China: Why It Can't Be a Global Leader 24 comments
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The market picked up since my March 4 (here) and March 9 posts (here). If you’ve played along, it is time for you to harvest some rocket gains… but that is not the subject of this article.
Instead I will discuss China. I like James Quinn’s diarizing on America’s fade-out (here) as brain food, but I just don’t see it. The question is leadership. What other nation can lead?
Well, Europe has not come to terms with flailing banks (see Harrison’s post here). Japan continues on its real, demographically-driven, low demand fade-out. Oil rich Middle Easterners invest, but don’t invent. Korea and Taiwan are small, and hurting on export declines.
Some think that this leaves China (see here) to lead the world into the future. But China can’t lead, and won’t for decades, if ever.
The Bottom 80%
Consider the USA in 1965. Manufacturing hums along. 160 million folks, mostly productive and decently educated. A growing service sector, expanding institutions, prosperity. Now add an event whereby the US expands its borders to encompass all of poor Latin America and Africa. Then strip out those regions’ natural resources, and you have China today.
China has 1.3 billion people. While 562 million (42%) are listed as “urban”, in truth there are 180 million in the metro areas that wow westerners – but a third of those are in slums and shantytowns that most westerners don’t see. The chart below gives you estimates of life in China for the bottom 80% -- on a purchasing power parity basis, this 80% average $11.58 per day to fulfill all of their needs.
click to enlarge
The truth is that China is two nations. One is booming, fast-moving and sophisticated. The other copes with a poverty equivalent somewhere between today’s Laos, Syria, and The Congo – except without the natural resources of those nations, as much of western China is non-arable desert or mountain.
No Domestic Demand
China’s bottom 80% earns $4.48 per day in USD: peasantry amounts. After food, shelter and education are paid, less than $2 is left for “desires” that are often priced in dollars – say, an iPod or a netbook manufactured in China.
China’s elegant solution since Deng was to mimic early Asian “tigers” with an export-led tide. Thus the bottom 80%’s per-capita income grew from $1.65 per day in the early 1990s, to $4.48 today. Deng’s solution worked.
But China can lead? Nations that can lead must be strong inside and out. And Deng’s solution hinged on two things: the assent of Western nations to buy stuff made in China, and cheap labor, from attractive currency rates.
A Manipulated Currency
In January 1990, the Yuan was Y4.73 to the dollar. By January 1994, the Yuan was cheaper at Y8.47 per USD. From 1994 all the way to December 2006, the Yuan stayed above 8 to the USD. Since, the Y/USD rate has been managed down -8% in 2007, and -7% in 2008, to Y6.83 today.
China’s economic growth has been a Faustian bargain. The BoC manipulated forex so the Yuan stayed eight to the dollar even as the China-US trade imbalance grew tenfold. Exports sucked out dollars from the US. Now China had to offload dollars, so it bought the “safest” dollar-denominated assets like Treasuries and Fannie and Freddie CMBS, to keep this great game – or Ponzi scheme, you could say if you were average Chinese – going.
As Milton Friedman might say: “You get what you get.” In Yuan terms, these assets’ value has sunk -15% since 2006 just by forex. If our Fed inflates us out of today’s crisis, there could be another -15% or more writedown that China will take on US long bond holdings.
Losses on dollar-assets impact China’s wealth position, so its economy. “Truth-time” puts forex back to Y4.7 to USD, if not Y3.5. China’s instant losses on dollar-assets in that scenario run to 25% of its GDP, or 40% to 45% if Euro-zone writedowns are included. That is, China would get the same wealth haircut the West just got – but China’s agony would be worse, with its less developed, less balanced economy.
China has no solution to its self-inflicted “bubble” of manipulated forex. Keep managing the Yuan, hope Western demand returns, then have to pour good money after bad into the West. Or let the Yuan float, take a massive wealth hit, then watch Western firms unbolt every Milacron from every factory floor, as labor unrest takes hold.
The People’s Party
A client of mine wintering in Europe is insufferable. When I ask what the vibe is on the streets of Paris, Berlin or Zurich, he says: “They don’t know they’re in trouble yet, their government hasn’t told them.”
It’s worse in the PRC. The average under-informed Chinese depends on government to direct, manage and assume the risk for everyday life (except healthcare, for which Chinese families must hoard cash).
There is a great misunderstanding of the People’s Party. The Party is Populist. It bows to the bottom 80%’s needs above all. But the Party is not monolithic. Current leaders must do what is “good for the people” (the 80%), or more populist figures gradually assume power, and quietly remove the old guard. Deng was such a figure, a master in orchestrating this dance.
