The China Vortex

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

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

The whole idea of an urgent politburo meeting just three weeks before the Beijing Olympics is a strong indicator of how serious the ruling levels of the Chinese government see this situation and would, in my opinion, be an ominous sign.

All of the signs point to an economy which is rapidly deflating, following on the falling performance of the Shanghai stock exchange, which has fallen more than 50% in the first half of the year. A lot of money which people thought they had made, and did not think of converting into cash thinking that it would go higher, is no longer there.

In China, this is always a warning sign of potential social instability. It also explains a lot about why the Chinese government has introduced new licensing regulations for online video and other communications means where people can communicate quickly, spreading views contrary to the official line, and events can quickly spin out of control.

If the Chinese economy deteriorates, as signs suggest, then it would be safe to say the government controls would tighten further. This would especially be the case in areas where foreign investment capital has gone into sensitive media sectors, which is always viewed with some degree of suspicion by the Chinese government.

Technorati Tags: Beijing, beijingolympics, capital, China, Chinese, communications, community, economic, economics, economy, events, exchanges, government, investment, licensing, money, news, olympics, online, people, prices, regulation, shanghai, social, stocks, travel, video

The Chinese government has done much to encourage the development of China’s west, particularly Sichuan province, which is the home to some 100 million people, making it larger in population than any single western European country, including Britain, France and even Germany.

From a business and consumers’ point of view, the region holds tremendous promise. Many large western companies, including Intel, Wal-Mart, MacDonald’s and KFC have all moved into the region in the hope of capturing some of the yuan which locals have to spend. From a consumer marketing point of view, and also from the manufacturing point of view, the region holds great promise.

However, this is still not enough. Compared to the east coast region’s of China, it is still far behind.

So what is holding the region behind in development?

In two words, it’s human talent. “Interesting places attract interesting people” is one of my favorite mantras. When I go to a place, I like to find interesting people, regardless of their profession, and listen to what they have to say. I look for different angles and insights from individuals which I cannot easily find elsewhere. Most of the time, I think of these people as very smart generalists.

My experience is that Shanghai and Beijing is full of interesting intelligent and very talented people, which is why I’m attracted to these two cities in China. They are evolving rapidly, which means that these cities have not yet congealed around certain professions in the way American or European cities, or even Hong Kong, have. They are full of surprises, and most of the time, these are pleasant surprises.

My theory is that these two cities draw the best Chinese talent away from the rest of China, leaving the other cities to struggle with the people they can convince to stay there, who usually are not as smart and talented. So, when Chinese or expats talk about Tier 1 cities (Beijing and Shanghai), they could just as easily be talking about quality human talent.

This creates a problem for western China: they have the consumers, and they can have good manufacturing up to the middle of the value-added chain, but they cannot catch up with Beijing and Shanghai at the top of the value chain.

Unless cities like Chongqing can figure out a way to keep the best human talent in Chongqing, the wealth and knowledge gap between the western part of China and the Tier 1 cities will continue to widen. Instead of climbing to the top, they will peak out around the middle and won’t make it into the ranks of world-class cities.

What the Chinese government, and most other governments, fail to understand is that it is not buildings, boulevards and museums which make cities world-class, it is very literally human talent. In spite of China’s huge population, I have only seen two cities, Beijing and Shanghai, which have the potential to make them world-class.

While some Chinese may take this as a slight, it’s worth remembering that the US, which has only 1/4 the population of China, but has a longer history as an economic superpower, has only three cities which can be classified as “Tier One”: New York, Los Angeles and Chicago.

There must be some undiscovered rule which makes this the case.

Technorati Tags: Beijing, chicago, China, chongqing, development, economic, economy, human, losangeles, newyork, population, shanghai, sichuan, talent, US

This week’s Economist has a lead article and section on “The New Colonialists” which covers China’s expansion and search for natural resources on a global scale.

For many Chinese, being equated with colonialism is a bad thing, because Chinese have historically seen themselves as victims of colonialism, having had Hong Kong taken away by the British, and the Unequal Treaties with the leading European powers in the 19th century. When the Chinese see themselves portrayed as new colonialists, they go into hedgehog mode, curling up and sometimes fighting back against their western critics who are criticized for not understanding or being sympathetic to the Chinese point of view.

This kind of attitude is not helpful for the western critics, and is not helpful for the Chinese. The issues are real, and they are too serious to be trivialized, and for people to get into nationalistic shouting matches. The effects are huge, as they will affect the overall health of the planet.

