Coming into the Year of the Yang Wood Horse I made 10 predictions about China in 2014. And on eight of the ten I was right, or at least have yet to be proven wrong, with half the year left to go.
Tensions with Japan have not quite risen to the level of a standoff but there has been no warming of the relationship and given the standoff that has occurred with Vietnam, resulting in violent anti-Chinese protests in certain Vietnamese industrial parks and the evacuation of some 4,000 Chinese, and the ongoing escalation of rhetoric between China and the Philippines, China has clearly shown it will stand firm in its territorial claim to most of the South China Sea, and the Diaoyu Islands (What the Japanese call the Senkaku Islands.) are certain to be no exception.
The one prediction that has not come true was my prediction that the government’s efforts to double wages over 5 years would inevitably lead to a materially higher rate of inflation. Through May the CPI rose only 2.2%, a paltry amount considering the 17% rise in wages officially reported by the government last year.
Why? I think there are two primary reasons.
The first was simply an error in judgment on my part. While I don’t doubt the government’s statistics, I don’t believe that the vast majority of individual Chinese, particularly those employed in the informal economy, are covered by those statistics. (Nor did they enjoy a 17% increase in wages last year.)
The second is that I failed to factor in the Chinese race to scale. Western companies, and public American companies in particular, measure profitability in terms of the Return on Gross Investment (ROGI) or some related variant – Return on Assets, Return on Equity, etc. They want to know how much money they earned on the investment made.
The Chinese, however, tend to focus almost exclusively on cash flow, in part, because the cost of capital is so low for Chinese companies. They can typically raise money on equity exchanges and/or from local governments or the banks they control for far less than even the highest – rated American companies can, even with interest rates essentially at zero in the US and Europe. In contrast to their Western counterparts, therefore, they are less concerned with what they earn on the money invested and more concerned with how much cash the company generates. It’s the difference between an investment-oriented investor and an income-oriented investor.
And it’s the difference between a company that looks to earn a return on past investments before investing further and a company that is willing to plough all of its earnings into further expansion. ROI is a game of timing. Cash flow is a game of scale.
Scale is a powerful weapon anywhere in the world, but nowhere can a business leverage scale more effectively than in China. In part this is simply due to the fact that because your suppliers and other business partners are themselves racing to scale, you, in turn, can leverage your scale on them. Scale begets scale, if you will.
Perhaps more importantly, scale begets government influence. Remember that the government has 1.4 billion people to employ, a responsibility it views as a literal matter of survival. It’s practical role, therefore, is to promote commerce as much as it regulates it. It’s a balancing act, for sure, but a company that can grow rapidly will generally find a powerful ally in their local government. In the extreme this can actually mean having a hand in shaping the regulatory agenda (and it’s a long agenda) in a way that promotes that company’s economic interests.
As a result, however, propelled by two decades of double-digit economic growth, many industries in China are now faced with severe over-capacity. By the end of 2011, according to the International Monetary Fund, China’s factories were running at only 60% utilization. Steel – with twice as much capacity as the market can absorb by some estimates – cement and aluminum top the list but chemical fiber and paper/fiberboard, which are key input costs for companies across a broad spectrum of industries, are all facing capacity gluts.
In such an environment companies are faced with the unattractive choice of either going out of business and walking away from their investment or taking business at any price that at least covers the company’s variable costs. And since many high capital industries are burdened with fixed costs that easily account for more than half of total costs, prices have a long way to fall, even in the face of rapidly rising labor costs.
And that, in a nutshell, is what is happening in industry after industry in China. Due to severe over-capacity market prices continue to fall, or at least remain stable, despite rising energy and labor costs, leading, in fact, to actual concern about the possibility of deflation and the impact that might have on the all-important real estate sector.
And that, in turn, leads to another trend, which in this case I did predict : A material slowdown in the pace of Western business investment here.
Of the 552 multinationals recently surveyed by the European Union Chamber of Commerce in China nearly half of the respondents agreed that the Golden Age for foreign investment in China was over; 61% of companies that had been in China more than 5 years agreed that doing business in China has become more difficult over the last year; and fully 1/5 said that they were considering withdrawing investments previously made in China
But what does this all mean for China itself?
In the end, probably not much. When it first began its transformation into becoming the factory to the world China needed both foreign investment and foreign technology. And it skillfully managed to get an abundance of both.
At this stage of the game, however, it has plenty of capital. The government, after all, is sitting on $1.2 trillion of U.S. government debt.
And the technology gap has essentially closed. Chinese companies have developed or acquired the same production technology employed by the foreign companies who came here with such enthusiasm over the last three decades.
And while employment and the commercial growth it requires are still the government’s primary concern, China doesn’t want to be the factory to the world anymore. The environmental and energy costs are simply too high for a country with limited energy resources and such high population density.
As a result, China is openly and publicly pivoting its economy away from the export-driven model that made it the world’s second largest economy to a consumption-based model on which it can continue to grow without the same exposure it faced in the past to the global economy and foreign currency markets.
The other side of that coin is a pivot away from an industrial-based economy to one based on the service sector – everything from entertainment to banking. Which is why de-regulation of the services industries, particularly financial services, is high on the government’s current agenda.
I find it highly doubtful, however, that the foreign service sector will find the same opportunities here that their industrial cousins did a couple of decades ago. While Apple still sells a lot of iPhones and iPads here, the tech industry in China is driven by Chinese companies (e.g. Alibaba, Huawei, Tencent, Lenovo, etc.)
And, I believe, that will continue to be the case in IT, banking, insurance, and the other key components of the service sector. For a couple of reasons.
The first is that the technology gap between Western companies and their Chinese counterparts is much narrower in these industries. Contrary to perception, there is a lot more technology at General Motors than there is at Google or Amazon. The latter rode the technology wave but it was the former that applied it in the most challenging ways.
And the second, as we in the West are now learning, is the degree of integration that naturally exists between the service industries like banking and telecommunications and the government’s interest in financial stability and national security. When it comes to financial services, where does the public sector stop and the private sector begin? As we saw during the 2008 financial crisis, that’s a fine line indeed, even in ‘free market’ economies like the U.S. and the U.K.
And as we’ve now learned from the revelations of Edward Snowden and others, the line between information technology and national security can likewise be blurred.
The fact is that when Western industrial companies came to China they needed little from the government other than land and permission. And the government, in turn, needed little from them other than capital, technology, and jobs.
That won’t be the case when it comes to the service sector. The Chinese government simply will not put its national security at risk at the hands of foreign IT companies whose loyalties will be naturally compromised. Nor will they want to ever expose themselves to having to prop up a foreign financial crisis not of their own creation.
The Chinese service and consumption pivot faces many challenges and a multitude of risks. But capital and technology are not among them. The fact is that China does not need direct foreign investment to pull this off.
So, while I was wrong about inflation, I was right about foreign investment and my mistake was not connecting those two dots.
The real lesson here, however, is that China’s pivot away from industrial exports to domestic service consumption is, in fact, a pivot out of the global economy. At many levels China is leaving the global nest, an economic and financial pivot that clearly positions the world’s second largest economy and most populous nation on a path to self-determination that will undoubtedly have a dramatic impact on the rest of Southeast Asia and the world. At a time when the West most wants to influence events in China, in other words, it will find itself with far less leverage with which to do so.
Copyright © 2014 Glassmaker in China
Notice: The views expressed in this post are strictly those of the writer acting in a personal capacity. They are not in any way endorsed or sanctioned by his employer or any other individual with which he may be personally or professionally affiliated.