What Happens To E-Commerce When Credit Cards Don’t Work?

October 9th, 2008

During the past several years in China, I have spent a good deal of my time explaining to Americans that e-commerce solutions do not have to depend on credit cards. In many parts of the world, such as Germany and Japan, and in China, e-commerce is about building payment gateways to different banks using debit cards or other devices which connect directly to bank accounts.

This was how Paypal started in the US. It is also how Alipay, Yeepay and other solutions work in China. Tencent, a company with a market cap of US$80B, based in Shenzhen uses a subscription payment system which also deducts payments directly from users’ accounts.

As the global Ponzi scheme which started as the subprime credit crisis continues to unwind, defaults on credit cards in the US will shoot up.

In the near future, credit will be given out much more sparingly. American society will very quickly change from a credit-based society to a cash-based society for most transactions. But there will be plenty of honest people who will need to buy, and sometimes they will want to buy online. If they don’t have access to credit and credit cards, how will they buy?

When you think about it in these terms, many of the payment solutions developed in China look more interesting, not just for China, but adapted to suit the needs of Americans who no longer have credit. Most likely these won’t be Chinese companies, but American e-commerce firms who want to develop something suited for Americans and the American market.

So which American company would come out with a non-credit card based payment solution? My guess is that it would be the leading e-commerce company, Amazon. I’d bet they are working on it right now.

Understanding the Global Financial Crisis

October 7th, 2008

Book cover of
Book cover via Amazon

One of the greatest challenges for the American system of government, and which has been laid bare by the current financial crisis is: “What do politicians do when their constituents ask for something which will win them votes in the short-term, but will prove disastrous in the long-term?” This is a very important question which has not been discussed or debated enough. Instead, most westerners naturally assume that it is better, especially when compared with China’s form of government.

Jack Perkowski, author of Managing the Dragon, has several posts on his blog which talk about the reasons and decisions for the current global credit crisis. They are the best explanations I have seen so far for what is happening and I highly recommend reading them.

For Chinese, home ownership is very important, just as it is for Americans. But Chinese would never think of asking the government to pre-approve their purchases regardless of their credit ranking. In fact, so far, there is no national credit-ranking system in China and many families save hard to make a down-payment for their home (which most Americans would call an apartment). Along with saving for their child’s education, this is the single largest expenditure they will make in their lives. Most RE transactions are cash transactions. And what is most interesting is that the private home ownership ratio (by percentage) is higher in China (70-80%) than the US’s 69% (source: Hoover Institution), even though the US had a system which, until very recently, offered free housing to all comers, without any qualifications. Very ironic that a country which is nominally Communist has a higher rate of home ownership than a country which has a free elected government and until recently, actively subsidized home ownership up to 100%, isn’t it?

This then raises a very good question: “If China has a higher home ownership rate than the US without offering junk loans which have led to the global credit crisis, then what was the whole point of the US incentive schemes, of which Fannie Mae and Freddie Mac, as well as the leading investment banks were such an important part of?” Jack Perkowski’s articles answer this very well. You see, the US built an ecosystem which turned banks into sales outlets for loans, then bundled these loans up and fed them to the global markets, where they are now causing so much grief.

Politically, and on the legislative level, this was part of a complex scheme which, at the end of the day, amounted to buying off different voting constituencies to win their votes. Which is a fancy way of saying “vote buying”.

With all the overbuilding which has happened in China’s cities, I would shudder at the thought that many of these residences were pre-approved without down payments the American way. This is why although there is overbuilding, the Chinese economy can still ride out the dips better than the US and global economy can.

Looking at the US now, it shows the danger of letting legislators who do not understand the economic consequences of their actions have too much power over complex economic issues.

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The New Investment Rules For China

October 5th, 2008

Following on the global credit crisis, many have come to me to ask how these changes will affect China. As I have said earlier, China and the US are two sides to the same coin, and it pays to look at them as one economy, as this Newsweek article does. It goes without saying that this crisis will have a profound effect on China, and I’m not optimistic about the capability of the Chinese central government in Beijing to deal with it as quickly as it should. Michael Pettis, who lives and teaches in Beijing, has been a persistent advocate of stimulating more domestic spending from Chinese consumers, and continues to advocate that position. I agree that this is necessary; I don’t think that this will happen quickly or on an even basis. There is a simple reason for this: stimulating consumer spending depends, to a large extent, on the rollout of a national healthcare system; this is something which Beijing has tried to do since the early 90s, all without success. When it comes to the lack of a national healthcare system, the US and China are in the same boat, and the national governments are equally ineffective.