Over the past thirty years, China has adopted an open economic development policy to raise the standard of living of the Chinese people. This policy has been enormously successful, unleashing the traditional Chinese ethics of curiosity about technology, thriftiness and hard work to elevate their standard of living dramatically. Today, China has the second largest economy in the world, trailing only the US, which is now currently undergoing a dramatic readjustment following the growing subprime mortgage debacle.

The party has been forcefully pushing a policy of development, and more significantly, urbanization of China, and plans to move more and more Chinese into cities. Throughout its long history, China has traditionally been a country mostly made up of farmers, engineers and small business people. The plan is for many of the farmers to become cityslickers, eating at restaurants, taking subways, and working in office towers.

The trouble with having so many big cities is that they are huge consumers of energy, which is why China now has to go overseas to satisfy this huge demand. Securing energy resources also means getting entangled in the affairs of many countries which are frankly, not very well-run. This in turn means that the country’s foreign policy has to feed its energy needs.

This is how America’s foreign policy and domestic energy policy got so screwed up. In Washington DC and across the nation, there is a strong and influential pro-Israel lobby, while the country depends on many middle-eastern countries which are hostile to Israel for its energy needs. These contradictions are unresolvable, and have resulted in the rise of middle-eastern terrorism and eventually in the 9/11 attacks.

Seeing these problems, it would seem to make sense that the Chinese leadership would find a new model for China’s economic development which did not depend so much on an outdated 19th century European mercantilist model for economic development in the 21st century.

Technorati Tags: , China, Chinese, development, economic, economy, energy, resources

Over the past few years, one subject has dominated Chinese thinking on the government and enterprise levels: how to take Chinese brands global. During the runup to the Beijing Olympics in 2008, and then the Shanghai Expo in 2010, this subject will become even more popular, as China’s economic power grows and the US’s economic dominance gradually recedes.

So far, the thinking is that Chinese companies, with some degree of Chinese government assistance, should buy leading US brands and manage them. This was the thinking, for example, behind Lenovo’s purchase of IBM’s money-losing PC division and the Thinkpad brand in 2004. It was also the thinking behind the aborted CNOOC purchase of Unocal, an offer which had to be withdrawn because of heavy US congressional pressure over security.

Outright purchases of foreign companies, in the form of hostile takeovers and mergers rarely go well, even when the cultures of the two companies are close. When they are as far apart as Chinese and western companies, the odds are overwhelmingly stacked against success.

Now there is renewed interest in buying western companies for yet another reason: the Chinese government is sitting on US$1.3 trillion in foreign exchange reserves, and with the dollar falling against the euro and other major currencies, there is strong pressure to invest this money in something else besides US dollars, which will continue to depreciate. In order to slow down this depreciation, the Chinese government has announced that it will establish a Chinese sovereign wealth fund to invest about US$200-300B in higher-yield investments. Within the past year, sovereign wealth funds have proliferated as foreign governments seek to diversify their foreign-exchange reserves out of US dollars, especially as the US subprime mortgage lending crisis has spread overseas.

For the Chinese government, which likes to do great projects which it can then use in PR to the Chinese people, there is a fundamental bottleneck: there are not enough Chinese who have international experience managing global companies. And those who do have the skills usually decide to spend their time and effort in the private sector where their skills are more needed. In one article some time ago, Business Week claimed that China needed about 75,000 international executives while there are only 5,000 available.

There is another problem with creating global brands: in most sectors, it takes an awful long time to create them. If you look at Toyota in the automobile sector, it has taken the company mostly since the period from 1945 to become established as a leading quality maker. When it comes to manufacturing, global brands are not made, they are earned on the basis of quality products.

The place where brands have sprouted relatively quickly are in the computing and hi-tech sectors. Apple has been around since the 70s and has undergone a dramatic rebirth under the tutelage of its founder, Steve Jobs, who returned in 1997 after Apple’s acquisition of NeXT. Since his return, he has launched the iMac, iPod and now iPhone lines, all of which have won critical acclaim from users worldwide. Steve Jobs has shown that he is that rare type of executive, someone who learns from his mistakes and is passionate about creating excellent products. Now, even for dedicated Windows computer users, Apple’s products are something worth thinking seriously about. When it comes to evoking pure passion among users, there is no company like Apple. The way Apple has launched the iPhone globally has shown that it fully understands how to use the power of the Internet and the media to create global attraction for its new products at very little cost. On October 26, the company will launch its latest version of the OS X operating system, Leopard.

The company’s success has been rewarded on Wall Street; the company now has a market cap of more than 148.2B and its shares are trading at $172.