Can the Party let banks and state-run firms fail? Many should be failing now: if they marked down their dollar-assets, Shanghai real estate, and loans to 50%-utilized factories, hundreds would fit any definition of “insolvent”. But in the Party’s China, this cannot happen. If the banks go under, the jobless grow too many, new, more Populist leaders will emerge. And power within the Party is everything in China.
So current Party leaders are in the hind-end spot of following the west, and hoping for our recovery. There’s nothing else for them. BoC Governor Zhou’s call this week for a new “world reserve currency” to replace the dollar (here) is only a bleat from the Party’s future sacrificial lamb.
Law and Education
Anyone who does business in China will tell you contracts mean little, judges reflect the Party, and it is a land of a hundred excuses, lies and slights veiled as misunderstandings. Rule of Law means nil. As much as we in the West seem to invent laws everyday to cope with this crisis, we still adhere to process. And when even process gives out, there remains the ballot box. Not so in the PRC.
China’s education system is producing a wealth of technical professionals like engineers, but to look at abstract numbers lacks context. China does not produce the smartest or most creative of these, nor does it produce a large share relative to its 1.3 billion population. In fact, the bottom 80% are under-educated: only 9 years compulsory education is provided. China spends just 2.5% of GDP on education, ranking it 155 out of 182 nations. Contrast this to Argentina’s 3.8% or Brazil’s 4.0%.
Historical Precedent
In 1989, Sony (SNE) Chairman Akio Morita published “The Japan That Can Say No” (here), which asserted that the West depended so much on a “smarter” Japan, that all Japanese should shed views of their country as a “poor island nation with few natural resources”, and embrace their own “innate superiority”.
We saw how that movie played. Trade runs two ways. In Japan’s case, its hoard of dollars led to a giant asset bubble and two lost decades. In China’s case, its dollar and Euro hoard may find a different path, but the outcome will be the same. Huge overpayments for in-vogue assets of the day (for the Japanese, Columbia Pictures, Rock Center, Pebble Beach; for the Chinese, natural resources firms).
It’s called “trade” for a reason. A manipulated currency, a one-way street, comes back to haunt.
China Can’t Lead
For each photo of the glitzy Shanghai Bund, imagine six photos of Mexico, Kenya or Cambodia beside it. Such is the PRC that the Chinese know – 14% glitter, 86% hardship or worse.
China has wealth in sheer numbers, but since most folks subside in poverty, this wealth is opportunity, not reality. China and its Party remain reliant on the ability and assent of other nations to raise the tide for its bottom 80%.
While we can expect a rotation that has China trading more to resource-rich Latin America and Africa, China’s biggest markets still will be where the numbers are – the US and Western Europe – for decades to come.
China can’t lead because it is mostly poor. It can’t lead because its snarky forex plan haunts it. It can’t lead because of its Party’s dynamics. It can’t lead because, like Japan before it, it has yet to learn that “trade” isn’t run as a scam, but goes two ways.
Which, in the case of a few Chinese engineers I’ve used, means actually paying for their copies of Office and Autodesk… too much to ask? When that happens, I’ll know the Chinese century may be beginning.
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China also has control of the reins of their country...I have not seen that yet in our leadership yet either. This country is facing an uphill battle for years to come.
On Mar 26 04:06 PM User 383724 wrote:
> The Writer is looking at a snapshot not the video- with all it's
> short comings, China has one key advantage over the United States,
> it's run by engineers not lawyers.
At least everyone will be entitled to a share of that bailout money equally.
Have you any idea how stupid that sounds. If the dollar goes down the Yuan goes up. Much more of their wealth is tied up in Yuan than it is dollars and if their currency is inherently strong they can print as many as they wish, just like the US has in the past. A weak Yuan is not making China rich. Quite the opposite really. They are clearly beginning to realize that they are now in a position to start flexing their muscles, and as exports are weak at the moment currency movements will actually have less impact now than before. Beside even if the value of the Yuan doubled against the US currency, home grown US product could never compete on price.
The worldwide education stats are notoriously difficult to compare across borders, e.g. some include private funding and some don't, and some include local funding and some don't. The bottom line is as of now a 18-yo kid in China has some 30% of chance to have college education, and that number is pretty decent.
That People's Party bit is laughable. The last premier to shape up the SOEs, laid off 20 million, during the Asian economy crisis in the late 90s nevertheless. Like they won't let firms fail if that has long-term benefits.
Frankly, I think the US actually did quite well out of the Cold War with Russia and perhaps endeavored to sustain the situation for longer than really necessary. It may well be that they are attempting a replay with China, they certainly seem to go out of their way to offend the Russians.
But don't be fooled, not all Europeans and others swallow all these arguments whole. China is becoming a valuable trading partner. Whilst Britain and Co. may still suck up to US Presidents they are not going to do it at the cost with good relations with Beijing.