So what are some investment rules you can use? Let me list seven below:

  • Avoid Shanghai and Beijing. Both have excellent universities, and Beijing has central government ministries while Shanghai is the commercial capital of China. In IT, companies have preferred to hire from Tsinghua for smart technology people. But there are major problems with both cities. First of all, staff turnover is too high, and costs are too high. In the past few years, staff have routinely asked for 20-30% raises just to stay in the same company! And with all the western companies constantly going into those cities, there has been a bidding war for staff. We are in tough times now, so do you really want to get involved in bidding wars over your local staff and deal with staff turnover issues? I don’t think so. And when it comes to Internet/IT, I say that the Internet already has become a platform and there is plenty of talent around. Do you really need expensive people from the very best universities in China who may prove a pain to manage? If you don’t, second-tier people who are reliable and don’t ask for huge pay raises are good enough, and maybe even better. When hiring local talent, look for tortoises, not hares. We are heading for much tougher times, and you need a good stable team. Beijing and Shanghai have too many hares. Your most loyal people will be the ones you hired and trained on the job. They will also be the ones who understand local market and conditions and connections.Another major issue about Beijing and Shanghai is that they are geared for exports, especially to the US. Do I need to tell you what happened to that export market?
  • Instead of going to Beijing and Shanghai, look at the 20 major city markets in China if you are thinking of selling to Chinese consumers. Now is a good time to get into services for Chinese consumers. Think of cities like Dalian, Hangzhou, Ningbo, Xiamen, Guangzhou, Wuhan, Nanchang, Chongqing, Chengdu, Fuzhou, Kunming, Nanning, Nanjing, etc. If you want to get into China under the radar (in my opinion, always a wise strategy), these are places to look at very seriously. If you need knowledge workers, as in programming or game production or pharmaceuticals, pay special attention to the local universities, and partnering with them to hire their graduating students. If you show the cash and commitment, and can guarantee jobs for their students, you will get multiple offers of good deals.
  • Guangdong and Zhejiang are the two largest manufacturing provinces in China. Guangdong’s factories depend on a huge pool of unskilled immigrant laborers, mostly young women, from Sichuan and other provinces. These factories and workers are going to be hit hard because of their dependency on the US market. There is too much overcapacity, too little value-added, and too little profit for most of these factories to move up the value chain. Unemployment in Guangdong and Sichuan will become a major issue. Zhejiang’s factories are mostly family-owned, and it has less reliance on immigrant workers. Because of Zhejiang’s strong private sector and private wealth, they will be able to make the adjustment in market demand from exports to domestic Chinese consumption more quickly.
  • If you are a private equity or hedge fund investor, you need to think about investment horizons. In order to make up for the dropoff in exports, Beijing and provincial governments would naturally think of investing more in infrastructure. So far, most of this money has gone into infrastructure, manufacturing and real estate. The problem is that these areas are already built up and have over-capacity. They are really at a loss about what to do. If you can help and offer investments which create jobs and upgrade the skill force, you are in a good position. Be sure to get your money and profit back within 15 years (by 2023). That is because if you are selling to Chinese consumers, you are selling to the current group who are in their 20s – 40s. By 2023, China’s demographics will fall off a cliff because of the one-child policy, and they will be in savings mode instead of spending mode.
  • When it comes to modernization, China is crossing a 30-foot chasm with a 20-foot rope, with each foot representing one year. China’s hardware development and infrastructure are very impressive and are the most modern in the world, as the Beijing Olympics showed. The hardest part to modernize is peoples’ mentality as the tainted milk scandal has shown. China’s aging demographics do not give it enough time to cross the chasm, so Chinese will get old before they get modern. When that happens, China will look like a bigger version of Japan, and will have all the problems Japan has today. Just hope that China has a national healthcare system in place by then.
  • The wealth gap will become wider over the next 10 years between the cities and the countryside, then stabilize for five years, then shrink as the city worker bees retire in 15 years. Rural infrastructure is less developed, and so far, the Chinese government has made all the wrong moves in rural development by not supporting the development of rural collectives for the farmers. There is an excellent article (in Chinese, h/t to Stan C) about the failure of China’s rural development, and how Chinese rural development will look like the Philippines with large food processing companies employing poor farmers. This organization is partly responsible for the Sanlu tainted milk scandal, and is copied from the US. But the US has a surplus of land and shortage of farmers, while China has a shortage of land and excess of farmers! If you are interested in macroeconomic issues, this is worth more study. Its view converges very well with the view of Yasheng Huang in his new book Capitalism with Chinese Characteristics, which I have also mentioned in my previous article.
  • The dumb money has already been made in China. It’s time to rebalance your portfolio to make smart money. It can be done, but it won’t be easy. Think smart, work smart, and invest for 15 years. By that time, you should be able to retire.

