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Reconsidering China: An Essay by James Vena

Posted Tuesday June 3, 2014 1:36:22 PM EDT

Have China's "growing pains" manifested into something a bit more troubling?  Certainly the potential of non performing loans, failing State Owned Enterprises, a waning desire to export and invest combined with an insatiable  appetite for consumerism and free markets spells expected trouble

Add the prospects of social unrest and you may see China embark upon a "Japan styled" lost decade.  Such an event will turn the global markets upside down and can indeed create an even bigger worldwide recession than the Great Recession of 2008. I sense big trouble is on the horizon and for the first time since the late 80's, I am now a China bear. Here's why:    

My first visits to Asia & China (on business) were in the early-mid 1980's and things were obviously much different back then. Aside from being much more socially oppressed and isolated, the most glaring difference was in its local economy, as all business was nationalized.

All companies were State owned (SOE), hence government run and managed. At that time, workers were essentially "drones", displaying very little in the way of desire or change, at least externally (or risk re-education to curtail selfish dreams of bourgeois capitalism).

In those days, international trade and foreign investment in the People's Republic of China, was in it's embryonic stage. Many corporations, especially from the USA, overlooked the isolationism, as they were seduced by the size of the new market.

Many of these corporations entered China with reckless abandon, making bad deals that ultimately often resulted in huge financial losses that wrote off as "investments". It was fairly standard for US and other foreign companies, to have the end products sold in "friendship shops" and other local stores, to Chinese consumers using only the local RMB.

Of course, it was illegal to convert RMB to FEC (foreign exchange certificates), and since the RMB was not convertible, with strict conversion restrictions in place for JV's, foreign corporations were holding "paper" that was devaluing on a monthly basis. Rather than fret over these embarrassing losses, most companies chalked it up as "tuition paid".

While it came as no surprise that this sort of control over the economy and it's people would make it difficult to believe that things would ever change, most stayed in the game, fearing to miss out on selling the proverbial "toothbrush" to billions of new customers. .

I saw things a bit differently. Perhaps it was due to my young and hopeful demeanor, but I saw beyond the Mao suits. Being young at the time, I was fortunate enough to be exposed to the industrious and driven, younger generation, that seemed to share my spirit of unrefined entrepreneurism.

Most of the people that I met in those days that were my age (mid 20's to 30 some-things) had a very similar thirst for knowledge with a shared intellectual humility. Clearly a trait that the older generation didn't possess as part of their understandably arrogant nature.

I remember, that the mid to late 80's, just prior to the Tiananmen Square (II) incident, this younger generation aspired to become rich, educated and desired a glorious, western lifestyle.

During one of my visits in 1987 to Lanzhou (Gansu province) on Joint Venture project with the local Oil Refinery (Sinopec), I recall being taunted with signs that were derogatory to western culture during the so called " down with bourgeois capitalism" campaign.

My recollection however was the noticeable embarrassment on the faces of the younger people in the delegation, not just for me, but for themselves and the abrasive behavior towards the Western cultures displayed by their elders. .

The younger they were, the less they agreed with the propaganda, in spite of living under the threat of a re-education process that most just didn't even know of, outside the walls of the PRC. .

Now, so many years later, as those people, of that generation, particularly living in the coastal cities found the glorious road to wealth, I started to question whether China, if need be, would ever be able to slow down its economy enough to stop it from one day spiraling out of control, without creating a breeding ground for social and civil unrest.

While many things have changed aesthetically, the reality is that most still believe that the government of China can suppress the animus from the masses if ever needed.

I am not so sure!

Surely there will not be a "Great Leap Forward II ", as the next cultural revolution ,will be the result of a widening wealth and freedom gap which will one day force the outright call for democracy.

After all, despite all of its economic achievements, China is not a democracy.

Recently, learning that China had clamped down on LinkedIn, Google and other internet sites in light of the 25 year anniversary of Tiananmen Square brought back some mixed feelings and an eerie "deja vu" type memory.