Another company which has succeeded in creating a global brand in a relatively short time is Google, which was founded on September 27, 1998. Google started as a technology company, and has morphed into a company which understands, and is now revolutionizing the media business. Coming from a very strong technology core base, they like to constantly talk about their technology, even though that is relatively unimportant backend stuff to most people. Very early on, Google figured out that as computing, and now mobile computing grew, more and more data would be accessed from online. The question was: “What was the economic/business models which would support it?” The answer is first search, and then other formats of online advertising. Google strived to make advertising more relevant and less disruptive, and strived to do this all with its Adwords solution.

It has also been a success on Wall Street. Even though expectations were high, it blew past the estimates with its recent earnings announcement , growing the company at twice the growth rate of the growing online ad market.

While Google has continued to have a hard time succeeding in China because of strong competition from Baidu, it is performing exceptionally well in other markets. Compared to their smaller local competitors, US companies continue to have a hard time succeeding in China. Nevertheless, Google continues to make inroads in China.

When talking about large investment amounts, it is easy to forget that the most important part of the equation in brand-building is always people, not marketing dollars or yuan. Buying into Apple and Google would get an inside view into how these leading companies are run.

So what is the best, the smartest way to buy into these companies?

My guess is that the smartest way is to buy Apple and Google shares on the open market and gradually build up enough to get a board seat, where the sovereign wealth fund’s proxies could quietly learn how these companies perform, and find out who are the people who really make contributions to the company. Steve Jobs likes to create the persona that he is Apple and Apple is Steve Jobs, but the truth is not that simple.

Be a smart passive investor, not a dumb active investor. Learn to walk before you run. While it may seem a longer, slower process in the beginning, this is actually the faster, smarter and more economical way to go. Can you think of another way where you earn money while you learn instead spending big chunks?

So to sum up, the benefits of buying into Apple and Google are:

• Great place to park those extra depreciating dollars and get some appreciation
• Great way to learn how digital online products and brands are made
• Great way to find out who the smart movers and shakers are
• Great way to learn how to become a smart passive investor

If the sovereign wealth fund is doing what they were set up to do, they are already buying Apple and Google shares.

Now that would be real smart…

Technorati Tags: Apple, brand-building, brands, business, China, crisis, dollar, economic, funds, global, google, investment, media, mortgage, sovereign, subprime, US, wealth

Rebecca McKinnon has a very interesting post at her blog “Thomas Friedman gets the middle finger in the Middle Kingdom”, which was part of her coverage of the World Economic Forum at Dalian.

During a panel, Thomas Friedman, author of The World is Flat, accused China of being a “free-loader” while the US carried the heavy load of being a “global guardian”. I really love the term “global guardian”; what does it mean? Does it mean that the US is protecting the globe
from an attack by Mars? Or Jupiter? Or is it some unknown Deathstar which we don’t know about? Does it mean that Beijing is keeping this a secret from the rest of the world so that it won’t have to publicly acknowledge this enormous debt to Washington DC?

Who defines the role of “global guardian” and the role it involves? It takes a lot of hubris even to bring the phrase up. How would you react if your spouse calmly announced that he was the “global guardian of our world against evildoers who want to destroy our way of life”? I think you get the drift…

Then in the post,

Friedman also argued that it’s in China’s interest to work more directly with the U.S. on geopolitical issues because if the U.S. fails, then China will have to pick up the pieces. “If there is too little American power China will be forced to respond to that,” he said.

Now I get it, Beijing is supposed to change Washington DC’s diapers when it makes a mess! So now Beijing is going to be the “global diaper changer” when the “global guardian” has… well, nevermind.

Unfortunately for Friedman, Sha Zukang, told the audience that the Chinese government is not anxious to assume this new role.

Sha rejected the whole idea of “soft power,” calling it a “condescending approach” and “notion created by Western developed countries.” When it comes to world leadership, he said the world’s leaders should not be “self-proclaimed” - he said they should be elected. China, he said, would not self-proclaim itself a world leader, because China’s policy is always to treat other countries as “equals.”

Translation: “Let’s take responsibility for changing our own diapers, instead of expecting someone else to do it for us.”

Another very interesting viewpoint put forward by Clay Chandler of Fortune magazine is that now that China is a world power (I really love the way the words “world” and “global” are thrown around), Chinese politicians are still giving boring speeches. Of course, American politicians never give boring speeches; I’m sure that any intelligent reader of this article can recite all the speeches of George W. Bush and the Senate and House heads by heart. Yes, I too, am deeply disheartened that Beijing has not announced plans to stage a pre-emptive attack against Mars so that the “global guardian” can at least take a small rest and enjoy a cup at Starbucks.

