The China Vortex

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.

Technorati Tags: China, credit, currencies, derivatives, economy, financial, globalization, instruments, lending, mortgage, products, qualityfade, subprime, trade, US

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.

Technorati Tags: credit, crisis, economy, georgesoros, globalization, subprimemortgage, US

Although Joseph Stiglitz’s book Making Globalization Work came out more than a year ago, I did not read the book until the past week. However, the book is so important that I must write about it for my readers.

For many people, globalization is a fairly black and white issue: either you are for it or against it. I have been a critic of globalization in its present form here, here and here. While a few who have commented on those articles believe that this meant I was against globalization, that is not in fact the case. I am just against globalization in its present form because all governments have so far acted in what they perceive to be their best national interests, when in fact they are acting in their own very narrow national and often, corporate, interests and have left most of their own citizens behind. This is especially true in the case of the US government which, as Stiglitz outlines in this book, has acted mostly as a proxy for large corporate interests, putting the interests of most Americans and everyone else behind those narrow interests, and without much regard for the consequences.

Stiglitz is very candid about how these interests, for the most part, are in fact contrary to the interests of other countries and the vast majority of US citizens. This is very admirable as Stiglitz played a major role in the US government, serving as chairman of the president’s Council of Economic Advisors in the Clinton administration and then in the World Bank, where he served as chief economist until January 2000. He is remarkably candid in his observations:

For much of the world, globalization as it has been managed seems like a pact with the devil. A few people in the country become wealthier; GDP statistics, for what they are worth, look better, but ways of life and basic values are threatened. For some parts of the world, the gains are even more tenuous, the costs more palpable. Closer integration into the world economy has brought greater volatility and insecurity, and more inequality. It has even threatened fundamental values.

This is not how it has to be. We can make globalization work, not just for the rich and powerful but for all people, including those in the poorest countries. The task will be long and arduous. We have already waited for too long. The time to begin is now.

These two paragraphs work for the citizens of all countries, not just the US and China.

Stiglitz comprehensively covers the problems with globalization chapter by chapter:

• Another World is Possible
• The Promise of Development
• Making Trade Fair
• Patents, Profits and People
• Lifting the Resource Curse
• Saving the Planet
• The Multinational Corporation
• The Burden of Debt
• Reforming the Global Reserve System
• Democratizing Globalization

Step by step, he looks at the current situation and its inequities, and proposes remedies so that globalization will work not just for the rich, but for the poor as well. His remedies are well thought-out and balanced, and also very well presented.

My question is: What are the chances of their adoption? I would say that I am not sanguine about the chances. There are too many variables at work, and so far, politicians have not shown the capability of national leaderships to rise above narrow interests. Even when it comes to narrow interests, they do not do the right things.

For example, let’s look at global warming, a problem which is literally becoming more serious every year. This will quickly lead to a series of cascading events which will rapidly spiral out of control, threatening the very existence of humanity as we know it. While there are very well-meaning people who want to do more to clean up the environment, they lack the basic understanding of economics to understand what needs to be done.

Essentially, we are keeping the costs of energy production artificially low by not figuring in the costs of environmental damage and healthcare upfront. This is the reason carbon emissions in China are running out of control.

Governments’ policies in pursuit of cheap energy are literally destroying future generations all over the world, since they will have to shoulder the costs of cleanup.

If there are future generations.

What is the real cost of economic development if future generations have to pay in shorter lifespans, lower quality of life, and a much more hostile environment where the people who are left are crowded into the relatively habitable parts of the planet?

Making Globalization Work shows that the future does not have to look like Mad Max. But are we smart enough to avoid it?

If you are interested in the future, then you must read this book.

Technorati Tags: , China, environment, globalization, globalwarming, government, policy, stiglitz, US

Globalization is based on something which doesn’t exist anymore: cheap oil to fuel the global transportation and logistics system.

Guess what? Cheap oil has gone away for good.