It is hard to believe that its been a quarter century since the massacre at the Square took place. Being someone that was quite active in China, (held a "liaison office" in Beijing) during that time, it still remains a bad (and sad) memory.

Blocking internet sites and oppressing the views of the people, seems to harken the old adage that the more things change, the more they stay the same.

As I stated earlier, while many things have changed aesthetically, the reality is that most still believe that the government of China can suppress the animus from the masses if ever needed.

After reading the dozens of news feeds and stories about the clampdown, its clear that many things haven't changed.

Going forward, I've been most concerned about the mounting internal pressures of discontent, along with a growing list of external tensions that have manifested over the last two years.

In my view, we should all be concerned that the headwinds that have been burdening China for the last few years are now becoming a bit more than the widely forecasted growing pains that are systemic.

The widening wealth gap, business opportunities and access to the finer things, between those who live on the coastal areas versus those who line inland, is troubling. Many, who reside inland, are patiently awaiting the wave of capitalization and the gloriousness of getting wealthy.

For some time now the Central banks have been "threading the needle", knowing that out of control inflation and an overheating economy will surely cause prices to spiral out of control creating unrest in the inland cities, but anemic growth will create economic harm to a very overrated economy.

One must remember that the first and most important concern for China, is its own domestic stability and security. If the people start to lose confidence in its leadership, all hell will break loose.

When I was in China during 1989, I saw first hand how quickly things can get emotionally driven and spiral out of control.

Currently I've been most concerned about the mounting internal pressures along with a growing list of external tensions that have manifested over the last two years.

The interior of the country, which is more than half of its population, have actually suffered because of the” new age” capitalism. Despite the storied and highly publicized new billionaires of modern China, over two thirds of China’s citizens earn less than the average wage of citizens living in some of the poorest countries in the world. This is not really surprising, as China has experienced this before.

China has seen such growth, mainly via global trade, create this same effect of rich and poor , coastal versus interior cities wealth gap several times in last few centuries. Further , as I stated, China would have to very carefully “thread the needle” to slowdown growth, enough to not allow runaway inflation to completely annihilate the non-coastal citizens, before they have a drink from the well of the “new age” capitalism.

As I wrote in an earlier op-ed, a move to allow the Yuan to freely float prematurely, would have further widened the wealth gap between the citizens in the coastal and non-coastal cities. This would surely lead to civil unrest, of devastating proportions.

Making sure this doesn’t happen, is China’s primary concern. So a policy to insure that the government does not lose the confidence of its people, is a very real story. Remember, Mao exploited these same tensions in the Long March into the interior to form an army of the poor, to ultimately fight and defeat the rich and powerful in the coastal regions. Of course, the long term effect on China, did not end so happily.

Mao’s conquering though division, manifested into an isolationist society shut off from the international trade ecosystem, that China previously exploited for it’s benefit. Isolationism led China to close the wealth gap, which in turn, left them equally downtrodden, hungry and very poor. The government, must convince the people that this will not happen again. China is not a democracy, so confidence is paramount to internal security.

My sources tell me that, even in light of the recent coup d’état (a very organized and covered up one) that most don’t know much about, most in China, are still confident that their government are leading them into the right direction. Nevertheless, the concerns are justified, and I caution that most of my sources are from SOE’s, and private JV’s, mostly in the coastal cities that have something now, to lose.

Now, a few years after my original report where I pointed out that China, cannot continue to grow at the unprecedented rates, without having a labor problem , many balked at my original statement that labor was getting expensive in the major cities, and labor shortages, were a real concern.

Well, once you stop listening to all of the politically motivated bashing, particularly being spewed by US politicians and their drone like constituencies, you’ll discover, that the cheap labor in China, for the most part is gone.

Factories are now trying to move inland, and the empty infrastructures are beginning to fill. This will be a process, but as growth slows, and manufacturing is moved inland, caution, concern and vigilance will be needed by Beijing, as problems could arise and another Coup attempt (this one will be harder to cover up) may erupt if the people living inland, lose patience and confidence in it's government. remember, China, is not a democracy.