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The New Value Economy Arrives

October 2nd, 2008

What a difference a month makes!

Just a little more than a month ago, China was basking in the afterglow of the Beijing Olympics, and the US still had an investment banking sector. Now, all China news has been taken up with tainted milk scandal, and the US consumers have changed from spendthrift junk-buyers into wondering whether they will have enough money to buy Campbell’s soup. (Last Monday, when the Dow went down 777 points, Campbell Soup was the only stock to go up. Can you say dark days ahead?) At the same time, Americans have come close to openly rebelling against the Bush administration-backed Paulson plan to bail out the banking sector and create liquidity in credit markets.

In the meantime, economists and politicians are debating whether this is the beginning of a recession or depression. Let’s just say that it’s going to be bad.

In China, the bad has different roots, in how the dairy industry has been systematically thinning milk, then loading it up with melamine so that it doesn’t look protein-deficient (it is). In fact, the problem is systemic, and is not just limited to the dairy industry. This is something which runs throughout Chinese society on a wide systemic basis because local officials are judged only on quantitative results instead of quantitative and qualitative results.

Wall Street and China took different paths, but both ended up with the same sack of shit. The trouble is that this sack of shit affects the whole society in both the US and China, and the rest of the world.

Now, if the problems were not systemic, all you would have to do is hire a PR firm, and they would quickly put together a PR campaign, the public would gradually forget, and everybody would get back to their merry business.

But it’s not that simple.

Recessions/depressions are like forest fires; they destroy a lot of the accumulated undergrowth and excess, providing an opportunity for new growth. We are now going through such a forest fire. It is likely that it is only just beginning. But it is worth thinking about what are the new flora and fauna which will grow and flourish in the environment which comes afterwards.

Here are my thoughts:

  • Transparency will be the rule instead of the exception. Instead of talking about quality, companies and government officials will need to show it.
  • The Internet and modern IT will turn into a transparency enabler. Think of webcams in dairy processing and manufacturers’ plants in China which anyone can log into anytime. Think of US members of congress listing all the contributions they take and publishing their meeting calendars, live and online.
  • For companies, proof of quality. This means that it won’t just be ads and PR. They will need to show how they create quality. A big question for service companies: “How do we show quality in what we do for our customers?”
  • Creating quality is no longer a one-way communications process, it will be two-way. Consumers will challenge the companies and governments, and they better have good answers ready. Smart companies will think of ways to weave some of the criticisms into product/service input and incorporating it on a near real-time basis.
  • We are witnesses to the crumbling and collapse of an old way of doing things, and the rise of a new way. Education systems all over the world have not prepared people for this, especially the business schools. If you are a newly-minted MBA, good luck!
  • An awful lot of companies in China are not going to make it. Many of them don’t deserve to make it. But there will be refreshing new companies with new ideas and who are committed to quality and value. Most of them will come from the private sector. Keep your eyes on Zhejiang for new ideas, companies, products and services! In my opinion, Beijing and Shanghai are vastly overrated and are not truly representative of China. They are still like the Treaty Ports of old: they have enough Chinese to make westerners feel like that they are in China without having to make a major adjustment in lifestyle, and enough ministries and public buildings to make the Chinese officials feel comfortable and in control. The relentless drive to lopsided urbanization at the expense of the countryside which Yasheng Huang puts forward in his book Capitalism with Chinese Characteristics: Entrepreneurship and the State, is a view which is sometimes discussed among Chinese, but which most westerners are not aware of. China is just now beginning to pay the very high price of this lopsided development.
  • There is going to be a lot of money to be made in helping the old companies make the transformation to the new value economy. Most of them won’t make it, but they are going to spend a lot of money trying. If you’re in change management and know how to market, you’re going to make a killing.
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Quality Fade: American or Chinese, Which is Worse?

April 5th, 2008

Paul Midler is an experienced sourcing expert who has worked in China for many years, and publishes The China Game blog. I believe that he is the first person to coin the term “quality fade”. Quality fade is, according to this article published in Forbes:

This is the deliberate and secret habit of widening profit margins through a reduction in the quality of materials. Importers usually never notice what’s happening; downward changes are subtle but progressive. The initial production sample is fine, but with each successive production run, a bit more of the necessary inputs are missing.

