The China Vortex

In the past few days, Henry Paulson has come up with his US$700B proposal to save the major lending institutions which made bad decisions re CDOs, with all the bad loans being covered by the US taxpayer. This is happening at a time when the US middle class is under unprecedented pressure already.

Over the next year, all the bad decisions made by China’s economic planners over the past 30 years will show through. These include:

• The decision to become overly dependent on the US as an export market, and buying US treasuries to effectively buy this single captive market and continue to sell it goods far beyond its capacity to pay for China’s exports.
• Somewhere along the line, a decision was made to jumpstart China’s economy and put it on the fast-track of economic development. To a large extent, this has happened. But China’s economy is like a body builder whose upper body strength is massive, but has toothpick legs. More incidents like the melamine milk incidents will become common, simply because the government is not equipped to handle incidents of this kind.
• China, unfortunately, has a reputation for cheap, low-quality products, in spite of the successful Beijing Olympics. For the most part, Chinese companies do not have the talent to work up the value chain creating better products. (There are some, but they are too few to make a significant difference.) This takes time to build.
• Exports will slow, and the Chinese domestic market will not pick up the slack fast enough to prevent major unemployment problems, especially among university graduates.
• The wealth gap between the rich and poor will widen dangerously, and real estate prices, which are already falling, will fall even more.

China became addicted to US orders and the US dollar the same way Americans became addicted to Chinese junk products. (This is a generalization; many goods are not junk. But the general image is of, well, junk.) For both sides, it was a dream which was too good to be true.

Now it’s over, and the Beijing Olympics are turning into the final hurrah for that period.

If you would like a well-presented systematic presentation, my friend Corbett Wall has written an interesting piece.

The fat days are over, and we are in for a tough 20-30 years ahead.

Several months ago I wrote about how Apple’s opening of the iPhone SDK and its App Store would create a whole new business ecosystem for application developers for that platform. Apple offers globally accessible hosting and payment clearance in return for a 30% cut of the app’s sales price.

Now, there are early signs that the strategy is paying off for some early application developers who have developed popular apps for the iPhone and iPod touch (which uses the same SDK as the iPhone) users. Eliza Block, who developed 2 Across, a word game for the iPhone platform, has reportedly cleared in the area of $2,000 a day according to this article.

The App Store is a new updated version of the shareware movement which took hold in the early 80s with the launch of the Apple Macintosh 128K. In those days, homebrew developers would develop games, apps and productivity tools which were distributed on floppy disks. (Remember those? If you do, you’re showing your age.) More often than not, these came with a message which went something like “If you liked this app, please show your appreciation by sending a contribution to this address.” More often than not, people just used the apps without sending money, although there were a few kind and generous souls who did.

Now, Apple has become the doorkeeper for these independent developers. There is no more reliance on the kindness of strangers; Apple takes care of global distribution and payment for new apps in return for 30% of the app’s sales price. For devs, the App Store is the perfect barometer for what’s hot and what’s not.

In contrast, Facebook and others have not been able to find the magic balance point between independent developers and their own corporate needs for revenue. When Facebook opened its platform to developers, it ended up enabling app developers to spam the FB audience, driving many away from Facebook. Now, with Facebook Connect, FB is trying to find that balance point.

Chinese social media companies are no better at finding the right balance between independent devs and their own need for revenue. While there has been talk about open systems in China, all of the competing business models in fact, are not open. Apple’s system is certainly not open. it’s just that Apple is willing to share in order to grow the pie.

Apple and Steve Jobs have successfully put themselves at the juncture of technology, business and hardware, and are willing to share a larger cut in order to drive up sales of a very attractive new hardware platform. With growing earnings from hardware sales, Apple can afford to be generous with devs, and is effectively subsidizing a new business ecosystem. By making some independent developers financially successful with App Store and getting that word out, they do something none of their competition have been able to do yet.

The question for Chinese companies such as Tencent is whether they are willing to use their high corporate earnings to subsidize their own independent developers’ business ecosystem as Apple has, and share some of the revenue in order to grow the pie for everyone? Or do they still think that they can own the whole pie? Tangos Chan says that they still believe that they can own the whole pie.

But Tangos believes that this will change in the future. In the meantime, more independent devs will gravitate to developing for the iPhone platform. It’s better to open up sooner while there is still interest in their platform because opening up later means that they will have to be that much more generous in order to attract developers away from Apple’s platform.

After all, that’s where the money is. And I’m sure that Steve loves how his competitors’ moves help his platform.

What more could he ask for?

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.

When I look at web apps and ideas in China today, practically everything I see has to do with the retail consumer. Popular fields are gaming, because it proven and China has a large gaming population, not to mention the success of the major players including Shanda and The9, and music and search.

The result has been a plethora of startups in these fields. After all, they have a demonstrated and successful business model based on advertising. God knows that there are huge amounts of advertising dollars just looking for half-decent excuses to be spent in China. VCs can use these as references in their decision-making and in valuation, which is good.

But the real money is always made when a new company breaks out in a field which was considered dead or dying. Right now, I think that field in China is web productivity apps.

There is a big hole between Office (Word, Excel, Powerpoint) and the web. In the US and Europe, this area is occupied by Oracle, SAP and Salesforce. There are Chinese competitors such as Yongyou and Kingdee. Google has made some significant headway with Google Docs, but there is still a long ways to go.

So far though, none of them have passed my Internet cafe test. This means that I have not seen anyone sitting on a computer in an Internet cafe using any of their apps. They are all playing games or chatting away.

This creates a chicken and egg situation; VCs fund companies which get the eyeballs, and hold back on those productivity apps which do not get the attention, but are far more meaningful and productive. And the companies which are making productivity apps, which take far longer to develop and mature, have trouble getting funding. The investment cycle gets shorter and shorter, but it takes longer to develop meaningful apps. As a result, the productivity apps market gets starved.

Something has got to change, and I hope that it isn’t too far away… Sometime soon, people will have to start earning money to play those games.