The China Vortex

@GregoryLent on Twitter just pointed me to this article, A User’s Guide to 21st Century Economics, by Umair Haque which I recommend highly.

After reading this article, some questions which came to mind:

• Chinese companies traditionally have not been good at adding value. How well can they adjust to the new 21st century economic situation?
• Chinese companies have been spending much on acquiring steady supplies of raw commodities. How much are they thinking of what is needed for the 21st century? Will they continue to build a twentieth century economy modeled on the American model, which is going defunct rapidly, or will they build a new development model for the 21st century?
• The 21st century development model is reliant on individual human talent and creativity, and making it possible for them to succeed. How is China going to attract the best minds in the world to China in the 21st century?

On this blog, I have been a frequent critic of the view that China is a threat to the rest of the world as a rising superpower. Most of the time, these critics have a clear agenda to sell with regard to fear of China, or are journalists who have very little understanding of China. If the latter group, their articles are really rehashes of “If China were a rising superpower like US/Britain etc. this is what China would be plotting to do.” For someone who has never been to China and does not understand the country and people, the argument makes sense. But for someone who has been in China for some time, it’s ridiculous.

The reason for this is very simple. Running a country of 1.3 billion people is a very tough job, and this is something these China newby articles invariably overlook. In simple terms, the daily challenges are huge and are much bigger than the rulers of the US and UK have to deal with. For the most part, Chinese are not nearly as docile as Americans and Britons, and are much more “creative” about the ways they express their unhappiness. The knife hiding behind the smile or 笑裏藏刀 is a useful phrase to be aware of in business and politics in China.

In recent days a new theme has popped up, and that is the government incentives from the Chinese government are beginning to show positive results in the Chinese economy. Some of the articles are:

• Differences Between Chinese and US Economic Recoveries
• China’s Stimulus Plan Ignites Economy

The Chinese government has acted forcefully, much more so than western governments, in fighting the effects of this recession which has turned into a depression. Compared to the west, the Chinese government has been the model of efficiency.

Sources in Beijing have told me that the Chinese government has offered companies full salary subsidies for company positions. That is, they have offered to reimburse companies full salary for positions in companies, especially positions for new university graduates. I am not sure if this applies to SOEs or if it also extends to the private sector. I am not aware of the full details of how it is implemented, but it does have the ring of truth. This has created a favorable market for employers, as many companies routinely lay off 80-90% of students following the three-month probation period.

Coming back to the rising superpower theme, this serves as an excellent illustration of a major point of mine: to become a superpower, you really don’t need to have a plan for world domination. You only need to be the last man standing when everyone else has already collapsed.

It will be very interesting to find out how long China will stand? The Chinese government is running the distinct risk of using all its bullets too early, and not having any left if the depression continues over a prolonged period. If that happens, the only thing China can do is inflate its way out. Another article point out the risk of this approach:

• Is China Pulling An Alan Greenspan?

If the depression is long and this scenario plays out, then China will become a very short-lived superpower, and will only be standing a very short time before it collapses on top of the heap with the other former superpowers.

You only win when you can walk away after the battle. Otherwise it is just a pyhrric victory.

(Trouble is, pyhrric victory is a western term which does not an equivalent in Chinese.)

UPDATE Feb. 20, 2009: Knowledge@Wharton has an article about the possible ramifications of the surge in lending by Chinese banks.

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 a long time, I have been telling my friends that China is not going to use its foreign exchange reserves to bail out the US and the rest of the world. Aside from the fact that China does not feel like a superpower, it is becoming apparent with each passing day that China has very real problems of its own, and is going to have use its own reserves to help itself.

Another popular argument is that the newly rich Chinese consumers will go out and spend their yuan, helping the newly poor west out of its self-made predicament.

I have a few stories to tell you which make me doubt this.

Recently, at an apartment in Beijing, I went out to take the garbage, which is in the common area of the building near the elevators. Shortly after going into this area, I noticed that the only lights in the area, which has no windows, were two low-energy consumption bulbs on the other side of the area. Nothing else was on except for those two bulbs, including the stairwell, which was completely black and did not have any lights on. Obviously, the building management company, in an effort to save electricity, had turned off the lights to less than what I would consider safe.

So these are the same guys who are going to bail out western consumers from their problems? Hmmm….

Anyone who has stayed in China for any length of time will find small cards which have a photo of an attractive young woman smiling prettily, with a rate card and mobile phone number on the back. On these cards, the young woman will offer “massage services” with services called 西班牙骑士 and 综合保健 offered. Sometimes the cards mention that the young woman is a university student.

Now, what caught my attention recently was that their rates had gone down! The most expensive package 综合保健 or Total Healthcare Package had gone down from 398 yuan to 298 yuan. My guess is that the market was pulling back, and these young women were asking for less, at least according to my completely informal China Masseuse Index.

Then yesterday I flew from Beijing to Shenzhen. On arrival at Shenzhen airport, I took a small 20+ person bus to downtown Shenzhen. During the ride, as we were going downhill, I noticed that the bus mysteriously went silent. Then, it occurred to me that the bus driver had turned off the engine to save gasoline/petrol costs and was coasting downhill until we reached the toll booth. After we reached the toll booth, he restarted the engine, and we were on our way.

Taken in isolation, I would have said that each would at most, have been an interesting and amusing anomaly. Taken together, they paint a picture of a society which is indeed worried about the future, and is doing its best to cut expenses.

