Full Article: How China’s Economy Must Change

Published in The Diplomat

Authors: Siva Yam, CPA, CFA & Paul Nash

China sailed through the global economic downturn. But with its export strategy now in jeopardy, China’s leaders must make push through reforms to maintain growth.

Mao Zedong, China’s “Great Helmsman,” was a keen student of history. It was for this reason, perhaps, that he was able at times to prognosticate with uncanny accuracy. He once predicted that “the natural forces of capitalism are about to stir among China’s farmers. If these forces go unchecked, society will become polarized. In the end, both the poor and the newly rich will become discontent.”

Mao was speaking, of course, about an economic dynamic transferring from one class to another, for capitalism was then, as it is now, nothing new to China. It has been part and parcel of Chinese culture for centuries, carrying the Celestial Empire through the cycles of production and consumption over several dynasties. It continued into the Communist era with only a relatively short, but very turbulent, interruption.

After Mao’s attempts to curtail private, for-profit ownership turned disastrous, his successor, Deng Xiaoping, set about to revive it under the equivocal epithet “Socialism with Chinese characteristics.” Deng allegedly proclaimed that “to get rich was glorious.” He felt that a socialist state could safely harness the benefits of capitalism, and that communism might work if everyone first got wealthy together. But what he failed to realize – and what Mao understood – was that unchecked capitalism produces social division.

After decades of headlong growth inaugurated by Deng’s reforms, a question once thought consigned to the pages of history after the Great Leap Forward and the Cultural Revolution has come back to haunt China’s communist leadership. Are capitalism and socialism really compatible, especially in a country with a colossal population and comparatively few resources? The answer seems to be emerging with alarming clarity as the gulf between China’s “classes” grows wider and more pronounced.

The most recent global financial crisis hasn’t helped. Throughout it, China has played a stabilizing role in the global economic system, thanks to the concerted effort of a centralized government willing to stay a pragmatic course. While some economists boldly predict that China’s growth engine will pick up and continue as before, there are signs that it may be running out of steam. If it does, the Chinese “economic miracle,” and those carried by it, including millions of poor migrant workers from China’s countryside who rely on factory jobs for income, are about to drift into uncharted waters.

For decades, China has built its economic strategy based on four pillars: exports, foreign direct investment (FDI), fixed-asset investment and domestic consumption. Of these, exports are central. They draw in FDI and support investment in fixed assets and domestic consumption. But exports have slowed dramatically and there’s mounting evidence that a fundamental change is under way.

China has long been inclined to regard itself as self-sufficient. This attitude frustrated British merchants when, in the 18th century, they made early attempts to establish trade and diplomatic relations with Beijing on an equal footing. The Qing court liked to believe that Western nations had little, if anything, to offer that China needed; it held the view that it granted trading rights only as a mark of favor to tributaries. China today has comparatively limited natural resources to support a population of its size. Foreign trade on a large scale, once regarded with distain by Qing mandarins, has become vital to China’s well-being, if only to sustain its massive importation of food, energy and raw materials.

To keep exports moving to its biggest customers – North America and Western Europe – China knows that two basic conditions have to be in place. First, Chinese goods must be cheap. Second, Western consumers must have disposable wealth to buy them.

To render its goods affordable, China helps its manufacturers minimize costs, at least initially. It offers them land, tax holidays, lax enforcement of labor and environmental laws, rebates on exported manufactured goods, and reduced import duties on equipment used to produce exports. It also encourages manufacturing that exploits the comparative advantage of the country’s immense labor pool. Companies that employ more labor receive favorable treatment. Accordingly, they break down the manufacturing process into components, each requiring many workers with few skills or little training.

When China embarked on its industrial export drive in 1976, it had little capital, technology or experience. It also had few foreign distribution channels and virtually no money for R&D. It therefore turned to one of its biggest untapped assets: Chinese who had emigrated to Europe, the United States and Southeast Asia. They had both the experience and the wherewithal needed to help China develop markets overseas. For its part, the government dispatched itinerant trade ministers to lure foreign manufacturers, big and small, to China’s coastal regions, where the cost of building infrastructure was significantly lower than in the interior.

