Investing In China For The Long Term

| About: iShares China (FXI)

"As Maine goes, so goes the nation," they used to say at election time. As China goes, so goes the global economy, we almost might say now. So here is a look at the future of China from the proverbial 40,000 feet.

China's economic renaissance is now in its fourth decade. One of its striking features, in addition to its success, is its constant state of change. The types of goods produced, the degree of dependence on cheap labor, the relative openness of markets and currency, all have changed dramatically in the 33 years or so since Deng Xiaoping first began the reform movement. From most reports, it appears that more changes in the direction of economic openness are coming with the next group of leaders.

This progression toward relative economic openness is quite extraordinary, given the oligarchic nature of China's government. To be sure, state capitalism still flourishes and cronyism remains rife. But both state involvement in business and rewards to political cronies have decreased in recent years, and there are signs that a greater crackdown on cronyism is in the offing.

Why does this progress take place? Could it be that the leaders of China have a vision of the future that entails a continuing opening of the economy? Could it be that the leaders of China have aspirations for the Chinese people that require that they become better off economically? Could it be that the leaders of China believe that China's future will be built on education, creativity, personal discipline, and hard work? My guess is that the answer to all of those questions is "yes".

How could that be? How could a group of self-perpetuating oligarchs arrive at such sensible conclusions, and actually implement them rather than using their power mostly to plunder and line their own pockets, as oligarchs have done in so many other times and places?

And if the Chinese oligarchs are so progressive, why have they not moved toward greater political openness as well as economic openness?

Chinese History

The 40,000-foot view of Chinese history goes something like this: During many phases of human history, China had the leading civilization in the world. This civilization, though cultured and supported by military excellence, was subject to breakdowns as peoples and tribes from China's borders attacked China and attempted to control its riches whenever such peoples and tribes thought they were strong enough. The power of China's rulers was, from time to time, insufficient to keep out the barbarians, and from time to time China was invaded, thrown into chaos, and its civilization was set back. Chaos was the thing most to be feared.

At a time of relative plenty, however, in the 18th and 19th centuries, the industrial revolution took China by surprise. Powerful guns and the efficiency of new machines made China a second-rate power, largely under the thumb of far-away England. This was a terrible humiliation. At the same time, China's relative weakness made it subject to Japanese expansionism and Japanese control, as Japan seized the opportunities of industrial processes before China did. As a consequence, the China of the late 19th and early 20th centuries was weak, chaotic, and this situation humiliated the Chinese people.

The Chinese revolution of 1911 seemed to promise a degree of progress and hope. For the first time, China established a republic, with Sun Yat Sen as its first President. But the initial promise of the republic was not borne out, as the country descended once again into relative chaos, with the Nationalists and the Communists splitting what had been a single revolutionary party. The Nationalists and the Communists fought for control of China from the mid-1920s to the Second World War, when Japan's invasion of China temporarily united them. The Communists defeated the Nationalists after the end of WWII, and in 1949 the Nationalists were driven from the mainland and took refuge in Taiwan. The Cultural Revolution, in which intellectuals and businesses owners were purged by the Communists, followed.

Deng Xiaoping came to power in 1978, along with a group of Communist leaders who had seen the Cultural Revolution and Mao's Great Leap Forward and did not believe Maoism was the way forward. They began to have a different idea of China's future and its future place in the world.

What Was the Logical Set of Goals for Deng in 1978?

After looking at the rest of the world and China's history, what would be natural tenets and goals of a group of people coming to power in China in 1978?

  1. Maintain order.

  2. Build a military that can assure no foreign domination.

  3. Utilize China's current backwardness to gain advantages in the global marketplace.

  4. Prepare the Chinese people for the future by better education, particularly in language and technical skills.

  5. Use China's market position to gain access to leading technology.

  6. Utilize access to leading technology and technical education and expertise to build a world-class innovative cadre.

  7. Gradually change China's backwardness into manufacturing excellence and efficiency.

  8. Maintain a tight control over the economy, gradually opening up to global competitive forces only when Chinese workers and technical personnel are ready to compete.

Thus far, China's leaders have followed this logical and sensible course. Most of the rest of what we know is "noise". What does that bode for the future?

Does China Have to Embrace Democracy to Succeed Economically?

The recently-published "Why Nations Fail", co-authored by M.I.T. economist Daron Acemoglu and Harvard political scientist James A. Robinson, suggests that China cannot go forward toward its logical economic goals if it does not open up its society, basically to democratic pluralism. This book, at the moment the darling of the more liberal set (see Thomas Friedman's op-ed, for example), makes assumptions about the Chinese leadership that may not be warranted.