It seems a long time ago, but last year, a great deal of ink was devoted to covering the issue of defective products from China. In some cases, lives were lost in the US.

If I have one criticism of Paul Midler’s criticism of this very real problem, it is the impression it gives that somehow unscrupulous Chinese exporters are deliberately seeking to cheat and harm Americans, when in fact, many more Chinese have been injured and even killed by defective products coming out of Chinese factories. It’s just that the US media does not pick up these stories because the victims are, well, Chinese.

But if we are going to be fair about this problem, then shouldn’t we talk about the Chinese and other non-American victims of this problem as well? I think so.

Now, when it comes to the credit bubble problem, the issue of quality fade becomes even more interesting. This time, the culprit is not Chinese, but American. For a problem of such immense proportions, which is getting bigger and bigger by the day, amazingly, no one has identified the human culprits responsible for the bad decisions. But then, accountability never been a strong point for this US administration.

In China, when there was a problem with deaths caused by tainted drugs, the head of the Chinese Food and Drug Administration was sentenced to death and executed. No one yet knows the size of the credit bubble, but I have heard numbers from $15 billion to $45 billion bandied about. Mind you, the US economy is a US$12 trillion a year economy, so we are basically talking about anywhere from 1 year to four years of economic output disappearing.

Americans are losing their jobs, many are losing their homes, and the Fed has been scared into a series of panic interest rate cuts and into subsidizing the purchase of Bear Stearns by JP Morgan Chase and offering a Fed-backed unlimited credit lending facility to US investment banks.

In this article from The Washington Note, Steve Clemons talks about how the US exported poisoned financial products.

So, while Chinese factories have on occasion exported defective products, the US has exported defective financial products. And the US government participated because Treasury sold T-bills which were backed by these defective financial instruments.

Hmmm….

Now, back to quality fade. Let’s see if we can modify his definition of quality fade to capture the credit bubble situation:

This is the deliberate and secret habit of creating the illusion of increased purchasing power through the creation of fiat credit derivatives of dubious value. Exporters usually never notice what’s happening; downward changes are subtle but progressive. The initial credit derivatives are fine, but with each passing year, lose their value as more credit derivatives are created until there is a gradual collapse and new currencies and trading rules have to be established.

(The italics are where I have made changes to Paul Midler’s original text.)

When it comes to quality fade, the Americans have been wholesalers, while the Chinese are just occasional retailers.

George Soros Speaks Out On Current Financial Crisis

April 5th, 2008

George Soros spoke today in a talk and interview about the current financial crisis which started with the subprime mortgage crisis and has now become a global credit cresis. The event was hosted by the Steve Clemons of the New America Foundation, and which hosts a blog called The Washington Note. If you are interested in an intelligent perspective from Washington DC which goes beyond the political polemics, it’s definitely worth adding to your subscription list.

The New America Foundation has made an MP3 recording of the interview with George Soros available. If you are interested in the current financial crisis and where it may eventually go, it is definitely worth listening to.

George Soros has just written and published a new book called The New Paradigm for Financial Markets: The Credit Crisis of 2008 And What It Means. Because of the rapid unfolding of the crisis, he has chosen to make the book available in digital format so that readers can get it more quickly.

The Shrinking US Economy:How Much Will It Shrink?

March 9th, 2008

The past week has shown that the subprime credit mortgage crisis in the US has metastasized into something bigger, and is spreading into other parts of the economy, and is now beginning to affect bond markets in the US. This is a worst-case scenario gradually unfolding before our eyes, and the Fed under Bernanke and the politicians seem unable to do anything to stop it, which is why they talk so little about it.

The issue made me think about something. Several years ago, a report was issued (I believe it was Goldman Sachs), which said that the Chinese economy would become the same size as the US economy by 2040 based on current trends. The key term here is “based on current trends”, something which almost never happens, as things almost never continue smoothly in politics and economics.

The present crisis in the US is causing what I call a double shrinkage. The size of the economy is shrinking as highly-leveraged credit derivatives are slowly worked out of the system. As these derivatives, which were as good as cash just two years ago, creating more money in the system than the Fed are worked out of the economy, the GDP of the US economy will shrink. It is not a question of whether it will shrink, it’s just a question of how much. That is something the market, the politicians and policy-makers are figuring out.

But it does not shrink just on the GDP level, it also shrinks on the US dollar level, which has been losing value steadily, and will likely continue to lose value as US interest levels fall. (The problem for the Fed is that although interest rates have fallen, US banks have tightened up their lending qualifications.) This means that US goods will become cheaper, and more foreigners will go to the US to buy real assets.