Chinese manufacturers quickly came to rely on a strategy known as the “Three Supplies.” Foreign companies supplied materials, samples or parts; Chinese companies processed, copied or assembled.

This strategy allowed China to build capital quickly and cheaply. It minimized R&D expense and created millions of jobs in China, even though most paid less than $100 a month, with few added benefits.

To nurture overseas demand for its goods, China created wealth, whether real or perceived, for its customers. It did so by keeping global interest rates low. Cheap Chinese products flooded the world market, dampening inflation and putting downward pressure on rates. At the same time, the Chinese government reinvested its gains in U.S. Treasury securities to bolster the U.S. dollar, sometimes without heed to the cost, forcing rates even lower. Coupled with innovative financial engineering by institutions in the United States, Western consumers saw the value of their assets appreciate and leveraged their spending in tandem.

China’s export machine pulled in unprecedented FDI as American and European companies hastened to outsource manufacturing to China for fear of being left behind. As exports and FDI escalated, investment in capital assets and infrastructure grew uncontrollably. Land prices skyrocketed as developer’s procured cheap land from the government by promising to foot the bill for infrastructure around their properties. Factories, theme parks, hotels, shopping malls, trophy buildings, toll ways and bridges sprung up all over. Construction cranes became the unofficial “Bird of China.”

The problem, of course, is that many of these projects were undertaken with feeble economic justification, and they have now resulted in significant excess capacity.

To keep their factories running since the global financial crisis, Chinese manufacturers have been cranking out products that aren’t being sold or that are sold at or below cost. Many have been able to report strong earnings by manipulating inflated land values. Some leverage their land’s value by borrowing against it to invest in other real estate projects. All the while, China continues to import enormously to maintain its basic manufacturing sector in the hope it will return one day to its former strength, as well as to support rising domestic consumption.

China’s export machine, however, ground to a halt when the U.S. housing bubble burst and the world plummeted into recession. Built on a strategy that aimed to dominate the global marketplace in low-value-added products, it seems now to have little prospect of returning to its former scale anytime soon. American and European consumers, who are trying to deleverage, are unlikely to resume their old purchasing habits. Moreover, since only a handful of Chinese brands – such as Tsingtao Beer, Moutai Liquor, Haier Home Appliances and Lenovo – are recognized overseas, most Chinese products remain at the mercy of importers, who now leave Chinese manufacturers with very little margin.

Unlike Japan and Korea, which have moved up the value chain, Chinese companies are still struggling to develop their technological and marketing capabilities. Chinese factories have remained complaisant for too long, preferring to chase a quick buck from OEMs rather than invest significantly in R&D or engineering. The thought of making significant investment without guaranteed success or immediate return is still, by and large, foreign to the typical Chinese business model. It is further discouraged by opaque government policy and the country’s history of choppy economic cycles. The long-term consequences are obvious – they are illustrated, for example, by the continued inability of Chinese automakers to sell into the United States.

With American and European companies still struggling and consumer demand soft, FDI into China has dried up. Some FDI still comes from big Western companies with well-established positions in the consumer market, such GM, VW and Samsung. Overseas Chinese in Taiwan, Hong Kong, Singapore and Malaysia continue to speculate in real-estate, buying up prime industrial parcels in places like Guangdong, and forcing foreign companies wishing to enter or expand at a reasonable cost to look to the interior, which is comparatively unattractive.

The other two pillars of China’s economic strategy still stand, at least for the moment. Investment in fixed assets continues, particularly in infrastructure projects funded by the nation’s huge foreign currency reserves. These are spurred on by the catch-word philosophy “If you build it, they will come” or paradoxical slogans about serving the people without paying heed to economic gain. Some have no economic basis, however, and their eventual failure will further impair the Chinese economy over time.

