Wednesday, September 26, 2012

China: What Next?

There is something that we need to remember about China; it is a powder keg. Like a powder keg, it is perfectly safe provided that there is no spark. The communist government of China undoubtedly realise the nature of the society over which they govern. When China opened with the reforms of Deng Xiao Ping, the government firmly turned its back on the world that was built by Mao Zedong, removing the imperial system that gave communism the legitimacy of the mandate of heaven. Mao was an emperor in new clothes, but rejection of the new imperial system represented by Maoist 'communism' left a gaping hole in Chinese society. It was a hole filled with the pursuit of economic growth. Never mind ideology, just enjoy a growing economy, and all the benefits that it will bring.

It is both a shallow and deep form of legitimacy. It is deep, because who would want to return to the poverty of the empire of Mao. It is shallow because it rests the stability and legitimacy of the ruling party only on growth in the economy. It gets worse; the Chinese government has raised expectations of endless growth to the point where it is a minimum expectation. This is combined with nationalism and resentment. Read a Chinese school history textbook in the original Chinese, and you can see how a metaphorical chip on the shoulder has developed. China is growing to become a major superpower, and with a desire to overturn the shame of recent history. What happens if China stops growing?

We may now be at that turning point. I emphasise may. There are worrying signs that are developing, and the prospect of a hard landing needs to be considered. A review of current news about China tells the story. Yukon Huang, writing in the FT 'gets it'.  The dispute over the Senkaku/Diaoyu islands are tinged with economics, and the economics are tinged with politics. However, the politics versus the economics may become ascendent; if the economy nose-dives, the risk is that nationalism will be seen as a route to re-establish the legitimacy of the government. There is a lot at stake when considering the Chinese economy, including the stability of Asia Pacific, and the intertwined question of the stability of China itself. In short, the stakes are high if China should have a serious hard landing. Perhaps not as high as this discussion might suggest, but certainly high.

From this context, I will review the questions surrounding the Chinese economy. We could look at the lows being plumbed by the Chinese stock market, but this particular casino is not to be trusted as an indicator of the real state of the Chinese economy. If the stock markets of the West have ceased to reflect economic fundamentals, the Chinese stock market has never really been anything but a stereotype of the Chinese love for high stakes gambling. Official outlets, such as the China Daily trumpet positive news, but are not trustworthy, being driven by political considerations. However, even official sources are reporting some worries about the Chinese economy.
BEIJING - Since the latest data reignited concerns about excessive production capacity in some raw materials industries in China, experts have urged those industries to step up restructuring and add more value to their products.

Data released this week by the National Development and Reform Commission, the country's top economic planner, showed that many raw materials industries have seen slowing growth and falling profits from a year earlier.

Total cement production in the first eight months grew by 5.9 percent, 12.5 percentage points slower than the same period last year, while the growth rate of crude steel output slowed 8.3 percentage points to 2.3 percent during the same period, according to the NDRC.

Profits of the country's building materials industry dropped 9.6 percent in the first seven months this year, with cement producers' profits plunging 53.1 percent.

The steel industry saw profits tumble 48.3 percent year-on-year, the NDRC said.
Zhu Hongren, chief engineer of the Ministry of Industry and Information Technology, said Tuesday in an exclusive interview with Xinhua that many materials industries in China are currently confronting serious problems, including overcapacity, dropping sales and sliding profits.
The problem is simple. China has state owned enterprises that have favoured status, and the Chinese government has been pouring capital at cheap rates into these industries. When the process started, the only direction could be positive; industry had been flattened by the destructive policies of Mao. As time moved forwards, the state juggernaut could hardly put a foot wrong, but in recent years - they have overtaken themselves; they are overinvesting in capacity for which there is no real market. A bust is on the way, albeit a bust that is backstopped by the government, and/or state banks that are likewise backstopped by the government. I have been discussing the malinvestment in real estate since 2008 (see post here) so will not continue on that theme in this post, except to say that some of the excess capacity will become even more 'excess' if there is a significant real estate bust. After all, miles of apartment blocks, office blocks, and shopping malls need a lot of industrial capacity to be built.

The possibility of an internal bust in China is intimately entwined with the wider global economy. The chinese economy was built upon a mercantilist export model. It has served China well in that it has seen what might be regarded as an economic miracle take place. It has seen the largest reduction in poverty in history, and a backward economy developed into a modern and sophisticated economy in the space of a heartbeat. I have said it before, and will say it again; the Chinese government played a blinder of a game. Stunning is the correct expression. They have almost managed to pull off an economic coup. However, as with so much in the Chinese economy, what started as an easy win game, as they have progressed, the game has become more complex. As the world economy faces increasing headwinds, this impacts upon the potential of Chinese exports. Furthermore, it is not clear that China is as competitive in some industries as during the period of huge growth.

Just one example of the increasing complexity is that there are reports of manufacturers wanting to return to the US due to diminishing cost advantages of manufacturing in China. In isolation, these reports offer a convincing case in some exemplar industries, but some perspective is needed. Whilst direct costs of manufacture need to be considered, location choices also bump up against other advantages of manufacture in China; the 'ecosystem' of manufacturers that present advantages above flat cost advantage i.e. large numbers of specialists, who develop particular areas of expertise (my own experience in China saw the development of an area that specialised in lighting, though this is not one of the areas that might perhaps attract foreign manufacturers). Although flat cost comparisons may favour onshoring, the ecosystems present another factor that will undoubtedly be considered in the decisions to return 'home'.There will be some impact from onshoring for cost, but this is only one factor that might influence the China policy of companies.