Roger Ehrenberg has written an excellent article about what US headlines will look like over the next 2-3 years on his Information Arbitrage blog. No wonder that even companies like Apple are looking overseas for sales growth in the face of slow growth in the US market.

This takes me back to the report which talked about China overtaking the US economy by 2040. The report did not take into account the shrinking of the US economy on both the GDP and currency levels. If the Chinese economy continues to grow and the US economy shrinks, isn’t it likely that the Chinese economy will overtake the US economy much sooner than 2040?

Of course, there are a lot of variables. Can China continue to grow at a brisk pace without a healthy US consumer economy buying Chinese exports? And what can the Chinese government do to curb inflation, which is growing faster than in the past 15 years?

We will find out…eventually.

Risk Is In The Eyes of the Beholder Part IV

January 29th, 2008

watercube.jpeg

Yesterday, the new national aquatics center was unveiled in Beijing. This will become the venue for the leading water events of the Beijing Olympics. After the Olympics are over, it will be converted to a shopping mall for Beijing’s masses.

Beijing is now the site for some of the most exciting architecture in the world. For many Chinese though, there is an underlying uneasiness. Is all this dramatic futuristic architecture the beginning of a new and exciting future of wealth and prosperity which Chinese have never experienced in their long history?

Or is this instead a blip of prosperity, and will the future be much less bright, and will their children and grandchildren look back and see the Beijing Olympics as the apogee of what has since become a downward trajectory? And will this architectural marvel become dirty and dusty and seedy?

China has seen prosperity before, only to have its dreams shattered. Westerners today see China as a rich, prosperous and growing power, but it has run into the wall before, and on many different points in history. The first Chinese industrial revolution, when Chinese factories started making goods for the Chinese market started at the end of the nineteenth century, with textile mills and flour processing factories spouting up in the Yangzi river delta, mostly started and financed by entrepreneurs from Shanghai and Wuxi. Then China went into political chaos in the period following the revolution which overthrew the Qing dynasty in 1911.

Another period of short-lived period of prosperity came in the early 30s, this was cut short by the Japanese invasion of China in 1937.

Then, in the period following the end of WWII, China fell into civil war between the two leading political parties, with the Nationalists losing and retreating to Taiwan. Following the establishment of the PRC, China was very poor, and then made even poorer by the Cultural Revolution. In 1978, the Chinese government essentially decided that they were tired of being poor and moved ideology off the national agenda. From now on, it would be about making money.

Even today though, with all their savings and comfort, Chinese feel that it can all change and all go away. That is why they save and sit on their cash.

Americans are the opposite. Until very recently, most Americans believed that the future would always be brighter, that although there were things that they did not understand, America was the strongest and most prosperous country in the world, and that there would always be a way. This is why theyspent their savings, and when their savings were gone, they would take loans on easy credit terms, promising to repay the loans and credit when they had income again. It led to a bigger and bigger mountain of debt. And now, Americans are much less sure about their ability to repay the loans.

This is a way of thinking which is completely foreign to Chinese, and makes no sense at all to them. For Chinese, the only real money is cash. And when money goes bad in times of high inflation, they don’t even believe in cash.

They believe in land, and if the politics becomes unstable, they go to gold.

Runaway inflation is something the Germans experienced in th 1920s, then again in the postwar period. Japan experienced it too in the postwar period. China also experienced it in the postwar period when the Nationalists had to change national currencies three times in the period up to 1949. With the runaway inflation in the cities, people had to carry their money in paper sacks to do their shopping. They would go to the markets carrying bags of money to buy their groceries, then they would use the same bags to carry their groceries back home.

When the Nationalists lost control of inflation, they lost the Chinese cities and the support of the business community. This paved the way for the establishment of the PRC in 1949. The first task for the government was then to stabilize the currency.

While China was very poor in the fifties, sixties and seventies, there was virtually no inflation.

Today in China, we are seeing the early signs of inflation again in food prices and property prices. For any Chinese government, and this government is no exception, inflation is the greatest single and most frightening enemy it faces. It may creep up slowly, but it unleashes forces which can easily spin out of control.

If a government cannot maintain the value of its currency, it cannot protect its citizens, and the people end up in the poor house. It’s that simple.

This is why the Chinese government will not easily revalue the yuan upwards, and why the government keeps such a tight control on credit.

One of the upsides for Chinese businesses investing in Africa is that although the people are poor, at least they pay cash. When times turn hard, you want to be paid in cash.

For most Chinese, you aren’t rich unless you own cash.

Credit is just a derivative and in tough times, no one wants derivatives.