Has China Embraced An Outdated Version of Corporate Capitalism?

August 23rd, 2010

As a consultant in software product development, I have followed trends not only in software development, but in other businesses as well. Software is one of those businesses which changes fairly quickly, since its main output is code. When software engineers decide to retire code or a standard, that code is said to be deprecated. In short, it is no longer supported in the current version, though it may be in previous versions. One of the major reasons for poor performance in consumer software is the support for deprecated systems and code; this causes a performance hit.

With the rise of the Internet, more service work is easily done in remote locations and time zones. This change is most common among software developers, many who work in other locations and are never seen in any office, but continue to contribute. It is also happening in the field of writing and reporting; I write for Forbes.com The China Tracker and Business Insider; but I have never stepped inside their offices. There simply is no need to.

Michael Pettis, an economist and observer of the Chinese economy, has made the criticism that China’s party, government and technocrats have invested too much in export production capacity, while Chinese consumer spending is actually shrinking as a percentage. This is all happening at a time when the rest of the world is looking to the Chinese consumer as the last hope for the global economy. Definitely, this is not a good sign.

The intrinsic problem is that China has become too dependent on its own state-owned enterprises to maintain growth and employment at all costs following the events of September 2008. Because they were so huge and had ready access to capital from the state-owned banks, they were able to keep China’s economy growing, even while the rest of the world headed into a funk. Nearly two years later though, cracks in the dike are beginning to appear.

For one thing, China’s economy has become too dependent on the large corporate enterprise. Both the US and China have been trying to do the same thing: trying to save large corporations at a time when they should be deprecated. This article from the Wall Street Journal, The End of Management, says it best:

Corporations are bureaucracies and managers are bureaucrats. Their fundamental tendency is toward self-perpetuation. They are, almost by definition, resistant to change. They were designed and tasked, not with reinforcing market forces, but with supplanting and even resisting the market.

In the US, government has become too closely aligned with the financial industry and its interests, and in China, the party exercises dominance and control of the economy through state-owned enterprises, many of which have become dependent on real estate speculation to be profitable. The WSJ article goes on further to say:

British economist Ronald Coase laid out the basic logic of the managed corporation in his 1937 work, “The Nature of the Firm.” He argued corporations were necessary because of what he called “transaction costs.” It was simply too complicated and too costly to search for and find the right worker at the right moment for any given task, or to search for supplies, or to renegotiate prices, police performance and protect trade secrets in an open marketplace. The corporation might not be as good at allocating labor and capital as the marketplace; it made up for those weaknesses by reducing transaction costs.

Mr. Coase received his Nobel Prize in 1991—the very dawn of the Internet age. Since then, the ability of human beings on different continents and with vastly different skills and interests to work together and coordinate complex tasks has taken quantum leaps.

Most of the reasons which Coase outlined for the creation of the corporation in The Nature of the Firm no longer exist. Thanks to Google and other tools, small organizations can resolve all of these issues for almost no costs at all. Isn’t it time we start thinking and talking about deprecating large corporations?

Of course, many in the US and China would argue that only a very small and select minority would be able to work on different time zones and in remote locations with minimal supervision; I would beg to differ. For many service jobs where key personal relationships are not important, this will become the norm within 20 years. It’s just that the US and Chinese government haven’t figured it out yet.

In China’s case, this change is particularly disturbing. Most outside observers of China don’t understand that the main metric which drives China’s economic decision-makers is job creation and employment, not company profitability. Recently, I was pointed to a long article by Daniel Cloud called Ghost Money. In the article, Cloud says:

Simply endlessly printing more money is more likely to lead to catastrophic failure – devaluation, inflation, default, or all three – than to any permanent rescue of the situation. That, in an open economy with large cross-border trade and capital flows, debasing your currency is not a long term solution to any real economic problem is something we’ve known for a rather long time. A one-off devaluation is sometimes useful, but the endless abuse of segniorage has not traditionally been viewed in a very favorable light. Someone will pay in the end; now we are beginning to see who it is. Anyone who holds a lot of sovereign debt is at risk of eventually discovering that it is fairy gold, ghost money, mere joss paper that didn’t ever correspond to any pile of goods and services actually available in this world. (Imagine an endless stream of ships leaving America full of cargo and returning from China empty, as if we were paying war reparations, individual Americans making terrible personal sacrifices to make sure the debt was paid…. The scenario is just so implausible.)