Seriously though, Friedman’s criticism of Chinese policy is, at its very least, an acknowledgement that the US has not been able to carry all its burden by itself and needs help. In this light, it should be interpreted more as a plea for help and assistance for the global guardian than as a rebuke of current Chinese policy.

In the article, Rebecca recalls:

A couple years ago a Chinese academic who advises the Chinese government on foreign policy issues told me that the best way for China to build global power, good will, and international credibility over the long run is to mind its own business, avoid criticizing the U.S. whenever possible, sit back and let the U.S. destroy its own power and credibility by itself.

There is a strong argument to be made that it isn’t so much that China has risen quickly out of seemingly nowhere, but that China’s growth appears accelerated because of rapid American decline. Put it this way, if China is riding an up escalator, and the US is riding a down escalator, at some point they will pass each other at an intersection point.

The only question is “When?”

Now the question becomes whether it is a good thing to accelerate decline. Wall Street routinely rewards companies which make dramatic management changes when they are in decline. The thinking is that it is better to make dramatic, even wild, changes in the face of falling sales and market share. Share prices go up even before the results of those changes become apparent, based on the hope that the new management can make the changes necessary. Wall Street is hoping for a happy ending, even though most of the time it doesn’t work. Doing something, even if it is madly wrong, is better than doing nothing when confronted with a bad situation, according to Wall Street. Then, when the company has hit bottom, it can either be acquired or claw its way back to recovery.

My question is whether this same rule should be applied to countries and governments? If the US is in a state of systemic decline, is it better to accelerate the decline, so that the country can eventually climb out of the mess it is in? The problem with this approach is that when a company screws up, a few hundred thousand people lose their jobs.

The problem with a country, especially one as big and powerful as the US, is that no one knows what the bottom looks like.

For this reason, the slow erosion and decline of American power will continue.

Technorati Tags: Beijing, business, China, dalian, economic, forum, friedman, geopolitics, global, guardian, mckinnon, rebecca, sha, thomas, US, usa, world, zukang

If there is one thing which never ceases to amaze me, it’s the sheer number of overseas investors seeking entry to China, who have a hard time seeing past the most basic facts and figures about the size of the Chinese market.

Most of these firms are American, which are, generally speaking, more addicted to numeric data than their European and Japanese counterparts. Some statements they frequently quote are:

• The number of mobile phone subscribers in China is now greater than the US;
• China is now the world’s second largest auto market, trailing only the US;
• China’s demand for oil imports has far-reaching influence far outside its borders;

Looking at China’s economic statistics in these terms, it is very easy for executives who have little or no experience selling products outside their own home markets to think that the potential of the Chinese market is something which will fund their own retirement nest eggs.

The great danger is that more often than not, they are unable to see past these initial assumptions about the Chinese market on the board and senior management level. In fact, as many learn to their own dismay, the Chinese market is complicated, filled with traps to capture uninformed executives who fail to grasp the difficult realities of China’s markets.

Let’s take a look at some of these wrong assumptions, followed by the facts:

• “The size of the Chinese consumer market is huge.” (True, but for the most part, there is no single national market and no way to distribute nationally; you need to negotiate deals city by city and province by province. Every city and every province wants its own unique distribution deal in order to have uniqueness in the marketplace. The main problem is not high costs, but the amount of time it takes to roll out. While the customer numbers may be huge, revenue per customer/user are usually in fact very low in the beginning for most sectors compared to other more developed markets.)
• “If I partner with a company with national distribution, then my job will be easier.” (True, but the companies which take on partners are usually the ones who are in trouble. Many of these are state-owned enterprises which lack business marketing skills, and are trying to translate their monopoly charters into revenue with the foreign partner’s help.)
• “Our product is so good that it will market itself”. (If you believe your own PR in this regard, your company deserves to fail.)

For the most part, the most successful companies in China’s emergent consumer market economy are firms like Suning (in consumer electronics), Shanda (in online gaming and entertainment) and Suntech (in solar energy).

What do these companies have in common? They are new, and while they did have some government backing and connections in their very early stages, they have now transformed themselves into privately-owned businesses with their own management team and CEO. For the most part, these companies are very centrally managed by their founder/entrepreneur. Unless a foreign company is able to present a very strong case for partnering with them, they will prefer to build and distribute on their own. Why should they share their profits and revenues with another company, and help to build another brand which may become a future competitor? After all, that’s how they became dominant in their own sectors; they’re not about to make the same mistake themselves.

As China’s economy becomes more market-oriented, China’s state-owned enterprises are struggling to define their roles in this new economy. It is not enough to have a government-granted monopoly charter; they need to become profitable. This pressure for profit usually comes from the Chinese government’s State Council, which is China’s cabinet.