Perhaps a more compelling driver for manufacture in China is concern about the nature of China and stability. For several years now, there has been a policy in many manufacturing companies of China +1. The principle is to have an alternative manufacturing base in addition to China as an insurance policy. That principle may be extended and become more widespread. The recent reaction of Japanese companies to the tensions with China will only serve to create concerns:
Nissan, Japan's top automaker in China, said it would halt production at a joint venture in China starting on Thursday, three days earlier than planned, and extending through next week's national holiday period.

A Toyota executive in Beijing, who spoke on condition of anonymity, said it was "likely" the automaker would cut output in China in the coming weeks. A Toyota spokeswoman said the company had no immediate comment.

Suzuki, meanwhile, said it had stopped one of two shifts that it normally runs in China.
Production slowdowns are a normal feature of the auto industry in mature markets like the United States, where they are used to keep inventories from ballooning and avoid pressure for automakers to offer deep discounts that erode profitability.

But the steps by the Japanese automakers to cut output in China are an anomaly in a market that has driven the industry's global growth over the past decade and where most automakers had been adding capacity until China's economic slowdown in recent months caused production to outpace sales.

The anti-Japanese sentiment in China at present is undoubtedly causing reconsideration of investment into the Chinese market. For the wiser Western companies, ccurrent tensions with Japan may be seen as a signal for caution; 'there but for the grace of God go I'. China is starting to look a little dangerous, and many companies will undoubtedly be considering the potential benefits of China in relation to the very real risks that result from a nationalist environment that might see sentiment and profits determined by political considerations. Combine this with worries about intellectual property theft, and all of the other vagaries of doing business in China, the shifing cost advantages, and China may start to look positively unattractive.

In summary, the hard times are now starting to impinge on China. Their confidence is perhaps their greatest enemy. In the early days of opening the Chinese market, they could hardly do any wrong. A willing and compliant labour market, open for business attitudes, and there was a state that could only win when it picked 'winners'. These advantages are diminishing in the overall picture. In addition, there was some wonderful playing of the 'great game' by China, which saw countries clawing at the doors of China, competing with each other for a piece of the 'action' and giving China the position the belle of the ball (to mix mataphors). It was a great recipe. However, it is no longer the belle of the bal. Doubts about the politics are surely starting to impact on the economics, and the economics are in any case no longer so attractive.

Up to this point, the economics has driven the growing Chinese confidence, and the confidence of the politics may now be negatively influencing the economics - and at a time when both global and national factors are working against the economics. There can be no better expression of the problems of Chinese over-confidence than recent reports of propsals for a 'bond attack' on Japan:

It’s not often that the words “bond” and “attack” are part of the same headline, but that’s exactly what appeared in the Sept. 19 edition of the Daily Telegraph.

The story, titled “Beijing hints at bond attack on Japan,” is a telling look at China’s economic policy — and it’s one that carries some important implications for the United States.
The gist of the story is that China has indirectly, with official deniability built in (a common Chinese tactic), threatened to attack the Japanese economy through the bond market by using quasi-official sources. It is an exemplar of the growing over-confidence of China, and an over-confidence that is self-defeating for their own economic position. Quite frankly, it is scary. China is throwing its weight around, and it is being noticed. They are overplaying what is a a powerful hand, but not as powerful as some in China might imagine. Whilst there are many politicians still courting China, there are going to be many who seek the opposite path. China's overplaying of its hand is going to strengthen the latter, and that could be very bad news for the Chinese economy.

There is plenty more that could be said about the situation in China, and China's economy in relation to the world economy, such at their proclivity for industrial (state sponsored?) espionage. There is much more that could be said about the state of Chinese investment (or malinvestment). There is much more that could be said to emphasise the questions of the sustainability of the Chinese economic miracle. However, this is an overview, and I have limited the review to a very broad overview.

Although I have lived and conducted business in China, and read extensively on Chinese history, both recent and modern, and speak (and used to be able to read) Chinese, I do not profess to be all-knowing about the Chinese situation. Having lived in China, I view China with affection and fear. I would like to see a bright future for China, but the politics in China threatens the miracle of the last few decades. The politics cause the fear, and the endeavour and determination of the Chinese people to create a better life creates the affection and also an admiration. Regardless of my personal views, warning signals are starting to flash, and I would not, if it were my money, risk my money by investing in China. I am somewhat conservative, but not risk averse.

Chinese workers are restive. Whilst a few reports do not make a trend, it is necessary to remember that Chinese workers have been raising their expectations, and that the expectations may be dashed in the even of a downturn.The growing wealth and expectations might not match up in the event of a serious downturn. We should also remember that nearly 50% of Chinese exports originate with foreign multinationals. China still needs those companies, and they may be thinking of alternatives to China.

On balance, I think that China may be entering a period when there is a real risk that the powder keg may be lit. It is both a worrying and scary conclusion. As China goes through another opaque process of power transfer, I can only hope that the new regime recognises that the current paths of policy are taking China towards a world of high risk.


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