So what can China do? Cloud goes on:

Export-led growth works well in a world where the price elasticity of demand for the exported goods is effectively infinite, where any decrease in costs will always lead to an expansion in sales. Even in a world like that, though, sooner or later the very development it brings about will put upward pressure on export prices. So even in a world where the first condition continues to hold indefinitely, sooner or later it will be necessary to switch to growth driven at least partly by domestic demand. But large countries like Japan and China are bound to run into another barrier as well. Eventually their exports will become so big relative to the economies they are exporting to that people in those countries will not be able to afford to continue increasing their purchases of the exports at the same rate year after year. A country the size of Singapore can afford to ignore the limits of their customers’ purchasing power. But both Japan in the ‘80’s and China in the last decade found themselves having to lend their export earnings back to the countries they were exporting to, to keep the growth in exports going.

Once you get to this point, it should be obvious to the exporter that he is never going to get paid back at today’s prices. (Where would the money come from?) The importer is likely to try to avoid bankruptcy by forcing a revaluation on the exporter, which is politically easier for him than persuading his own voters to adopt the necessary austerity measures would be. The exporter, seeing this risk, will frantically try to switch over to an economy based on domestic demand. Whether or not he can do this depends on the condition of his political system.

Basically, Cloud’s argument is the same as Pettis’, that there is way too much capacity for the Chinese consumer to absorb, and if the Chinese consumer doesn’t spend, we are all effectively screwed. According to an article in the Financial Times, Chinese retail consumers are reluctant to spend. Cloud says that the only way out is for political reform to come to China.

If that is indeed the case, then the Chinese government will continue to fund Chinese money-losing state-owned companies until it can no longer do so. The Economist has a recent article on how the Chinese government has introduced a new circular bail-out for SOEs.

Hmmm. Looks like short-term thinking to me. Short-term bailouts do not resolve long-term structural issues.

For this reason, an article by Perry Link, a long-time China authority, in the the New York Review of Books drew my attention. This article was titled “Waiting for WikiLeaks: Beijing’s Seven Secrets” goes into some detail about the seven closely guarded secrets which are closely held in the party’s archives. I won’t go into detail about those secrets here, but what grabbed my attention about the leaked story was the final paragraph:

The anonymous reporter who leaked the contents of the July 21 meeting commented on a looming atmosphere of demise at the meeting. The underlying mood, he suggested, was, We had better get control of these archives, and perhaps destroy them, before a day of reckoning is upon us.

Does this sound like the confident leadership of the world’s fastest growing major economy? You can draw your own conclusions.

At the same time, there is an article in the People’s Daily titled “Chinese leaders vow to make Party affairs public”.

Hmmm. Interesting.

There is a point which western critics of China and the Chinese government have not pointed out. To a large extent, China is where it is now because it has followed the western model of economic development for developed economies, while retaining its own political system. Critics like Cloud say that this is why China is doomed to failure; it has followed the economics, but did not follow the political model.

I don’t think that it’s that simple.

The real problem in the Chinese model is an over-reliance on state-owned enterprises and since 2008, state-created employment. In fact, what the Chinese government should do is increase lending to Chinese private companies, and allow them to compete on a level playing field with Chinese SOEs. Instead, the Chinese government has focused all its attention and capital on Chinese SOEs, while pretending that the Chinese private sector doesn’t exist. At best, the party has treated China’s own private sector as the wife’s red-haired son from her first marriage.

For a long time in the US, private companies have been the main engine of growth and job creation. But unfortunately, Americans are not as good at entrepreneurship after they have been in the US for several generations. In the US, the best entrepreneurs have historically been the immigrants who have opened restaurants, groceries, laundries and other small businesses. They would then save money, sending their children to the best schools, so that they could become managers, doctors and lawyers. This has been true of every immigrant wave to the US, and is why the US is so dependent on new immigrants. Then, when their kids go into the mainstream, they become the new white-collar class of doctors, lawyers and managers. The problem now for blue collar workers, is that they look for jobs at corporations, and when they can’t find any, they go on welfare. But the problem is that the system is broken, and most state governments are broke.

Compared to the US, China is more fortunate. It has always had a large population of entrepreneurs. But many have had trouble finding capital to start their own businesses, or feel discriminated against by the government, which is why so many continue to emigrate to Australia, New Zealand, Canada and the US even though they have been able to achieve some degree of success in China. The end result is that many of the best remaining entrepreneurs are government bureaucrats, who abuse their privilege to become wealthy. Then the Chinese government goes after some of those, putting them on trial for corruption, and serving them up to the people as examples of how the government is helping them.

But doesn’t it make much more sense to help China’s own private sector by providing them needed capital for growth at critical moments? Why should China’s own private sector continue to be treated as the red-haired stepson by the government?

The best way for China to stimulate real consumer growth and spending is to remove the barriers to growth for the Chinese private sector, so that they obtain needed capital to grow at home in China. This will work much better than any slogans about Chinese global brands, innovation and creativity for large Chinese SOEs.