The stewardship of China’s economic leadership will deserve a lot of credit, for threading this proverbial needle. It’s still too early to tell, but knowing this is their main concern, is a great step towards interior stability. This shift away from the expensive manufacturing costs in the major coastal cities, is creating a boon, in many Southeast Asian, countries, that are now being sought as an alternative to China’s high labor costs.

It is important to point out, that while this may be welcome news to manufacturing communities in the world, China uses private savings of its citizens to finance its industrial infrastructure. Dwindling exports, cannot be a sustainable phenomenon and will ultimately cripple domestic consumption. Not good for those who are hoping to take advantage of the new export markets they are finding in China.

Remember, China's industrial production is designed to be larger than its domestic economy can take up. China must export, to finance their import of raw materials. It’s a two edged sword, but China must have a policy in place that insures demand for its r exports. China now is doing this by methodically investing money in the economies of consumer countries.

You now see China moving eggs from its US basket, to other nations, as a means of diversification. Many would like you to think that they are making a political statement or trying to blatantly manipulate foreign currencies. It’s simply a matter of planning the future to ensure access to a growing global marketplace

The economic downturn the USA and debt crisis in Europe at the end of the last decade created a decrease in trade to both of these major trade partners, while not being able to appropriately increase domestic demand in order to take up the slack, due to the “two thirds”, not being economically able to do so. Compounding it’s concern is the fact that the coastal populations with the wealth, depend on exports. The impoverished interior requires subsidies that will become a burden to provide when if global economic growth slows to a crawl.

China, also finds itself with a need to protect itself, militarily. Issues in Tibet, trouble on the border with India, and the continued cat calls by the USA to interrupt China’s foreign trade, has left China in a position that it needs to consider protecting itself. It wouldn’t take much for the USA to cut off China’s access to the sea-lanes of trade. US politicians are doing too much saber rattling, for China to just write off this possibility. China, is simply reacting to what the USA is capable of, in a day and age, where the China bashing is at monstrous proportions.

In a nutshell, China will continue to have growing pains, will continue to have escalating labor costs, will continue to engage in their plans to narrow the wealth gap by moving factories inland, will continue to invest in other countries, continue to diversify those investments and will continue, to understand that the problems they face, are not understood, by so many of its critics and pundits.

China, revised its forecast downward just one half of one percent yesterday, and the markets reacted negatively (other headwinds notwithstanding). Can you imagine the inflationary pressures and collapsing debt and monetary markets if China faced an out of control civil uprising?

The thought frightens me, and is only eclipsed by my fear, that many who don’t understand modern China, or its history, are calling for changes and creating the fear, that will surely increase the odds that such a catastrophe can happen. The fragile thread that china is holding, needs less, not more pressure.

Recently, the CBOC insinuated that an end to the appreciation of the YUAN, was going to be a necessity, for at least the time being.

The FT stated “Top Chinese central bank officials on Monday said China’s huge trade deficit in February showed that the value of its currency was close to equilibrium after more than six years of gradual appreciation. This trade deficit is a positive sign that the reminbi exchange rate is close to its equilibrium level,” Yi Gang, deputy central bank governor, said at the National People’s Congress, the annual session of China’s rubber-stamp parliament.

China has had some surprising deficits in trade over the last few months. Rising imports of commodities helped drive the change, from trade surpluses, and rising labor costs, hurt exports.

The end of cheap labor in China, is no longer a prediction, but a reality. The shift towards looking to China as a consumer of imports, has also manifested due to the rising labor costs and fatter wallets for those who live in the coastal cities.

“On March 5th Standard Chartered, an investment bank, released a survey of over 200 Hong Kong-based manufacturers operating in the Pearl River Delta. It found that wages have already risen by 10% this year. Foxconn, a Taiwanese contract manufacturer that makes Apple’s iPads (and much more besides) in Shenzhen, put up salaries by 16-25% last month.” According to a an article written in the Economist.