On Mar 26 04:31 PM User 383743 wrote:
> This article is a typical silly and sick western journalistic mindset
> or rather power-hungry psychosis. NO single nation should seek
> to rule the world. The US cannot rule China much more the world
> and China cannot, does not, and should not rule the world. Like
> it or not, there are five or six governing nations and China is one
> of them. The days of superpowers are gone!
>
On Mar 26 06:38 PM JX wrote:
> PBoC is the central bank. BoC is a the 3rd largest commercial bank
> in the world by market cap after ICBC and CCB. Some of the data
> is dated. But overall you are right China is a relatively poor county
> at a per capita basis. If Yuan is to appreciate against US dollar
> from 1:6.8 to 1:3.5 (nearly double), sure the foreign currency holding
> would be worth less (in Yuan term), but the domestic assets would
> be worth more -- roads, bridges, factories, etc. Plus even your
> bottom 80% would have twice as much income (in dollar term). BTW,
> if that happens, which in my opinion quite likely, within the next
> 5 years or so, China may have a larger economy than the US (now $4.4
> trillion vs. $14 trillion). For those who start punching numbers,
> just remember China has been under-reporting its real growth by having
> stealthy higher GDP deflator numbers.
>
> The worldwide education stats are notoriously difficult to compare
> across borders, e.g. some include private funding and some don't,
> and some include local funding and some don't. The bottom line is
> as of now a 18-yo kid in China has some 30% of chance to have college
> education, and that number is pretty decent.
>
> That People's Party bit is laughable. The last premier to shape
> up the SOEs, laid off 20 million, during the Asian economy crisis
> in the late 90s nevertheless. Like they won't let firms fail if
> that has long-term benefits.
Comments on "The Bottom 80%": I have heard many definitions of "middle class" and "poverty", but never one based on the qualifier "metro areas that wow westerners". Striking ethnocentricism notwithstanding, just because you do not live in the top 40 cities, does not disqualify you from qualifying for the middle class. I'm not saying China is a rich country by any stretch, but it is somewhat misleading to compare them ($6,100 per capita GDP, PPP) to Laos ($2,100), Congo ($3,800). [Later you also try to make the comparison to Cambodia ($2,100) and Kenya ($1,734)]. That the bottom 20% of China is around the same level as the average in Laos or Cambodia isn't all that meaningful to me. That's like trying to draw some sort of conclusion by comparing America's lowest 20% (~$10-12k) and Kazakhstan ($11,563), Iran ($11,209), or Bulgaria ($12,372).
"No Domestic Demand": It is misleading to use non-PPP figures in China and try to put it in the context of the U.S. standard (and then label it "peasantry"). Again, middle class is not defined as being able to purchase an iPod. The majority of chinese cannot afford one. But they can purchase a Aigo MP3 player for a lot less. Does that disqualify you from the "middle class" or make you "poor"? I personally don't think so.
"A Manipulated Currency": You call it a "manipulated currency", I call it a managed currency. The goal here is to provide stability to encourage investment and development. Most export-oriented investment has come from the big exporting countries and entities, and disproportionately so the once with ethnic links: Hong Kong, Taiwan, Japan, South Korea, etc. Most U.S. and European investment is geared towards selling into the domestic market.
Its currency reserves, while not insignificant, do not represent the vast majority of the wealth of China. The vast majority of the wealth of a country is its domestic productive capacity, which is a function of many variables like fixed investment, education levels, natural resources, legal processes etc. While China certainly manages their currency to maintain a stable environment, in the long-term it is improvements in the productive capacity of the country that will drive global competitiveness. China today is not just cheap labor. It is relatively inexpensive labor combined with the latest fixed capital investment and production processes that is driving its competitiveness and market share gains in a variety of industries.
"The People's Party": I would disagree here. Over the last decade and change, the Communist Party has really been all about the top 20%, not the bottom 80%. That is one of the major sources of unrest. Today, people join the party to be successful in business. It is the 80% who have been getting shafted. They lost their SOE jobs in the 90s. Until food prices started to recover in the mid 2000s, the farmers were all but forgotten - incomes in the countryside had been stagnant for years. And the migrants have only recently been recognized as a critical piece of the economy.
In your treatise on why China cannot lead today, you actually failed to mention the most significant hurdles China faces over the next twenty years: demographics and environmental degradation.
If you are trying to make the point that China cannot lead today, I will not disagree with that statement. Their actions, direct statements and policies clearly indicate that they are not trying to be the leader. However, it is clear to me that China's role as a leader is increasing with the size of their economy. That is almost inevitable in our lifetime (next 50 years).
Of course I could be wrong, as it wouldn't be the first or last time.