Let me back up and state some of the fundamental points on which I am emphatically in agreement with the authors of Why Nations Fail:

  • Competitive markets greatly enhance the opportunity to create economic progress.

  • The development of competitive markets was a material factor in the success and spread of the Industrial Revolution.

  • Competitive markets do not exist in a vacuum. They require political systems that sustain them.

  • If a political system is, in the authors' term, "extractive", meaning that if those who control the political system use it for their own economic advantage, to the exclusion of the advantage of more ordinary folks, then competitive markets cannot flourish and the relative magic of competition is defeated.

  • A political system that values and protects a multitude of points of view is the kind of political system that is likely to protect "competition" rather than individual "competitors".

So far so good.

We could expand on those generalities by discussing the history and roles of contract law, impartial courts, antitrust laws, and non-discrimination laws- in short, the things that level the economic playing field. We also could discuss the role of laws that stand on both sides of the competitive divide, such as patent laws and labor laws. After such an historical review, we would conclude that pluralistic, democratic political institutions appear to be a better foundation for competitive markets than other forms of governance. But the authors of Why Nations Fail seem to go further. They suggest that such a form of government is a sine qua non for competitive markets to flourish. There I part company with them.

Benevolent despots are few and far between, as are philosopher kings. But if we look at how the Chinese oligarchy has conducted itself since 1978, we may be seeing something different in action.

China's history does not include democratic institutions. The Chinese authorities have observed that in many places where democracy first takes hold, economic progress is stunted or political relative chaos results. Post-Communist Russia has not been a great success. India was an economic failure for its first 40 years of democracy, and India only became an economic success, arguably, to compete with China. Pakistan has been an on-again-off-again democracy dominated by its military. Indonesia has suffered from despots. Japan has had ineffective political institutions that have ended up running huge deficits and debt that are likely to burden the Japanese people for several generations. More recently, the countries that have won freedom through the Arab Spring pretty much all look like they'll be having a tough go for quite a while. If you governed a country that had two fundamental enemies- chaos and foreigners -would you bow to foreign pressure by inviting chaos? I submit that if you were a sensible ruling class, you would not do so.

At the same time, as a sensible ruling class, you would perceive the great economic benefits that competitive markets bring. You would, therefore, steer a gradual course toward more competitive markets. You would be quite cognizant that the competitiveness of a market is a relative matter, and that as long as you move toward greater competitiveness, you will be making progress and potentially spreading the benefits of economic progress to greater numbers of your people. This course of action would be consistent with policies that the Chinese leadership has followed with success since 1978. I expect the Chinese leadership to continue these policies over the next two decades. And I expect that such continuity will succeed. Points 1, 2 and 6 on my list above (tight political control, military strength, and an emphasis on technological excellence) are highly unlikely to change, but many details will change in the direction of more competitive openness.

Impact on the Global Economy

The Chinese leadership will continue to care about the global economy because their economic goals are based on success in global markets. That means that China will gradually import more. But it also will gradually become a very powerful force in innovation and precision manufacturing. China will continue to demand an important place in international institutions and affairs. China will seek to avoid war because its leaders have studied history and understand that even though the winners write the history, they also often are losers as well. But China will not take it lightly if it is not treated with respect.

Since WWII, all wars have been civil wars. That is, they have been wars between factions (ethnic, political or religious) within a country. The wars that grew larger (Korea, Vietnam, Iraq, Afghanistan) usually have involved one or more foreign powers- in all of these cases including the United States- entering on the side of one or the other of the combatants. China and the U.S. were thus involved in the Korean War. Internecine conflicts will continue to arise. Except on its borders, China is unlikely to intervene, except if the U.S. intervenes first.

China has used its backwardness to advantage. In the future, it will seek to become a cutting edge competitor rather than backward one. I do not think China's relatively closed society, which I expect to continue to open up gradually, will stand in its way. Openness likely will come gradually when it has to.

To Americans like me, and Europeans as well, I will only say, "Stop nattering at the Chinese. Learn to compete better or we will get run over."

I am a China investor for the long-term. Being optimistic about China's future, I am bullish on the global economy long-term. Yes, I know about what happens in the long-term. And I know that the market can remain irrational longer than I can remain solvent, so I do not employ significant leverage. But if my children and grandchildren continue to invest for the long-term, my family will do well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .