China - What Future?

When you visit a Chinese bank, you will likely be presented with a series of buttons that you can push so that you can rate the service level of the cashier. The buttons, of course, are there to encourage the cashiers towards good service. The reality is that the buttons should be marked from 'surly' to 'downright obnoxious'. The state owned banking systems, despite the best of efforts, remains unreformed.

It is only a few years since the Chinese banking crisis, when the Chinese government bailed out the banks and placed their mountain of bad loans into a special fund. My question is; has anything changed since then?

The answer, in the opaque world of Chinese business, is that no one will know until the government decides it is time to know. In a previous post I pointed out that the Chinese construction boom may be a bubble. In particular, large numbers of apartments are being built, and individuals are investing in them only to leave them empty. One of the curiosities of Chinese property is that, as soon as a person has lived in an apartment, the value of the apartment falls. The result is lots of investors are leaving apartments empty in the hope of the value of the apartment increasing. This looks very much like a bubble.

In addition to apartments there are the endlessly multiplying malls and department stores. In an expanding economy, it may be that there is a real demand for these. The question is whether there is the demand for the numbers that are being built. I can only comment on the city I lived in (Xi'an), but it did appear that the construction was already outstripping demand and that this did not seem to deter new construction starts.

In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case. However, if there is bad lending into construction, it is not too great a leap of imagination to think that other lending may also be bad. Having said this, if it does go wrong, if the banks have been lending poorly, then the Chinese government has the finance and will to bail out the banking sector. As such, whilst a risk to the Chinese economy, the danger of bad lending is more that it will hurt the economy, rather than a banking crisis destroying the economy.

On the other side of the equation there is a growing, and aggressive private sector, often managing to grow their businesses without any help from the banking system. Go to a Chinese province such as Guangdong, and you will see the reality of such businesses. For example, I lived for a while in a city called Zhongshan, which is now supplying the majority of the world's lighting. Just outside the main city is a town with literally hundreds of factories all devoted to manufacturing and selling lighting. It presents international buyers with an incredibly competitive one-stop shop. As for lighting in Zhongshan, the same for many other markets. They nearly all have similar clusters.

In effect China is creating clusters of excellence, where whole cities or districts are specialising in particular products and markets, and doing so in a highly competitive way. This allows all of the benefits of network effects, whilst creating an environment of incredible cost efficiency. Each cluster generates its own supporting infrastructure, and economies of scale. Each firm is continually looking at its neighbour, and any new technology, new process, will spread rapidly through the cluster.

This kind of arrangement is very common, and may be part of the reason for the success of Chinese manufacturing. It has certainly turned China into the old cliche of the 'workshop of the world'. We are now all aware of the resulting exports.

The big question for the future of the Chinese economy is how their economy will cope in the coming recession. If we think of the area of Zhongshan that manufactures lights, what will happen when the export orders start to decline? We know that, in a housing market downturn (crash) less people will move house (a time at which people are likely to buy lighting), and that there will be less house building, less office construction and refurbishment and so forth. Export orders will certainly decline.

It is at this point that we come to a big question mark.

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.

In one respect, if China remains stable, we can be sure that China will continue in growing its share of the world export market, even if the size of the market overall declines. China, as has already been mentioned, has benefits of scale. In addition to this, it still has a large untapped pool of labour which will serve to provide labour for growth for many years yet.

In the point above, I have mentioned stability. This is one of the big question marks over China's future. The Chinese government relies upon economic growth and nationalism for its legitimacy. If the economy does falter, and this brings hardship to the rising Chinese middle classes, then there is real potential for instability. With over 100 million often discontented migrant labourers, disenchanted ex-military (traditionally they leave the military and go straight into a comfortable job in a state owned enterprise, but this has stopped), even more disenchanted peasant farmers, all that is needed is a discontented middle class leadership to create an explosive situation. And a spark.

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before. In the meantime the Western world needs to accept that it is no longer in a position to continue with its complacency. China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

Note: I am sure that many readers would want a more firm outlook for China. However, in the case of China, sound information is lacking. As such, it is difficult to see how anyone can really predict what will happen next. The worrying part about this is that China is increasingly important in the world economy, and therefore what happens there is of great importance. Such a large question mark means that policy formulation becomes less certain.

What Is Going On In The World Economy?

I had planned to write a long and detailed essay on this subject, but have recently been pressed for time. As such I am hoping that I will be forgiven writing a brief introduction to such a large topic. I am afraid that the introduction will lack references and specifics, for which I will apologise in advance.

The starting point for my explanation is where the world economy is now. As just about everyone will be noting, there is a housing crash in progress, a rapid decline in consumer spending, and retail price inflation in the UK and USA. Europe is also sinking into troubles, as are New Zealand and Canada. Australia remains a bright spot.

In short, most of the Western economies are falling off a cliff. In my essay 'A Funny View of Wealth' I detail how this situation has arisen in a fairly mechanistic way. What I do not cover is the real roots of the current problems.