China’s domestic consumption has expanded substantially since 1978. While China now boasts the world’s second largest number of billionaires, 80 percent of its people still earn less than the average person in Bolivia, one of the poorest countries South America. Inflation and rising labor costs are translating into increased manufacturing costs. Although the newly rich spend, they spend largely on foreign goods made by companies like Louis Vuitton, Apple or Mercedes Benz. They send their children abroad to be educated; they go out of country for vacation; and they shop overseas in places like Paris or New York. A large proportion of domestically manufactured goods, apart from those with uniquely Chinese or patriotic appeal, now wind up on the open global market awaiting buyers or disposal.

The Chinese government has responded with new policies aimed at changing this trend. Government officials, for example, are now asked to buy only domestically-made vehicles. But it will take time for these policies to have any real effect, particularly in a society where new-found wealth and status are prized as symbols of progress at the expense of practicality. Besides, foreign goods still represent a level of quality as yet unachieved by Chinese manufacturers generally.

In short, rising domestic consumption has not given Chinese manufacturers as big a boost as expected. If anything, it has made their goods less competitive overseas.

There are signs that the U.S. economy is on the road to recovery, which is clearly good news for China. But China’s trade strategy is overshadowed by unprecedented challenges. Going forward, Chinese manufacturers will find it increasingly difficult to rely on a strong domestic economy, favorable government policies and low-cost labor. Since the country already dominates the world market in low-value-added, commodity-type goods and has little to offer in the proprietary, higher-value-added arena, something will have to change. China’s manufacturing export strategy must, of necessity, enter into a new era.

China sailed through the global downturn on the back of extensive investment in fixed assets, but with its export strategy now in jeopardy, it won’t be able to fund growth indefinitely, even with its large reserves. Chinese companies will have to “go out” to compete, developing their own global brands and technology. They will have to alter their management structure to become true multinational corporations rather than simply OEM contractors.

The government already recognizes that in order to compete internationally the country has to shift to technologically advanced manufacturing. Precision and reliability are essential to many of the new products that China wishes to sell overseas, especially those that must meet stringent safety standards. Branding and R&D activity must also take a step up. Many Chinese companies are unfamiliar with these, particularly the private ones, and unless they catch up quickly they will find themselves at a loss. Most brands are owned, and R&D funded by the government in China. This will have to change. Labor will change too. Humans will have to be replaced with robots and computerized numeric control processes, creating the socially and politically dangerous question of what to do with redundant factory workers.

Chinese society is deeply rooted in relationships. This is reflected to some measure in the country’s current social polarization and poor government transparency. In a society where personal relationships and cronyism carry significant weight and government controls are stricter, the state of the economy has serious ramifications. When it prospers, people tend to be content. When it slows, they become discontent. Those deprived of upward mobility can despair or even become radicalized, often holding the government to blame. And discontent isn’t limited to the poor. For China’s newly rich, money is like an opiate. When it slows, they too become discontent, and discontentment on all sides inevitably leads to instability.

China needs to grow to remain stable. To maintain growth, it will have to adapt to changing conditions. Like America over the course of the past few decades, China too must experience the pains of globalization if it is to change structurally to compete and prosper. The government has to push forward the reform process with renewed urgency – to deepen transparency and foster a stable, consistent legal system. It can’t allow this process to peter out, leaving only a system of changeable laws and arbitrary enforcement. It must also encourage the separation of “guanxi” (personal relationships) from business and demand that decisions be made based on sound economic rationale.

It’s unrealistic, of course, to expect Chinese culture to change overnight. But by taking confident strides towards greater transparency and the rule of law, China will instill confidence, both in its own citizens and in foreign investors. As this happens, it will become easier for China to acquire the skills and non-strategic technologies it needs to carry it to the next stage of development, as well as for U.S. companies to reinvigorate their operations in China. In the end, both countries can only benefit.

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