This article was first published on PBS Newshour on Oct 23, 2013. The author's new book "Tiger Woman On Wall Street" will be released on Nov 8, 2013 by McGraw Hill, one day before China's "Third Plenum".
When foreigners visit China, they are often impressed by the country's spectacular hardware: the modern architecture of the coastal areas, the fancy international hotels and luxury shopping malls, a high-speed railway that runs at more than 180 miles per hour while still providing passengers with Wi-Fi access.
The continuous news cycle that contrasts China's economic success with the lukewarm economic recovery in the U.S. and E.U. reinforces this view. A poll released in July by the Pew Research Center shows that many people around the world believe China is poised to overtake the U.S. as the world's leading superpower. China's economy continues to chug along at more than 7.5%, with projections showing that it will surpass the American economy by 2030. Many Americans think that it is merely a matter of time before China takes over the world.
But what is conveniently dismissed, amidst the popular American declinism, is that China still lacks the "software" to support and sustain the impressive hardware. By software, I refer to the rule of law, accountability, governance, and most importantly the quality of its people, as citizens, workers and managers. China's educational system has failed to produce either an honorable or an innovative labor force - defined broadly to include those who make their living by their hands and by their brains.
Investing in a business is ultimately about investing in the people who run it. I learned from my investment career on Wall Street that a business is only as good as its managers and its corporate leadership. Assessing the integrity and quality of management should be an investor's priority in performing due diligence, especially in emerging markets such as China. If the manager is a crook or has serious character flaws, none of the other business factors will make the target a good investment.
China's success story is based on a single economic mode, that of mass production of low-value manufacturing products using abundant and cheap labor, massive capital investment and endless economies of scale. That growth prescription has lost its efficacy. The country's changing demographics make this system increasingly unsustainable, as China's aging population and rising wage costs eat away at the abundant supply of cheap labor.
The policy of accelerated urbanization, using carrots as well as sticks to cajole 200 million sometimes reluctant rural residents into the cities, will not reverse the trend of rapidly rising cost structure. In fact, unheeded urbanization could turn into a costly economic, human and political failure. After all, China still has yet to deliver equal rights to approximately 250 million migrant workers in its cities, rural citizens who are denied access to many urban social services under China's restrictive household registration system.
In addition, the environmental degradation that is a byproduct of the country's capital-intensive, externality-ignoring development model is undeniable. Chinese citizens are seeing their life spans cut short by the poisonous air in the largest cities - most pronounced in the capital Beijing - the worsening water quality, and the polluted soil and food grown out of it.
The weakness of China's civil society, including the absence of free media, freedom of religion and freedom of speech, is another manifestation of how the lack of human and social capital hurts the quality of life and sustainable growth prospects. China's leaders increasingly view the formation of a civil society as a threat to the government - a sort of insecurity on view in ongoing crackdown on social media and the mid-September arrest of a Chinese businessman known for promoting civil society.
These measures show Chinese society is moving in the wrong direction, with negative implications for its economy. To upgrade and invigorate its current economic model, China has to adopt a more open, pluralistic political system. To transition to a more value-added, service-oriented economy, the country needs a society with a judicious mix of what Albert O. Hirschman, the Nobel Prize-winning development economist, termed "exit, voice, and loyalty": freedom of choice, freedom of expression and the ability to work together toward a common goal.
Last but definitely not the least, China's ultracompetitive education system, which continues to prioritize propaganda and memorization above independent and critical thinking, weakens the country's workforce. Major changes-some of which will compromise the state's tight control over its citizens-are called for to produce a labor force compatible with the advancement of the economy.
Drawn to the American values of individualism, freedom and social mobility, I left China in 1996 to pursue a liberal arts education at Middlebury College in the rural Vermont. During the 17 years since I left China, it is astonishing to notice that education remains first and foremost a device for drilling party ideology into impressionable minds, despite the dramatic changes in the society and economy. Textbook material exemplifies and glorifies the party-how it takes care of its people, the way a parent does for a child, and how society should therefore be appreciative and obedient, ready to put self-interest aside when the party asks.
Teaching ideology in itself is not a problem, but dictating which idea is right or wrong is a problem. Every school in the world teaches some sort of ideology. American schools prioritize freedom of choice and individualism, for example. They encourage students to dare to be different, to think out of the box, to take risks, and to lead. The products of those ideologies include some of the world's greatest innovators, such as Bill Gates, Mark Zuckerberg, and Steve Jobs.
China today is essentially caught in a prison of its own past success-the staggering and unprecedented achievement of lifting 500 million people out of poverty in 30-plus years. Chinese people are energized and anxious at the same time. Outsiders are awed, and they assume past glory is indicative of future achievement. But the country's trajectory seems similar to that of an athlete on steroids. As with most athletes on steroids whose temporary outperformance is likely to followed by a long period of underperformance.
To avoid this fate, China's singular focus on fast growth and the purely quantitative bottom line in the past ought to be shifted to the quality of economic growth, of the country's citizenry, and of the society. Wresting control from vested interests and carrying out the dramatic reform to institutions necessary to make this shift will be difficult, but it is the only way maintain China's spectacular economic performance.
Many transitional economies, including Japan in the 1960s and 1970s and Korea in the 1980s and early 1990s, have gone through a period of super growth and succeeded in advancing to a new model. A rich history of the developed world gives China an advantage: it can learn from other countries' history and avoid some of their mistakes, if it chooses to.
Within the country, a consensus is beginning to form, from the top leadership in Beijing to corporate executives to average citizens, that the country is nearing an inflection point that will force it to reflect and reform. Yet the vested interests that have enriched themselves on the country's old growth model have so far mostly succeeded in putting on the brakes. This conflict of interest should send a clear message to investors: buyer beware at this tipping point of China's growth. Assuming that the past rate of growth is the norm for the future may only invite costly mistakes.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.