“It’s not cheap like it used to be,” laments Dale Weathington of Kolcraft, an American firm that uses contract manufacturers to make prams in southern China. Labour costs have surged by 20% a year for the past four years, he grumbles. China’s coastal provinces are losing their power to suck workers out of the hinterland. These migrant workers often go home during the Chinese New Year break. In previous years 95% of Mr Weathington’s staff returned.

This year only 85% did. (Last year, my friend Shaun Rein, wrote a book called “The End of Cheap China” and I highly recommend it to those who are curious and affected by this shift).

Kolcraft’s experience is typical. When the American Chamber of Commerce in Shanghai asked its members recently about their biggest challenges, 91% mentioned “rising costs”. Corruption and piracy were far behind. Labour costs (including benefits) for blue-collar workers in Guangdong rose by 12% a year, in dollar terms, from 2002 to 2009; in Shanghai, 14% a year. Roland Berger, a consultancy, reckons the comparable figure was only 8% in the Philippines and 1% in Mexico.”

The Yuan has appreciated by nearly 8% against the dollar since the Chinese government allowed it to begin rising again in 2010. It is up about 24% against the dollar since 2005. The most recent Big Mac index indicates that the yuan may be undervalued against the dollar by some 40%."

When The Economist computed the index differently last summer, in order to take account of variations in per capita income across countries, it found that the yuan was close to fair value. China continues to run large surpluses with America (though America exported over $100 billion in goods to China for the first time in 2011). More balanced trade overall and a sharp reduction in the growth of its foreign-exchange reserves suggest that China's currency may be a lot closer to the "right" level than American politicians would like to hear.

Because of these changes, China is freeing up finances, expanding it’s manufacturing sector inland, and doing all of the diligent things that I wrote about here in this post. We should recognize and embrace the ideas of China, who is being much more proactive, than the USA was in 2007, when trouble was on the horizon.

This opinion by Jeffrey Frankel written in project - syndicate furthers some of my points. "China watchers are waiting to see whether the country has engineered a soft landing, cooling down an overheating economy and achieving a more sustainable rate of growth, or whether Asia’s dragon will crash to earth, as others in the neighborhood have before it. But some, particularly American politicians in this presidential election year, focus on only one thing: China’s trade balance

True, not long ago the renminbi was substantially undervalued, and China’s trade surpluses were very large. That situation is changing. Forces of adjustment are at work in the Chinese economy, so foreign perceptions need to adjust as well.

China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. (Indeed, official data showed a $31 billion deficit in February, the largest since 1998.) It is clear what has happened.

Ever since China rejoined the global economy three decades ago, its trading partners have been snapping up its manufacturing exports, because low Chinese wages made them super-competitive. But, in recent years, relative prices have adjusted.

The change can be measured by real exchange-rate appreciation, which consists partly in nominal renminbi appreciation against the dollar, and partly in Chinese inflation. China’s government should have let more of the real appreciation take the form of nominal appreciation (dollars per renminbi). But, because it did not, it has shown up as inflation instead. The natural price-adjustment process was delayed.

First, the authorities intervened in 1995-2005, and again in 2008-2010, to keep the dollar exchange rate virtually fixed.amp#160; Second, workers in China’s increasingly productive coastal factories were not paid their full value (the economy has not completed its transition from Mao to market, after all). As a result, China continued to undersell the world."

But then the renminbi was finally allowed to appreciate against the dollar – by about 25% cumulatively during 2005-2008 and 2010-2011. Moreover labor shortages began to appear, and Chinese workers began to win rapid wage increases. Beijing, Shenzhen, and Shanghai raised their minimum wages sharply in the last three years – by 22% on average in 2010 and 2011. Meanwhile another cost of business, land prices, rose even more rapidly.

As costs rise in China’s coastal provinces, several types of adjustment are taking place. Some manufacturing is migrating inland, where wages and land prices are still relatively low, and some export operations are shifting to countries like Vietnam, where they are lower still. Moreover, Chinese companies are beginning to automate, substituting capital for labor, and are producing more sophisticated goods, following the path blazed by Japan, Korea, and other Asian countries in the “flying geese” formation."

Finally, multinational companies that had moved some operations to China from the United States or other high-wage countries are now moving back. Productivity is still higher in the US, after all."

Like certain other aspects of the US-China economic relationship, China’s adjustment is reminiscent of Japan with a 30-year lag. Japan’s trade balance fell into deficit in 2011, for the first time since 1980. Special factors have played a role in the last year, including high oil prices and the effects of the March 2011 tsunami. But the downward trend in the trade balance is clear. Even the current account showed a deficit in January.

This development has received relatively little attention in the US and other trading partners, which is curious, given that, two decades ago, Japan’s big trade surplus was the subject of intense focus and worry – just like China’s now. At the time, some influential commentators warned that the Japanese haddiscovered a superior economic model, featuring strategic trade policy (among other attractions), and that the rest of us had better emulate them. Either that, or the Japanese were “cheating,” in which case we needed to stop them.

Most economists rejected these “revisionist” views, and argued that Japan’s current-account surplus was large because its national saving rate was high, which reflected demographics, not cultural differences or government policies. The Japanese population was relatively young, compared to other advanced economies, but was rapidly aging, owing to a declining birth rate since the 1940’s and rising longevity.

That view has been vindicated. In 1980, 9% of Japan’s population was 65 or older; now the ratio is more than 23%, one of the highest in the world. As a consequence, Japanese citizens who 30 years ago were saving for their retirement are now dissaving, precisely as economic theory predicted. As the national saving rate has come down, so has the current-account surplus.

China faces a similar demographic trend, and also a push to unleash household consumption in order to sustain GDP growth. As in Japan, the downward trend in China’s saving rate will show up in its current account. The laws of international economics still apply.

Today, China faces challenges to many interests, and in my view, a real and too big to cover up and contain coup d’état cannot be completely ruled out. The effects on the global economy will be akin to a financial Armageddon.

I was there and a victim in business of the 1989 Tianamen Square incident. Business stopped and money didn’t flow for a long time. And that was a time that China, was in its embryonic stages of being an important factory to the world, with prospects of being the largest economy in the world and new dictators of consumerism.

In addition, two of China's buffer regions are in turmoil. ”Elements within Tibet and Xinjiang adamantly resist Han Chinese occupation. China understands that the loss of these regions could pose severe threats to China's security, particularly if such losses would draw India north of the Himalayas or create a radical Islamic regime in Xinjiang. The situation in Tibet is potentially the most troubling.

Outright war between India and China -- anything beyond minor skirmishes -- is impossible so long as both are separated by the Himalayas. Neither side could logistically sustain large-scale multi-divisional warfare in that terrain. But China and India could threaten one another if they were to cross the Himalayas and establish a military presence on the either side of the mountain chain. For India, the threat would emerge if Chinese forces entered Pakistan in large numbers. For China, the threat would occur if large numbers of Indian troops entered Tibet.”

China therefore constantly postures as if it were going to send large numbers of forces into Pakistan, but in the end, the Pakistanis have no interest in de facto Chinese occupation -- even if the occupation were directed against India. Likewise, the Chinese are not interested in undertaking security operations in Pakistan.

The Indians have little interest in sending forces into Tibet in the event of a Tibetan revolution. For India, an independent Tibet without Chinese forces would be interesting, but a Tibet where the Indians would have to commit significant forces would not be. As much as the Tibetans represent a problem for China, the problem is manageable.

Tibetan insurgents might receive some minimal encouragement and support from India, but not to a degree that would threaten Chinese control.

The key for China is maintaining interior stability. If this portion of Han China destabilizes, control of the buffers becomes impossible. Maintaining interior stability requires the transfer of resources, which in turn requires the continued robust growth of the Chinese coastal economy to generate the capital to transfer inland.