Their preferred solution is to set up a joint venture with a foreign company, which injects startup capital since the Chinese government, as a matter of policy, does not inject capital into joint ventures, instead offering other fuzzy stuff like “markets” and “connections” into the joint venture.

Most of these joint ventures fail because the two sides fail to do the hard work to insure that there is a complete alignment of interests and accountability for their investment in the JV. Most of the time, I blame the foreign partner’s inability to see past the market hype and think and discuss the whole project through with the Chinese government partner and clearly defining which partner has responsibility to perform what needs to be done.

The endless procession of foreign companies who come to China and throw good business sense to the winds without performing proper due diligence in order to secure a footing in the “China market” never ceases to amaze me. Why is it they seemingly only do this in China? Do they think that the Chinese will throw them out of the country for asking good legitimate business questions?

Chinese SOEs are in particular need of modern management skills, especially in the areas of marketing, sales and cost accounting. Foreign JV partners would in fact be helping the Chinese companies reform by holding them accountable to reach specific business goals. The SOEs have strong connections and resources in a potentially large market.

It is only when both sides are honest about their goals and expectations that they can succeed.

Technorati Tags: autos, board, business, China, Chinese, data, diligence, due, economic, economy, facts, global, interest, investment, investors, joint-venture, management, market, oil, phones, Shanda, SOE, Suning, Suntech, US

This is the opinion of Paul Craig Roberts, who previous served as Assistant Secretary of Treasury during the Reagan administration, and is often quoted as the “father of Reaganomics”. (You can read the Wikipedia entry about him here.)

Recently there has been discussion about China’s threat to use the “nuclear option”, or and basically destroying the value of the US dollar as a global reserve currency by dumping more dollars on the markets than they can absorb in a short time, forcing the dollar into a free-fall.

The prevailing wisdom among US economists is that China would not make such a move, as the damage to China’s own economy would be too great. Roberts rebuts this claim saying that

American economists make a mistake in their reasoning when they assume that China needs large reserves of foreign exchange. China does not need foreign exchange reserves for the usual reasons of supporting its currency’s value and paying its trade bills. China does not allow its currency to be traded in currency markets. Indeed, there is not enough yuan available to trade. Speculators, betting on the eventual rise of the yuan’s value, are trying to capture future gains by trading ‘virtual yuan.’ The other reason is that China does not have foreign trade deficits, and does not need reserves in other currencies with which to pay its bills. Indeed, if China had creditors, the creditors would be pleased to be paid in yuan as the currency is thought to be undervalued.

In addition, he refutes the claim that China would lose US markets with such a move.

The notion that China cannot exercise its power without losing its US markets is wrong. American consumers are as dependent on imports of manufactured goods from China as they are on imported oil. In addition, the profits of US brand name companies are dependent on the sale to Americans of the products that they make in China. The US cannot, in retaliation, block the import of goods and services from China without delivering a knock-out punch to US companies and US consumers. China has many markets and can afford to lose the US market easier than the US can afford to lose the American brand names on Wal-Mart’s shelves that are made in China. Indeed, the US is even dependent on China for advanced technology products. If truth be known, so much US production has been moved to China that many items on which consumers depend are no longer produced in America.

Roberts then builds a case for China’s dumping dollars as a reaction against US pressure for revaluing the yuan, refuting claims that this is an impossible scenario.

Consider that if China were to increase the value of the yuan by 30 percent, the value of China’s dollar holdings would decline by 30 percent. It would have the same effect on China’s pocketbook as dumping dollars and Treasuries in the markets.

Consider also, that as revaluation causes the yuan to move up in relation to the dollar (the reserve currency), it also causes the yuan to move up against every other traded currency. Thus, the Chinese cannot revalue as Paulson has ordered without making Chinese goods more expensive not merely to Americans but everywhere.

Compare this result with China dumping dollars. With the yuan pegged to the dollar, China can dump dollars without altering the exchange rate between the yuan and the dollar. As the dollar falls, the yuan falls with it. Goods and services produced in China do not become more expensive to Americans, and they become cheaper elsewhere. By dumping dollars, China expands its entry into other markets and accumulates more foreign currencies from trade surpluses.

Basically, Roberts makes a strong case for the argument that the US no longer has leverage over China and global financial markets the way it used to. You can read his whole article here.

Have we reached a tipping point in American power and global influence?

Technorati Tags: Beijing, China, Chinese, deficit, dollar, economic, economy, Fed, global, information, interest, rates, research, trade, US, yuan