Why China Won’t Throw A Lifeline To The West

October 12th, 2008

Hu Jintao with George W. Bush.
Image via Wikipedia

With all the chaos on world’s markets, it is easy to overlook developments in China. The biggest piece of Chinese domestic news is the decision to give limited rights to land use to China’s farmers. This decision came out of the Third Plenary Session of the 17th Party Congress of the Chinese Communist Party (三中全会), which is now convening in Beijing.

The overall thrust of this meeting is to focus on the development of rural China, which has not fared so well as the east coast cities. If the cities continue to develop, and the countryside continues to stay poor, you have the recipe for social unrest on a large scale.

The salient points about China’s development are that China has about 1/3 the arable land of the developed economies for farming, and about 500M live in cities, while 800M continue to be rural Chinese. National development plans (many of which were formulated under Jiang Zemin, who came from Shanghai) called for the urbanization of China.

China’s first 30 years of reforms required the development of the eastern coast to attract foreign capital, and to make the companies and the westerners who came to China feel comfortable. Only when they had reached some level of comfort, and were attracted by the market potential would the capital follow. They became comfortable and the capital and trade followed.

And now the westerners living in Beijing, Shanghai and the west expect the Chinese with their nearly US2T in foreign reserves to bail out the western economies? Let me tell you why it won’t happen.

  • Successive Chinese regimes have always lost power when they coddled the urban elite and ignored the needs of the countryside. This was how Mao rallied the Communists, surrounded the cities (the strategy was called “using the villages to surround the cities” or “乡村包围城市”), then threw out Chiang Kai-shek in 1949. Hu Jintao and Wen Jiabao know this, and know that they need to swivel around and develop the countryside so that the wealth gap can be narrowed.
  • The Chinese government will focus on developing a new size of town, which in Chinese is called the 城镇 or village town. This will be mainly a distribution, education and trading center for farmers and their families in the immediate vicinity. Population will be 250-500K.
  • For the next 15-30 years, the cities will stagnate in growth. People will not lose their homes the way they do in the US since China does not have foreclosure laws, but their salaries will not go up. Many of the wishes new university grads entering the workforce hoped they had will just become dreams. Somehow they will have to learn to live in this new drastically changed environment.
  • The Chinese government is already talking about the development of rural infrastructure including rural insurance, microlending, etc.
  • Many young Chinese who would have scoffed at the idea of working in the countryside will now go there, simply because job opportunities in the east coast cities will be limited. This, in turn, will help to clean out the party apparatus in the countryside, which has been seen as generally corrupt.
  • Western companies will not benefit too much from this next stage of development because they do not, for the most part, understand how to sell to the bottom 2/3 of the Chinese pyramid. Most only know how to sell to the top 1/3 in the cities. Companies which will prosper are those who sell to the “local local economy”, or bottom 2/3, as Jack Perkowski calls it, as opposed to the “local foreign economy”. The local foreign economy is city-based on China’s east coast; the local local economy is mainly rural and inland.
  • The companies which will survive and prosper are the swift pivoters who can quickly learn how to sell to the “local local economy”. This means that they made some money in export manufacturing, but now switch to sell domestically to Chinese consumers in the new inland towns and cities. Not many companies can do this, but those that do will do well. Most will be entirely new businesses, and local Chinese brands will have an advantage.
  • This next stage of development will require a lot of money. Those foreign exchange reserves of US2T will be needed by China. Now, if you ruled China and you had the choice of 1) lending the money to the west, which has just acted about as irresponsibly as anyone can imagine or 2) investing the money in China to narrow the wealth gap between rich and poor, city and countryside and keeping your regime in power for more than a half century, what would you do? I think that it’s a pretty easy choice.

China may now have the world’s largest foreign exchange reserves, but that is not what makes a country a superpower. The recent tainted milk scandal has shown that it is still lacking controls in many key areas, and it is far short of being a developed nation. Instead, China is a developing nation with rich reserves it needs for its own development.

In order to become a developed nation with a developed economy, it needs to spend that money on building its own infrastructure and narrowing the wealth gap between the developed cities on China’s east coast and the inland countryside. Any Chinese regime which acts otherwise would be making a very risky decision, and would be putting the future of its own rule in jeopardy.

China can manage without export markets, but it cannot survive if its own countryside is in turmoil.

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China’s Public Sector On The Defensive

September 4th, 2008

One of the recurring themes of China’s reforms and opening up over the past thirty years has been the expansion of China’s private sector, usually at the expense of the public sector, or government-invested industries. This is a theme which has been often overlooked in the west, even by westerners in China, as they are more focused on the relationship with western companies, specifically Western Foreign-Owned Enterprises (WFOEs). There are three important components in the Chinese economy: state-owned enterprises, private companies and WFOEs. For the most part, the WFOEs are only allowed to play a peripheral role with all kinds of restrictions placed on them from time to time. It is highly unlikely that the Chinese government will allow them to play major roles in any sector.

The most important and vibrant part of the economy are the Chinese private sector. In spite of being out of power politically, occasionally suppressed, lack of capital and resources, it has managed to the point where it now employs more people than the public sector.

Let’s take a closer look at the media industry, just to cite an example. All official media, including newspapers, magazines, books, television and radio are owned, in one way or another, by the government. These might be the central government, provincial government or municipal governments. The performance and careers of these government officials are often measured by how these media perform: if they perform, the careers of these officials go up, if they perform less than well, then it goes into their performance evaluation, and has an effect on their careers.

The challenge for the official media in China now is that they are, generally speaking, losing audience to smarter and more creative challengers from the private sector in fields like online gaming. When this happens, and audience and circulation go down, these officials have to think of ways to address the situation. If that doesn’t work, they cover up the bad numbers.