So that, from the street, is my reasoning for thinking why China will not help the west. It has too many problems of its own.

UPDATE: Caijing, the leading economics and business magazine in China, has a short report which supports my observations about falling energy demand from Chinese consumers. (h/t to Bill Bishop)

Lately, there has been much discussion about Baidu’s problems re the disclosure that they were accepting payments from makers of less than consumer-friendly products for higher rankings. David Wolf has an excellent posting about how Baidu has hurt itself in the public relations battle, with some significant assistance from CCTV and Google. According to David, Google China has positioned itself to benefit from some advertisers who eschew Baidu’s former position of accepting money for high positioning, without taking a second look at some of those companies which paid for those high rankings.

On one level, Baidu is a victim of its own success. Search engines are really mapmakers: they show what’s in the neighborhood. In its early days, before Baidu became pervasive, it may have been alright to take money for businesses to show up on the map without caring too much about the reputation of the business. After all, search was a comparatively new thing, and Baidu, not yet public, wanted to grow as fast as possible, both in terms of its indexes and database, and in financial terms. But now, everyone knows what a search engine does and expects it to basically tell the truth. And if it doesn’t, they are shocked and outraged. (Whether this is real or feigned shock and outrage is another story. We’ll get into that later.) Unfortunately, Baidu’s management failed to take into account their own success, and failed to make the transition to a more open, fair, ethical and transparent model before it became a full-blown shitstorm. Making the change would have hurt the company’s earnings, something Wall St. analysts would not have taken to kindly, so they were stuck. Instead of acting proactively, they took the other path, which was waiting for something to happen to them.

And it happened.

So does this mean the beginning of the end of Baidu’s erosion as search engine market leader in China? Actually, it’s not that simple.

Ultimately, it depends on Robin Li, Baidu’s CEO, and how he chooses to handle Baidu’s salesforce, who have aggressively brought in the bacon so that Baidu would look good for its investors and Wall St. The big question for Robin Li is: “How can he rein in his salesforce just when he needs them the most?” The Baidu salesforce is the main differentiator for Baidu; it has been able to sell keywords to China’s SMEs, getting it far greater penetration than Google in the Chinese tier 2 and 3 cities and in the countryside. Can you imagine Robin calling in his salesforce and telling them to do business and background checks on customers? That would be a very good way to get your salesforce to rebel in a split-second! Can he afford such a rebellion just when global economies and markets are tanking and Chinese are cutting back on spending, and when Baidu is expanding aggressively into e-commerce and other fields?

I don’t think so.

But then, it’s a stalemate for Baidu’s salesforce too. It’s not like they can up and leave and go to Google China, taking their clients with them. Sure, Google China likes the sales numbers they generate, but they cannot accept their sales practices.

Checkmate.

That is why the only thing Baidu can do is stay quiet, and hope the crisis is soon forgotten by its SME customers, and the wider audience, and can get back to business as usual. Of course, Baidu’s challengers will do their best to keep the issue in the public spotlight as long as possible. That is what the public relations battle which is now shaping up will be all about.

Baidu’s strategy of hoping that the issue will be soon forgotten is not a good strategy, but it’s the only strategy left in the eyes of their current management. But a strategy based on hope is not really a strategy, especially when you are under attack.

It’s time for a change.

If Chinese companies were more like most publicly listed US companies, somebody would step forward and take the knife, setting the stage for widespread change in direction and a whole new team. (Except if you are one of the Big Three from Detroit or a Wall Street banker. But, for the most part, those industries are exceptions and their gravy days are over.)

And that is why Chinese companies cannot make dramatic change, just when they need it the most. And, in short, that is why Chinese companies will not become global leaders.

I have mentioned earlier that I have spent the past few months working on setting up an IAB (Interactive Advertising Bureau) Greater China. Recently, there have been some major developments. But before I get into those, I would like to talk about what I have learned.

IAB is set up as a non-profit business association for the digital advertising industry in each country market. Its mission is to enhance revenue growth by working with advertisers, ad agencies and media by reducing business friction. It does this by promoting standards and practices which make it easier to push out campaigns, measure results, and to optimize campaigns. Sometimes, IAB also plays a role as an industry advocate with the various governments and organizations (such as the European Union).

In China’s case, the most important issues in the near term have to do with standards for ad formats. The market is fragmented, which means that advertisers and ad agencies have to deal with multiple ad sizes, formats and naming conventions. This makes it that much more difficult for media planners and buyers and advertisers to get meaningful results from their interactive campaigns. Human energy and attention span, which are always in short supply, have to deal with mundane instead of more important practical issues.

The way IAB deals with these issues is to set up task forces and committees so that industry players can talk about, then propose standards to resolve these issues. Companies which are competitors in the marketplace first recognize the problem, then work on proposals for common standards to resolve these issues. After review and approval, they become IAB standards.

An important part of the value proposition for an IAB Greater China is to bring in a process of open discussion about standards, proposals and review for this industry. My discussions have shown to me that this is something Chinese companies would very much welcome, just as much as western companies.

In China, it’s always important to have the relevant government agencies in the loop, and I’m happy to say that after explaining what IAB does, they understand and even support its goals.

So let the process begin!

Major Developments

There has been major progress on bringing in some major players as board members and members of IAB Greater China. The paperwork has not been finished yet, so I am not free to say more, but it would be safe to say that there will be important announcements coming out soon.

November is going to be a busy month.

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.