On Mar 26 03:40 PM John Thomas wrote:
> The one screaming buy out there now are the emerging markets. The
> US, Europe, and Japan are now committed to spending trillions of
> dollars to shock the global economy back to life. This is costing
> the emerging economies nothing, and gives them a free ride back to
> prosperity. IT turns out that the smaller economies are financially
> better off than the big ones, with a decade long export boom blessing
> them with massive foreign exchange reserves and little debt. China,
> Russia, India, Brazil, and Turkey will be the big beneficiaries.
> You can buy the specific ETF’s for these countries, or go with the
> generic iShares MSCI Emerging Market ETF (seekingalpha.com/symbo...),
> which has already started to outperform US markets in a big way.
> It’s a once in a century opportunity to buy the highest growth corners
> of the world’s economy at severely knocked down prices.
Great comments, thanks! A few culpas first: sorry about the distorted chart, don't know why that didn't work; also, my title was "Why China Can't Lead (today)", not "China: why it can't be a global leader" (this header wasn't mine but SA's).
Look, I own both the FXI and EEM. China, India et al are great 25 year plays; huge markets, expanding, etc. My question was, who's the leadership today? And despite what I see on SA, often downbeat on USA prospects, my answer still comes up with the US as the lever to move the world economy forward.
2 cool comments -- from dybyx and User3837... -- had me consider if "leadership" was conceptually valid anymore, if any one nation's "leadership" can drive the world forward anymore, and whether that "drive" was even necessary.
I have to conclude yes, leadership as a mantle is valid. In any setting there is one leader or at least a moderator; this is millennia of human socialization talking, not me. And yes, the "drive" of leadership is still necessary, since drive yields benefits that accrue to the whole world. Which we can short-hand "innovation".
Innovation takes curiosity, faith, creativity, spirit. It flourishes under rule of law, and maybe even classic liberalism (freedom to say, do and explore), and further possibly capitalism.
And just for these plus the other reasons I cited, China is not ready to assume a leadership role.
I've worked with China weekly, if not daily, for the past three years. The export-oriented factories that I've dealt with are at 50% utilization now (rather than 100%+ twelve months ago), so a lot of migrants now have to move back to the interior, and subsistence lives.
China is going to be an exciting place, we can all agree. But China still needs to get itself right, before leading.
One example of this: many SA posters, and US media and politicos, like to mention the USA's "crumbling infrastructure". If the US's infra is crumbling, most of the EEM nations' infra is "crumbled" or more often just non-existent.
Not to mention politics, the press, the environment, the fact that 40% of the population works in agriculture. The list goes on.
The headline was not mine, and it's wrong. China is already a world leader: hey, it made everything that I'm using to write this.
Well, it made everything except my mind, and my thoughts, that is. Think I'd feel comfortable writing this post, and thinking these thoughts, if I were a PRC citizen?
Best to all -- pg
You might be surprised at how much the Chinese is aware of their own short-falls. Watch their policy moves and you will get a glimpse of this.
On Mar 26 01:17 PM dybydx wrote:
> I think you made the wrong assumption that the Chinese leadership
> wants China to be the world leader.
>
> By all visible measures, China has been playing a shy role in international
> affairs. In politics, China rarely veto in the UN. In military, the
> Chinese military made less expeditions than US, UK, France or Russia.
> In econmics, the RMB isn't even convertible at large quantities.
> What made you think they are even making an effort to lead?
>
> The Chinese leadership advocates "peaceful rise". The objective is
> to advance welfare of the Chinese people while staying out of sight.
Great article. Probably not PC enough for most people. Thanks!
On Mar 26 04:06 PM User 383724 wrote:
> The Writer is looking at a snapshot not the video- with all it's
> short comings, China has one key advantage over the United States,
> it's run by engineers not lawyers.
A knowledgeable position on China/US economics arises out of 3 sources: (i) doing business in China at some experienced level; (ii) deep knowledge of global economics arising from a MNC, global institution (UN,OECD, IMF etc), or (iii) strong established track record as an academic (Stiglitz). Garot (should I say parrot) merely regurgitates the positions of others.
In fact, most of the follow-on posters show a greater understanding of global dynamics today, as well as the historical trends, than the writer. Kudos to these posters.
economists have been running china, and it shows. unfortunately, they have continued to hold all the money in government - in state owned banks - holding back domestic consumption, creativity, innovation. the lack of domestic economy is now china's greatest weakness, and what it should aggressively seek to unleash. there is latent creativity here but it is focused on unproductive measures due to the lack of laws, police, and general stability. this is not japan. this is a country all its own, with many cultures interacting now, creating mini-melting pots all over the country... but which is going to have a very hard year, i believe, when the tail end of consumer drop off catches up.
and this is natural and good, and it will hopefully force the government to unleash the incredible entrepreneurial spirit and hunger for shopping that exists here.