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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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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