Yet another reason to avoid going on an oil-based economy in the waning days of big oil.

Technorati Tags: globalization, logistics, oil, transportation

JP Morgan Chase has just purchased Bear Stearns at $2 a share, an investment bank which was valued at $150 a year last year. Equity and capital markets are poised for a volatile week. The US Fed is set to make another rate cut, a desperation move, on Tuesday. This is likely to push the US dollar into free-fall, and set the stage for inflation in the US and later worldwide. More and more companies and individuals will choose to distance themselves from the US dollar.

Some time ago, I talked about why globalization, at least in its current form, would fail. Globalization has been oversold, especially in the US, where it was seen as leading to some growing kumbaya world where everyone just got along. That is not happening, and will not happen.

There is a strange resemblance between the way globalization was sold and the way real-estate was sold up until last year in the US. Up until 2007, Americans were told that real-estate prices would never go down, they only leveled off in bad times. When the bad times passed, then real-estate prices would climb again. Globalization was sold the same way.

It didn’t matter if American factories were relocated to China because Americans would find something else to do which would add greater value-added. Guess what? Americans haven’t found where that new value-added is, which in turn is leading to higher unemployment, and a generally angry population. We will see how their anger is channeled when the November elections come up.

In the meantime, Chinese government policy, through its VAT policy, encourages local governments to set up factories which waste energy to make products with very little value-added which Americans have bought on credit. Calling this real growth is just a fantasy, to use polite language.

This is why inflation is already flowing through the Chinese economy, first with food prices, and is now working its way through the system. It is likely that the situation will become much worse, and will soon hit the Shanghai and Shenzhen bourses.

The _real_ globalization where value is _really_ created is about enabling people to work productively in different regions with little or no damage to the environment, and enabling them to use their skills in a productive manner without having to travel great distances which previously took a lot of time. But that is not simple to explain, is it?

The business valuation models for these new productivity tools do not yet exist. Ironically, the valuation models for hocus-pocus subprime-mortgages did exist. It’s just that they got turned upside-down in a short time.

So what have all the risk consultants been measuring lately? I’d say that they’ve been out to lunch. That’s why, in these times, the Chinese approach to measuring risk makes more sense.

Technorati Tags: bearstearns, consulting, globalization, inflation, jpmorganchase, productivity, risk, subprimemortgage

Chinese can be very peculiar about some things.

One thing which is especially peculiar by western standards is that they get really annoyed and angry when a lot of money is lost, and they are not afraid to say so. Take the Chinese government’s loss, er investment, in Blackstone Group for example.

Within several weeks of the investment being made, Blackstone’s share price took a bath, and many Chinese got really angry. As a matter of fact, they got so annoyed that they actually demanded accountability. They reasoned that since this was their money, they had some say about it.

Obviously not a rational move. They just don’t understand the rules of the game.

Compare this with the subprime mortgage scandal in the US, which has morphed into a never-ending nightmare, seemingly growing bigger and bigger all the time…

Has anyone been blamed or gone to jail? No. Has anyone been held accountable? No. Have newspaper editorials placed the blame on anyone for the disappearance of billions, maybe trillions, in dollars? No. Is anyone angry because the futures of millions of Americans have been put in financial jeopardy? No. Have you heard any of the candidates talk about doing something about this? No.

We are above such petty finger-pointing, which won’t do any good anyway.

We’ve got more important things to worry about like race, and the right to life, and illegal immigrants taking American jobs, just to name a few…

In the meantime, the Chinese are having a hard time finding Chinese fund managers who want to invest and manage their trillion+ in reserves, especially since the Chinese manager of the Blackstone Group investment was unceremoniously removed from his post. Managing all this money sounds like an invitation to an execution.

Your own.

In the meantime, the French are partying with recent events of their own at Societe Generale…

In light of recent events, many Chinese can be excused if they think that globalization sounds more than a little like an invitation to the premier crossing of the Titanic from Southampton to New York.