Virtually all of the challengers in the Internet media field are private companies which are venture capital funded. In short, they are all private sector. When the audience moves to the private sector companies, public sector media companies tend to lose first audience, then revenue.

Many westerners look at the media ownership issue in China too much from a political and social oppression angle.

Actually, there is a lot more to it than that. It’s about what industries will still stay in Chinese state ownership, and how they will remain competitive in the hyper-challenging Chinese market. The official media has tried to counter-balance this trend by showing women in bikinis and other devices, but the trend to the private sector media (or user-generated media) is continuing. This is what Chinese ministries are thinking about all the time.

After all, if there are no longer competitive industries in the state’s company portfolio, how will it get revenue?

Excuse Me! How To Regulate Micropayments?

August 27th, 2008

In China, you know something has become big when the government starts worrying about how to regulate it. (Come to think of it, that’s the way it is with most governments, not just China’s.)

China’s central bank, the People’s Bank of China, has asked the Finance Department of People’s University in Beijing to come up with draft plans to regulate micropayments in China. (People’s University is traditionally the training ground for government officials.) Right now, micropayments occupy a gray area, which means that they are not technically legal or illegal. They just exist.

And they are unregulated. Right now, the Chinese government has no idea about how to regulate this market, which it obviously expects to grow substantially. Some have even grumbled that this new virtual economy will eventually grow in size to rival offline economies.

The most successful subscription micropayment based company in China is Tencent, which is based in Shenzhen and gets unofficial support from the Guangdong provincial government. (The Chinese have a saying: 天高皇帝远 which literally means “The skies are higher when the emperor is farther away.” Unfortunately for most western companies, they are not aware of and do not heed this very wise Chinese saying.) It has its own virtual currency, the QQ-Coin, which can be purchased one-way with Chinese yuan, but cannot be converted back into Chinese yuan. The company recently announced record earnings.

You get big, you get regulated.

Getting The Dragon Right

June 12th, 2008

On June 11, I attended an event in Beijing where Jack Perkowski, author of the book Managing the Dragon talked about his experiences doing business in China and on the Chinese economy. He also keeps a blog where he talks about China-related topics. In March, I had read the book and wrote an online review which you can read here.

During the dinner talk, Mr. Perkowski talked in greater depth about some of the issues he talked about in the book. Most of the audience of 20+ people were people who had considerable experience living and working in China.

He talked about how he saw China as having two different economies, which he calls the “local foreign economy” and the “local local economy”. He sees the local foreign economy as being made up of 400M people who have average annual income of US7500. The other 900M people have an annual average income of US2500. Right now, these are almost separate economies in the same country. The existence of the local local economy, which is very cost- and price-sensitive, means that there is a large part of the economy which needs modern things, but cannot afford western prices. Many Chinese companies are looking for new ways to reach this audience. This means that manufacturers are always looking for new ways to constantly cut their costs to reach them, which in turn leads to a very high rate of innovation.

An example he mentioned were piston rings. There are six global piston rings makers in the world, but there are 400 in China. The reason for the China discrepancy is because there is demand for cheaper solutions from the local local market, who are always looking for cheaper and more competitive components. While they have the same need for transport as the foreign local market, they cannot afford the expensive brand components.

In contrast, the foreign local economy accepts a higher level of costs, and is less sensitive to pricing pressure. These are mainly export manufacturers which have come to China from the US or Europe and come to manufacture auto parts first for their home markets and then later, other markets. Mr. Perkowski believes that in order to survive, it’s essential to reach down into the local local market. Unfortunately, many American car makers were unaware of this market, and wanted to sell only into the foreign local market. In the meantime, the toughest Chinese makers which have prospered and survived, claw their way into the local foreign market, where they are much leaner, meaner and smarter than the major US makers.

It made me think that in reality, China has a domestic market and an export market. The domestic market can be thought of as the local local market, and the export market is the local foreign market. Eventually, the two markets will merge, but it will take some time before that happens.

Mr Perkowski mentioned that the US “makes” 16M vehicles annually, of which 5M are imported from other countries. This means that in reality, the US makes some 11M vehicles annually. According to him, American makers are not able to make money on small cars, only on larger vehicles such as SUVs, which Americans are no longer buying because of high gasoline prices. The Chinese auto makers, in comparison, are able to manufacture small cars profitably. This year, Chinese makers will make some 10M+ vehicles, putting Chinese manufacturing capacity on a par with US makers. He believes that China will overtake the US economy in size, and Americans will have to get used to the idea of having the second largest economy in the world. (My note: Of course, it will take some time for India to take the world’s second largest economy position away from the US.)

He believes that the place where the US will continue to be dominant will be in efficient capital markets. This is a place where America will continue to be the world’s leader.

Mr. Perkowski does not speak Chinese, but his good common sense about doing business in China showed that he had a good deal more knowledge about China than many of those who speak the language. In his case, common sense and a good attitude have more than compensated.

Risk Is In The Eyes of the Beholder Part II

January 28th, 2008

Chris Masse’s excellent MidasOracle.org, which focuses mainly on prediction markets, has a posting called Journalism Failures – Big Time.

The Midas Oracle article links to an article by Risk magazine nominating Societe Generale as the equity derivatives house of the year.

(You better check out the link soon before the magazine’s management takes it down.)

In case you haven’t heard, Societe Generale has been having some problems lately. We’re talking about US$7B losses because of a rogue trader, which even with the dollar falling, is not chump change.

I couldn’t invent this kind of shit even if I wanted to, and I’m a pretty creative guy.

Now if this is the kind of advice the western risk experts dish out, kind of makes you wonder, doesn’t it?

I’d say that the Chinese way of the CEO making all the risky calls himself according to his or his mistress’s mood at the moment is more reliable, and maybe, even more scientific…

The emperor has no clothes.