However, in one post, I do make a start. The post in question is the 'Cigarette Lighter Problem'. I will do my best to summarise this. Basically the post asks the question of why it is that an identical cigarette lighter, delivered through near identical distribution systems, to near identical shops, with identical levels of service, can cost 9 times more in a Western country than China? Where is the added value to justify such a differential? If we think about it, there is no justification. The underlying difference is that the West is just more expensive. From this we can then ask a difficult question; why?

It is here that we come to the problem. In order for us to support such a high cost of living it means that some part of the economy will need to be creating huge added value, generating massive amounts of wealth. Although the cigarette lighter is one case, there are many, many other cases that are the same. Where is all this wealth that is being distributed through the economy coming from? Where are these fantastic wealth producers?

As soon as we ask this question, we can start to survey the economies of the Western World, as I did for the UK in 'A Funny View of Wealth', and find that there is no sector that is producing this apparently prodigious wealth. Sure, in all of the Western countries, there are some very good wealth producing companies, but the trouble is that, if you look at the figures, you find that countries such as the UK have not, for example, been increasing manufacturing output, or exporting enough services to explain growth. Even more troubling is if we make the comparison between China and the UK, for example, and ask what hugely wealth creating businesses that the UK has, that China does not? Increasingly the two countries (at least if we look at Chinese cities) have similar infrastructure, similar levels of services, similar levels of technology and so forth. So how is it that our lighter can cost so much in the UK compared with China?

In other words, where can the huge competitive advantage be found in the UK economy?

It is at this point that there may be possible to hear mutterings about a 'better educated workforce', and similar arguments. However, this is not a good of itself, and is increasingly questionable. Having worked in the Chinese university system, I was involved in preparing Chinese students for studying for post-graduate degrees in Western countries. The students the Western universities were accepting were being rejected from Chinese universities.

Another example given as a justification is technological superiority. The people who make such assertions are probably not aware that such technologies and processes are being exported wholesale to China, as Western countries have sought to gain competitive advantage from lower labour and operating costs. Only the most sensitive technologies and processes are prevented from being exported. In any case the complete disrespect shown by Chinese companies for intellectual property rights, renders many defences against export meaningless, in particular in a world where intellectual property is so rapidly and seamlessly transported.

A year ago, the might of the Western banking system may also have been given as an example of advantage, but with sovereign wealth funds bailing out Western banks, few would suggest such an idea now.

So where is the advantage? How is it that the Western economies are generating enough wealth to support the cost of a lighter being 9 times higher? If we look for the source of wealth, it is not possible to come up with anything substantive.

So what has been happening in the world economy? Over the last ten to twenty years, it appeared as if an economic miracle was taking place. Sustained growth, low inflation, and increased wealth.

But is that what was going on? I have argued that this is not the case in 'A Funny View of Wealth' so will not rehash the arguments here. The important point is that something dramatic has occurred in the world economy. For the moment I will focus on China, as that is the country I know most about.

In the case of China, it opened to the West following the reforms of Deng Xiaoping and, from a modest start, saw an accelerating pace of growth, albeit starting from a low base. The momentum of that growth only started to be felt in the late 90s. At that time, for consumer goods, the whole Chinese economy (if I remember correctly it was a person from Nestle who I spoke with) was of similar size for consumer goods as Germany. Although there had been excitement about China before this, it was only at this point that everybody started to take notice, and that the pace of growth really represented a major shift in the world economy.

So what was happening when China opened up. The extraordinary thing that occurred was actually the conjunction of two vitally important processes. The first of these was the introduction of a massive source of labour into the world market, in this case nearly a billion new units of labour (and no, they were not all poorly educated, as even in the late 90s China was churning out large numbers of university graduates). Now this, of itself, was not important. There had always been large sources of cheap and untapped labour around the world, but most of the labour remained under utilised. What made the real difference with China, was the massive investment and technology transfers that were taking place from West to East.

China emerged onto the world market with a government that was uniquely business oriented (at least by the 90s), with their legitimacy built upon the foundations of ongoing economic growth. To facilitate such growth they built infrastructure, and a framework that told the Western businesses that it was a safe bet to invest in China for the long term. The result was a flood of foreign direct investment, and a flood of technology and know-how into China.

It is at this point we come to something rather special about China, and that is Chinese culture. The miracle in China was that Mao ever managed to pull off the communist revolution. I will not to into history here (even though I have a passion for modern Chinese history), to explain how it happened. The important point I would like to make is that there is something in Chinese culture which seems to make them (in general) naturally good businesspeople. If you visit Vietnam, Malaysia, Indonesia and so forth, you will find Chinese businesspeople at the top of the economy, despite their being minorities.

So what does this conjunction of factors add up to? The first point to make is that, in order for a massive supply of labour to be brought into a market, it takes more than just existence. In order for the labour to come into play, it requires the technology, capital, infrastructure and will. In the case of China, all of these elements came into play.

The result is that China had actually managed to bring a huge amount of labour effectively into the world market,. That process is still continuing, and still has substantial reserves still waiting to come into the market. This labour includes every level of skill and education.