Most likely, these new businesses will start small. At the beginning of this article, I talked about how there is less need for large numbers of people and large corporate organizations anymore. This is what Schumpeter’s creative destruction thesis was all about.

Through its control of the financial sector, the Chinese government and party has the basic tools to help China regenerate itself more, much more, than it has up until now. It has long been my view that China is a nation of small business people, farmers and engineers. The problem in today’s China is that there is not a good balance: the engineers have too much power and influence on policy, and the small business people and farmers have suffered at their expense. The engineers are good at producing, but are less good at profitability. This has led to severe imbalances in China’s economy and society.

The Chinese government has, within its own hands, the power to unleash China’s small business sector and private entrepreneurs not only as a force for change inside China, but as a force which can change the world for the better. So far, it has not given them that power.

Historically, China has had major social disruptions when the rural and urban gap widened too much, and the rural population felt that they were ignored by the central government. The Chinese Communist Party came to power in 1949 based on widespread rural support for what was seen as a largely corrupt urban Kuomintang leadership. Yet this is what is happening now in China; except this time, the gap is widening at a much faster pace. The leak from the party archives meeting shows that the party is aware of this imminent danger at its most senior levels, yet has no way to deal with it.

Now, the Chinese government is trying to build an urban middle class while retaining a dominant public sector. This has never been done before, and the leak from the party archives meeting suggests that even the government leadership has its doubts about whether it will succeed. It is time to rebalance Chinese society so that the private business sector and farmers have a greater say in China’s future. This is all the more reason for China to build a REAL urban middle class; one which is based like Taiwan’s, Hong Kong’s and Singapore’s, on a vibrant, healthy and growing private business sector.

It is time to let a hundred flowers bloom in China’s private sector.

How US Investment Banking Excesses Helped China’s State Sector

April 25th, 2010

When the banking crisis broke in September 2008, the global economy went into shock and nearly collapsed. The Chinese government was widely seen as being the most proactive in reacting to the crisis, injecting more than US$570 billion into the Chinese economy.

Because China’s four leading banks are all state-owned, all of this money quickly reached Chinese state-owned companies. This stood in stark contrast to the US, where the banks were bailed out, but the money did not make it to companies and individuals, largely because the banks sat on the cash received, mainly to cover their own capital losses, and in many cases, to pay out bonuses to management.

Only recently have the Obama administration and congress started tentative investigations into the investment banking practices which brought the world economy so close to the brink. Since the US economy is now largely based on FIRe (finance, insurance and real estate), and because the financial lobby is the most powerful and well-funded lobby in Washington DC, changes and reforms have been slow in coming. In spite of this, even in the early days of the investigation, there are signs that there was more to it than just investment bankers flogging poorly understood derivatives to unknowing corporate clients, there was deliberate fraud at the heart of it.

Today, the Chinese government and economy have come out of the crisis smelling like a rose. Certain indicators, such as auto sales in China, show China overtaking the US as global leader, and unlikely to relinquish it back to the US. Compared to the US and EU, China seems positively great, and the government has made all the right moves, investing in infrastructure and keeping Chinese consumers happy and spending. Optimists believe that now Chinese consumers and its middle class have stepped in and filled the gap left by the weakening of the US consumer.

Looking a little deeper though, while the Chinese government has succeeded in the short-term, their moves raise long-term questions. Here are some of the problems:

  • Most of the money found its way to Chinese state-owned enterprises (SOEs), many of which are in commodity imports and heavy manufacturing such as autos.
  • China’s economic development is following the US economic development of the 1950s; which is oil-based transport. Imports of coal and oil have dramatically increased in the past year in spite of government efforts to diversify to nuclear, wind and solar.
  • As the Chinese government funnels more money through its state-owned banks into SOEs, the party and the government ironically have less control over them. Recently, the Chinese government has used administrative measures, such as ordering 73 companies out of the real estate sector and, in some cases, dismissing executives on corruption charges, but these are not a long-term solution to a systemic problem.
  • More Chinese university graduates look for jobs in SOEs instead of the private sector, seeking job stability instead of looking for better job opportunities, or a chance to start their own business as in previous years.
  • For the most part, Chinese SOEs are over-staffed and inefficient. But because of the crisis, and the overall makeup of China’s economy, they seemed destined to take up a bigger part of China’s GDP.
  • China’s seemingly unquenchable demand for commodities and raw materials, is in large part, driven by a lack of faith in derivatives. This is directly related to Wall St. investment banking practices which ran wild and unchecked under the Bush administration.

The flip side is that China’s private sector is in its most precarious position since China’s reforms began in 1979. While it has always been difficult for small businesses without strong government connections to raise capital, the situation has become worse recently. Yasheng Huang, in his book Capitalism with Chinese Characteristics: Entrepreneurship and the State touched on many of these issues.