Should exports stop flowing out and raw materials in, incomes in the interior would quickly fall to politically explosive levels. (China today is far from revolution, but social tensions are increasing, and China must use its security apparatus and the People's Liberation Army to control these tensions). Maintaining those flows is a considerable challenge.

The very model of employment and market share over profitability misallocates scores of resources and breaks the normally self-regulating link between supply and demand. One of the more disruptive results is inflation, which alternatively raises the costs of subsidizing the interior while eroding China's competitiveness with other low-cost global exporters

For the Chinese, this represents a strategic challenge, a challenge that can only be countered by increasing the profitability on Chinese economic activity. This is nearly impossible for low value-added producers.

The solution is to begin manufacturing higher value-added products (fewer shoes, more cars), but this necessitates a different sort of work force, one with years more education and training than the average Chinese coastal inhabitant, much less someone from the interior. It also requires direct competition with the well-established economies of Japan, Germany and the United States.

Military issues are now at the forefront of Sino – US relations.

“China depends on the high seas to survive. The configuration of the South China Sea and the East China Sea render China relatively easy to blockade. The East China Sea is enclosed on a line from Korea to Japan to Taiwan, with a string of islands between Japan and Taiwan. The South China Sea is even more enclosed on a line from Taiwan to the Philippines, and from Indonesia to Singapore.

Beijing's single greatest strategic concern is that the United States would impose a blockade on China, not by positioning its 7th Fleet inside the two island barriers but outside them. From there, the United States could compel China to send its naval forces far away from the mainland to force an opening -- and encounter U.S. warships -- and still be able to close off China's exits.”

China simply doesn’t have a navy capable of challenging the United States. China is still in the process of completing its first aircraft carrier; indeed, its navy is insufficient in size and quality to challenge the United States. But naval hardware is not China's greatest challenge.

The Chinese have never had a carrier battle group in the first place, and there has been little reason to have one, as China, in its more than 4000 years of documented history, has never, attacked or tried to occupy another nation.

The primary tenets of the Chinese thinking are Taoism, Confucianism and Legalism, which demonstrate that China, really has no need nor historical precedent to be an aggressor or military power.

That said, China understands this may now be a problem and has chosen a different strategy to deter a U.S. naval blockade: anti-ship missiles capable of engaging and perhaps penetrating U.S. carrier defensive systems, along with a substantial submarine presence.

The United States has no desire to engage the Chinese at all, but were this to change, the Chinese response would be fraught with difficulty.

China is therefore supplementing this strategy by acquiring port access in countries in the Indian Ocean and outside the South China Sea arena..

Beijing already has financed and developed port access to Gwadar in Pakistan, Colombo and Hambantota in Sri Lanka, Chittagong in Bangladesh, and it has hopes for a deep-water port at Sittwe, Myanmar.

In order for this strategy to work, China needs transportation infrastructure linking China to the ports. This means extensive rail and road systems. Which will be difficult at best in many areas in the ASEAN region.

A Bigger problem for china nowadays stems from internal security. “The People's Liberation Army (PLA) is primarily configured as a domestic security force -- a necessity because of China's history of internal tensions. It is not a question of whether China is currently experiencing such tensions; it is a question of possibility.

Prudent strategic planning requires building forces to deal with worst-case situations. Having been designed for internal security, the PLA is doctrinally and logistically disinclined toward offensive operations.

China must present itself as an essential part of U.S. economic life, but today if you listen to US politicos speak, it is evident that most do not necessarily see China's economic activity as beneficial.

I for one see that in many ways, China has been beneficial as the “factory to the world” and will move to the “consumers of the world” which will be equally beneficial, to the global economy. As a matter of fact, I will argue, that China, saved the world ‘s economy in 2008.

Now, if the rest of the world, doesn’t recognize how fragile the internal structure of China will become if the citizens lose confidence, and the next coup, isn’t thwarted, I think that we will all find out the hard way of how important and politically stable and financially viable China is, to world economy.


James A. Vena

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