Basic economics says that if supply increases, then prices will come down. We then have to ask what will happen when such a large pool of labour enters the world market? Will the price of labour go down? Well, of course it will........it is basic economics. What has made the real difference here is that the entry of this labour has been supported by an equalisation of capital and technology. All the Chinese had to do was learn how to do business, something for which they seem to have a cultural talent for. This has also occurred over the last twenty years.

Now if we accept this, how does this explain the current state of the world economy? The first thing to note is the balance of payments deficits of the West have been supported by capital accumulation in the East. This has seen a massive transfer of wealth from West to East. The East has continued to lend to the West on the basis that, like the West itself, it believed that the West was naturally more stable and a solid economic bet (sorry for the metonymy here, but it simplifies the expression of the ideas). As such the West has been going steadily further into debt, with both consumers and government borrowing like madmen. All the time both the lenders and borrowers were under the illusion that this situation was sustainable.

The result of all of this spending was an illusion in the Western world that nothing had changed. We had moved into the post-industrial service based economy. The share of manufacturing in the economy steadily declined and the economists all accepted this as a perfectly sustainable new economic order. The reality was that massive borrowing was just delaying the inevitable, the readjustment of the world economy to the massive input of productive labour. In delaying the impact of this adjustment, the imbalances have actually become far greater than they would otherwise have been. Even now, the West is still not prepared to take on the new competition of the emerging economies, in particular China. If anything, the West is in a far more grave situation than would have otherwise been the case. The massive debt that has been accumulated must now be repaid, and this at a time when the West desperately needs capital to invest in rebuilding collapsing economies.

The best way to explain this is through a 'what if' scenario. Let's imagine that Western governments had become alarmed at the balance of payments deficits, and that they had realised that something must be done. Instead of encouraging the credit boom, and boom in government deficits, the government had sought to face the challenge of new competition. The logical policy would have been to address the cost base of their businesses, as well as the cost base of government. Furthermore, they would have realised that the only way forward would have been through a gradual devaluation of their currencies which, whilst making individuals, poorer, would have helped their manufacturing industries remain more competitive, and thereby slow the exodus of industry overseas. It would have been a painful adjustment, but it would have retained capital within the western economies, slowed the competitive growth of China, and would have allowed a relatively painless adjustment.

Instead, what has happened is that the adjustment is now happening. Huge sections of industry have already disappeared overseas, currencies are falling in an uncontrolled way, and so forth.

Now, as Western currencies fall, there is great potential for the Western economies to once again become competitive with the the Chinese and other emerging economies. The West is getting poorer with the drop of the currency, but that was always going to be a necessary adjustment. The cost of labour was always going to have to go through a process of equalisation. The problem now arises that the adjustment is happening at a time when the capital cupboard is bare. The banks are stricken, and government has already stretched credit to breaking point. The result of this is that, if capital is to be raised, it needs to come from the East.

I hope that, at this point, the light is coming on. The situation as it now exists is that the Western economies can only regain their competitiveness based upon finance from the East. This means that large sections of the Western economies are now going to be owned by the East. Either that, or any prospects for recovery will be very, very slow indeed.

Furthermore, it will become apparent that many of the things that we have taken for granted in the West will become unaffordable, such as bloated government and welfare states. Quite simply, if we are to compete with the East, we must either be adding significantly more value than the East can manage, or we need to have at least a comparable cost structure. The latter option looks more realistic.

As I have said, this is a very quick review and is short on facts and figures. However, the principles are very clear, and I believe rational. The current crisis is therefore a rebalancing of the world economy and, unless the West responds to the reality, the problems will persist, if not get worse. We have had very little competition and took 'top dog' status as a natural course of affairs.

We are now learning that this is just not the case.

Economic Growth??

Just a very quick post. For those that have read my other posts, this will make more sense. The Times today reported the following:

'The drop in confidence, highlighted in new monthly figures, threatens to exacerbate Britain’s economic woes as hard-pressed consumers curb their spending, further undermining economic growth. Last week’s revised figures found that the pace of growth halved to 0.3 per cent, the lowest level for three years.'

This wonderful snippet just serves to illustrate the lunacy that has gripped economics and economists. In this paragraph the newspaper conflates growth with consumer spending. How is it that consumer spending represents economic growth. Surely it is no such thing. Growth is productive output. Whilst provision of a service is output (e.g. retailing) in one sense, it does not represent economic growth for the UK. It represents redistribution of money within the UK economy, and often means an outflow of money from the UK economy (where the goods are imported), and the increase of debt in many cases (which hardly constitutes growth, and may also represent an outflow of wealth if the root source of the lending is from outside of the UK).

At the heart of this idiocy is the measurement of economic growth to include the activity of consumers. This only represents growth if the activity of consumers is based upon their productive activity. The trouble is that increases in consumer activity can be the result of increase in debt. How does this represent economic growth? Where the activity is measuring debt based spending, it is actually measuring economic decline.