UPDATE: Just in case you had any doubts the inmates might indeed be running the insane asylum, read this.
(hat tip to Chris Masse).

Technorati Tags: blackstone, China, funds, globalization, investment, titanic, US

This morning I was watching a TV program on China’s CCTV-4 which talked about the history of gold, historically and in China. The program, all in Mandarin, had a fascinating format. It started off with history and the Bretton Woods agreement of 1945 and when the US controlled about 80% of the world’s gold reserves. At the time, the US Federal Reserve had a standing policy of letting non-US citizens redeem their gold at a price of US$35 per troy ounce, while not allowing Americans to own gold. Then, as the value of the dollar fell, Nixon basically opted out of Bretton Woods and the US government would no longer redeem gold. This started the period of different currencies floating against each other in floating exchange rates.

Before and during Bretton Woods, because of the tie to gold, the US dollar was often referred to as “meijin” 美金 instead of the now popular term “meiyuan” 美元 or US dollar. The implication is that in earlier times, the US dollar was as good as gold.

Not now.

In 1979 with 17% inflation in the US and the Soviet invasion of Afghanistan, gold shot up to US$850 an ounce. Then when things settled down, so did gold prices.

Now, because of all the trouble with the US dollar and the subprime mortgage crisis, gold is back between US$700-800 per troy ounce.

Then the program took a curious turn and started interviewing Chinese who were investing their savings in gold. The best way to describe it was as if it had suddenly become the Home Shopping Channel program for gold. China opened up the gold market to trading for Chinese retail investors in Oct. 2002. Then it proceeded to interview housewives and ordinary Chinese urban consumers about their investments in different gold markets, all in China, and how much money they had made. Then there were interviews with gold analysts for gold exchange websites, all of whom were gold bulls.

And this program went on and on for an hour. The interesting thing is that this program was broadcast on CCTV-4, which is the news channel. And of course, nothing gets on this channel without official approval. The underlying message of the program was that gold is a good investment for Chinese investors in turbulent times. Not euros, not yen, and certainly not the dollar.

Gold. So go forth and buy gold, and rest assured that you will not lose your investment money. I could not escape the impression that the Chinese government was trying to talk its citizens out of putting their savings in dollars, and wanted them to save their money in gold.

Fascinating!

Ever since the subprime mortgage crisis began, the US dollar has become the currency nobody wants. Private equity and venture capital firms from the US have been actively investing in Chinese companies, just because they want to get out of US dollars. This pace is picking up as even the top-tier VCs from the US are relocating to China. Sometimes I think that if you breathe and can count to 10 in English you can get seed funding for your China startup. (Follow-up rounds are not as easy; they depend on company fundamentals, at least for now.)

It seems like the Chinese are getting tired of buying economic activity in the form of exports to the US, and getting paid in depreciating dollars. Add to that some other recent tensions, and you get the picture that things are going to start getting more rocky on the economic, military and political fronts.

There was a time when the US financial markets were looked up to and trusted by the Chinese and the rest of the world as a model. That trust has been shattered. At the end of the day, that is what capital markets depend on to work: trust. Already we are seeing a trend away from going public in the US and to other capital markets.

All of this adds up to my view that globalization is one of those ideas which makes good sense when viewed from 30,000 feet, but simply will not work in the real world of economic, political and military power.

The US dollar’s fall, in a way, is a direct result of globalization. When the US had the world’s leading economy and was the home of the world’s most voracious consumers (consumers who continued to consume even after they had no savings), the rest of the world had almost no choice except to use the dollar as the main currency for international transactions. With the rise of Japan, then the European Union, and now China and the African nations, that has all changed. Economic strength and activity are now highly diversified; there is no single center of power.

China is investing heavily in the development of Africa. The world-famous China-Europe International Business School (CEIBS) based in Pudong, Shanghai will soon announce plans for an African campus. Other parts of the world, including India and oil-rich countries of the world continue to grow. And they have less need for dollars which continue to depreciate in value. Add on to this the general unpopularity of US foreign policy in the rest of the world. They are looking for more stable investments which more or less keep their value.

All this adds up to a picture of a world which has less demand for dollars. If the US did not rely on depreciating the dollar as a policy to lessen the debt burden, the falloff would not have been as precipitous as it has become. Sometime soon, American consumers will have to learn about living within their means, and saving money. I’m of the opinion that the sooner they learn, the better. In order for it be worthwhile for Americans to save, the dollar must be stable.

If there is one thing impressive about China, it’s all the investment in infrastructure. Sure, a lot of it is tacky and even poorly constructed, and sometimes there are bridge collapses, but it is getting better in quality. Most importantly, the government is building for the future.

It’s time the US started investing more in its own future, instead of just consuming for today.

But now, the world is looking for other choices besides the US and the US dollar. And globalization is giving the rest of the world more choices to pick from.

Technorati Tags: , , China, consumer, dollar, economy, globalization, gold, infrastructure, investment, trade, US

With all the talk about globalization, as well as what is working and what isn’t about it, it’s time to drill down and find out what businesses are global by nature, and what businesses are local by nature.

For companies who are entering China, or are planning to go from China into international markets, this is a very important issue. There are some businesses which by their nature are global and others which are more local.

There are several businesses which by their nature are global. They are:

• Raw materials and commodities
• Transport, logisitics and distribution
• Manufacturing
• Commoditized services such as back-office operations and software outsourcing
• Finance, especially wholesale banking
• New technology development and research

Then there are other businesses which are more local/national in nature:

• Retail and brand marketing
• Most legal services
• Internet services
• Accounting services
• Foods and food-related services

My experience is that the businesses which are more wholesale in nature tend to cross national borders and become more global in nature, while those which are closer to end consumers tend to be more local and national.

If there is an irony, it is that the least sexy businesses are the most global in nature, while the more sexy brands and Internet businesses are in fact, local. I believe that there are several reasons for this:

Some of you may be surprised to note that I include Internet services in local businesses. If fact, they are. The struggle between Baidu and Google is largely a struggle over who has the larger local language search advertising market, Google, which gets most of its revenue from its home US market in English, or Baidu, whose services are almost entirely in Chinese. Even though China has four times the population of the US, the time when Baidu will overtake Google in terms of advertising revenue is still far far away.

One of my pet peeves is the amount of hype first-time visitors to China swallow, thinking that they can plan their retirement on a “China strategy” without in fact coming and living in China and making an effort to understand the people and culture and building relationships on the ground. More often than not, the people who have dollar (or yuan) signs in their eyes come from the services sectors, which are in fact, more local in nature. The ones who are making the money in China are the big wholesalers, but they have enough presence of mind to keep their mouths shut.

Lately, Dan Harris of China Law Blog has been talking about the opportunities opening up in the Chinese services sector because of policy changes. Most likely these changes will be led by another wave of service entrepreneurs coming into the country, or as is more likely, a new batch of local Chinese entrepreneurs offering services to China’s urban middle class. After all, they know the language, have the opportunities and can make the fast move.

For businesses which are local by nature, and are mostly in retail, the challenges come in several forms. The costs of crossing national boundaries to establish a name presence are always huge. This is an area global ad agencies are designed to address, even though their market has undergone huge changes.

The other huge challenge is human talent. How do you find the human talent who understand the needs of the parent company, and at the same time, can build relationships in a new market and understand what consumers want?

This is the real challenge of globalization.

Technorati Tags: accounting, baidu, commodities, distribution, finance, global, globalization, google, internet, local, logistics, manufacturing, marketing, retail, services, talent, technology

For the past fifty years, globalization was offered as the answer to all the world’s ills: it would raise standards of living in the developing world, it would create more wealth, nations would understand each other better and eventually trust each other, and so on and so forth.

I’m going to state what is increasingly obvious: globalization is fading in the struggle against nationalism for peoples’ hearts and minds. The world has not become global; instead capital, wealth, classes and class values, as I have mentioned in the previous post, have gone global while leaving most of the rest of the world behind. For the moneyed classes, nations are less important, perhaps even irrelevant. That is happening now as the Chinese economy grows and Chinese companies are expanding their presence to other nations by investing in their financial companies, for example.

But the moneyed classes represent only a comparatively small percentage of the world’s population. Most belong to the middle class, who still see the world in terms of the nation-state. What do they think?

They are becoming more, not less, nationalistic. A recent article shows that Chinese consumers are gravitating to Chinese brands, not western brands. In the online search struggle, search engines become victims of these games.

The simple fact is that although the US and Chinese economies are tightly bound together, and depend on each other as their largest trading partners, they do not trust each other. This trust is getting wider and deeper with the passage of time; it is not getting smaller. People for the most part, still think in terms of national interests, not global interests.

As the rich/poor divide widens, and as the US dollar weakens and the US standard of living starts to head downhill, it will become expedient to blame globalization for the country’s ills. We aren’t there yet, but we will be. Previous administrations and the WTO will be blamed for the shortcomings of globalization. Increasingly, China and the Chinese people will be seen as a threat to western values and the western way of life.

This will make it increasingly difficult for brands to become international. Are they national? Whose side are they on? Who sits on their boards? These are questions they will be asked more and more.

That is why globalization is failing, and will ultimately fail. It’s just that no one wants to take the blame and be the first to make the call.

But that will happen soon enough…

Technorati Tags: China, Chinese, economy, globalization, nationalism, trade, US, usa, values, western, wto

One phrase I have heard frequently from well-to-do Chinese business people is 钱无祖国. Roughly translated into English, this means that “capital has no homeland”; it largely goes wherever it can get the best return for its owners.

The flip-side of this statement is that the nation-state, this political entity which has been so important for the past 500 years, is gradually losing power and influence. As technology enables individuals more and more, governments and large organizations lose power, influence and attraction.

How many bright young people have you met who said “I want to work for a large organization?” In the tech sector, the number is small; most prefer to work at startups. I predict that this trend will soon spread to media and other fields. It’s just easier to get things done and you don’t need to share the profits among as many people.

This is what those who criticize the article about sovereign wealth fund stakes in Google and Apple don’t understand. When a corporation’s shares are traded on the open market, a corporation is no longer just a national entity, it is a global entity. Apple and Google are global corporations, not American corporations. Their owners, shareholders and employees are global, not just American. They just happen to have their main domicile in the US and were first incorporated in the US and are subject to US laws, but that’s it. Only if capital restrictions are put in place can you prevent anything like the scenario I have put forward from taking place. If the US were to do that, it would amount to the US government admitting that globalization, a policy that all US administrations have pedaled to the American people for the past 50 years is wrong and is bad for America.

Doug Rediker has an excellent article about the difference between how national banks and investment banks see this trend.

If there is one area where many Americans have fallen woefully short it has to do with educating themselves about the importance of managing your finances in a smart manner. Roger Ehrenberg draws an excellent picture of how the subprime mortgage mess grew, and how most Americans are responsible.

The same rules of economics which apply to individuals also apply to countries and nation-states. Foremost among these is the rule that if you remain a debtor over a prolonged period of time, you lose control of your own destiny, and become subject to the whims of others.

The pendulum has now swung in China’s favor; in the 19th century and first half of the 20th century, China was the economic basket case. For the most part, Chinese have learned the importance of savings and not going into debt. Will the next generation of Chinese remember this lesson? Time will tell.

Americans need to face up to this unpleasant reality, and the sooner the better. The first step to recovery is to recognize that one is in trouble and needs to change current behavior.

The old ways just don’t work anymore.

Technorati Tags: Apple, business, capital, China, Chinese, economics, globalization, google, nation-state, subprime, technology