.

The infrastructure for the Internet was built in a way which did not clearly follow national borders. A US IT company may have web servers in Iceland, which now has the most stringent laws protecting data privacy. The data may or may not sit on the company’s own web servers; it could just as easily sit in the cloud, on servers provided by Amazon, Microsoft, Google or Apple, adding yet another layer of abstraction. Just thinking about the legal aspect of this is likely to throw lawyers into a tizzy of billable hours.

In contrast to this, the Chinese government has been very protective of Chinese consumer data. In China, consumer market research is a restricted industry, meaning that non-Chinese market research companies are not allowed to enter the field. In order to enter the industry, most western market research firms need to form joint ventures or partner with multiple Chinese market research firms. While the western market research firms do the analysis, the data is usually kept in the hands of the Chinese market research firms. This way, the data about Chinese consumers is always kept in the hands of the Chinese market research firms, and never leaves China’s borders.

The only exception to this rule comes with regard to personnel files in western multinational corporations. Most US and European firms have centralized HR departments at company headquarters; these include detailed personnel files for all staff and management, regardless of country and location.

Throughout this discussion, it has become very clear that the Chinese government does not adhere to the currently dominant western notion that information should flow freely across borders. This position has been made crystal clear in the showdown between Google and the Chinese government over censorship. I see the Internet sovereignty assertion as the first step in a systematic pushback against the free flow of information argument.

How could the Chinese government push back further? The simplest and most logical argument would be to claim that all personnel and data files on PRC citizens must not leave the PRC’s borders, and giving the security services the right to go to western MNCs’ HR departments to perform data audits to make sure that they are in compliance. Such a move would throw their HR departments into chaos, as it would mean that headquarters would no longer have the personnel files of PRC employees.

If the PRC government were to make this claim, it would effectively claim that it has control over all data about its citizens.

To sum up:

• There should be a healthy debate about the free flow of information across borders. For too long, this is a position which has been supported without question in the west, and those who have challenged it have been routinely tarred and feathered by the press. This lack of an open debate about this aspect of the white god is not a good thing.
• The PRC government should clearly state its position on data, and express how far it intends to go. If the government stakes a claim to all PRC citizen’s personnel data, will they extend that to their medical information and later, genetic data, too? Will the individual have any control or recourse over their own data, or will the government always be the final arbiter and decision-maker? The Chinese government should makes its position clear, without resorting to slogans and nationalism.

This would be best for everyone, especially the Chinese people.