In the internet field, I have noticed, for example, that many of the entrepreneurs and innovators in the field are choosing to emigrate from China instead of starting their businesses in China. China has a thriving Internet sector, but the successes are those which already have venture capital funding, or have successfully gone public. For practical purposes, the early stage innovation part of the pipeline has gone dry.

It is hard to say if this is true for many sectors in China at this stage, but if there is one truth now, it’s that innovation and entrepreneurship are a vital part of every economy. In today’s China, innovation and entrepreneurship are too dependent on government connections for success. For this reason, these relationships are open to exploitation, corruption and abuse.

The Chinese government for its part has been very ambivalent about the private sector. Both the president and premier have made occasional statements about the importance of helping and protecting private enterprise businesses, but disappointingly, few of these statements have turned into tangible policies and measures. Since the Chinese government has been pressing other governments to recognize China’s market as a market economy, why don’t other governments press the Chinese government for clearer policies for China’s own private sector? Some of these questions may be:

  • Do Chinese private companies have equal and open access to raising capital as SOEs?
  • Are their products and services distributed and marketed equally in the domestic market?
  • If they are subject to any kind of unfair competition, then what channels do they have to appeal to?
  • If the answer to any of the above questions is no, then what policy commitments is the Chinese government prepared to make to remedy the situation?

    • While the Chinese government and SOEs are powerful and cash-rich now, the real heroes of China’s reforms are China’s entrepreneurs and innovators, and the hard-working and industrious people. It’s time they got some recognition and fair treatment both inside and outside China.

Understanding Trial Spots

October 21st, 2008

If there is one thing which most western companies coming into China miss out on is the idea of “trial spots”, or as they are called in Chinese 试点。

So what is it? Basically, it’s a city, place, province or region which is used to try out something experimental which has not been tried before. When China first opened up, Shenzhen was a trial spot for opening up the economy to foreign manufacturing investment. When the experiment succeeded, it was pushed out to the other parts of China. Shanghai and Beijing were opened as tier one cities to foreign companies and employers, mostly in the service sector. When these experiments worked, the opening up gradually started. In most cases, the trial spots were selected by the central, provincial or municipal governments.

Now, there is another little secret. Large SOEs (state-owned enterprises) also often have their own trial spots. Most of the time, these are used to put some of the rising senior-level managers in to try new management practices. They are usually given a city, and a long leash, and are encouraged to try new ways of management. Often these managers are people who have made it to a certain level in a state-owned enterprise, but will not or cannot rise higher because they are somewhat non-conformist, and shall we say, less interested in politics. (Remember that in SOEs, the party also has a say in the selection of candidates for senior positions.)

Frequently, the Chinese way of handling these non-conformists is to give them a “trial spot” where they can experiment in a city or provincial division on their own. If something goes wrong with their experiment, then the damage is limited to their immediate market. If, on the other hand, the experiment was successful and includes practices which can be used on a larger scale, then that person may be promoted to a higher position with greater responsibility. This is how the current leadership of China has been groomed, just to cite an example.

The interesting thing is that many western companies, even consultants, are completely unaware of these practices. They look at their choice of investment areas in western terms, which usually means that which is clear, and out there, in the open.

They don’t study the people.

Instead, they should ask where the different “trial spots” are, and the backgrounds of the people they are dealing with. The right questions to ask for SOEs are:

  • “How did this person get to this position?”
  • “What is he trying to do?”
  • “How is he different?”
  • “What do his employees think of him?”
  • “What are his goals and his definition of success?”

If it sounds like questions an intelligence agency would ask when examining the new leadership of a country, then it does because it is just like that. I call this “due diligence with Chinese characteristics”.

And how do you get this information? I find the best way is walk in and ask (In Chinese, of course. Speak English and you only get the official line.)

For the most part, you will never find these people in Beijing or Shanghai unless they have been very successful. These are two highly conformist politically-charged cities, and the only way they make it to these cities is if they are in very senior positions, and their views have been vindicated.

Generally speaking, Chinese, even including the party, are more tolerant of non-conformists. Just don’t look for them in Beijing and Shanghai. Deng Xiaoping, the architect of China’s reforms, was for many years considered a non-conformist and was punished repeatedly for his views. Eventually, his policies became the mainstream.

So, how will the recent economic problems affect things? Basically, we are going through the collapse of an old world order, and nothing new to replace it has come up yet. The Chinese government, the party and Chinese SOEs will be looking for answers on what comes next to restore order, growth and stability. After all, this is what Chinese social stability depends on.

For Chinese government and party officials, it will be a good time to be something of a maverick. But these mavericks will only survive and prosper if they can come up with the right answers to some very tough questions.