China’s Mixed Signals in a Strange Year

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Op/Ed Commentary: Chris Devonshire-Ellis

Dec. 31 – As we look back on 2009, the year ends with a more upbeat feel to it than 12 months previously when the true impact of the global recession was making its scale apparent. However, 2009 was a strange year and it is with a mixture of some relief and concern that many can put the past 12 months to bed.

The year began with financial uncertainty, with many businesses in China preparing not just one budget, but several. The “everything will be normal” budget, the “cutbacks needed” budget and the “total meltdown survival” budget. Fortunately, not many businesses needed to apply the last one, although there were several – read many – cases of foreign investors pulling out, some with considerable losses. Overextended, stretched by the strict security of China’s labor laws, some just upped and left, probably never to return; others, reliant on a U.S. market no longer buying, barely scraped through alive. With the laying off of Chinese staff not a financially viable option, many foreign investors have had to dig deep just to keep their staff employed and their offices open. The true nature of China’s socialist policies will become apparent in the next two years as these businesses learn whether the Chinese government will make it easier for them to recover via a lowering of tax and welfare burdens, or will continue to squeeze them.

One thing became clear in 2009: China is no longer the cheap option when it comes to hiring labor. As the pendulum swings in China between rampant socialism, socialism with Chinese characteristics and rampant capitalism, the country needs to find a common ground to treat businesses equally. It remains something of a paradox that the West’s investing capitalists are pressurized more to conform to China’s ultra strict adherence to social rights than its domestic companies are. Chinese companies are often able to generate assistance from the state to deal with loans or structured layoffs, while foreign investors are purely required to pay the bill without local government support – hitting the Western capitalists harder than their domestic companies. Promoting at the foreign investors’ expense China’s own brand of socialism , while domestic companies are bailed out capitalist-style is not a level playing field.

A developing nation?
The nature of investment into China has also changed. The days of foreign investors piling in to assist with largely infrastructure projects are receding. China’s ports can turn a cargo ship around in terms of unloading and loading it in little under eight hours (to compare, in Mumbai it takes three days). It is possible to drive from Hong Kong all the way to China’s border with Russia along a multi-lane highway. Vehicle number plates identifying cars from all of China’s provinces can be spotted in most major cities confirming China’s national highway infrastructure reach. And in a major sign that China may not be the “developing nation” it prefers us to believe, a ticket can be purchased from Lhasa, one of China’s poorest cities with minimal foreign investment, to Beijing along a route that travels the highest mountains and most difficult terrain to engineer on earth. Trains too have improved, China now boasts the what it calls the fastest train route in the world, with the 350 kph service between Wuhan and Guangzhou being launched just last week. It’s not just about Shanghai anymore in terms of speed or record breaking investment. Lhasa, a poor city, sparkles with brand new trains, airport facilities and is due to be linked, again by train to neighboring Kathmandu. When investment of that magnitude is poured into a remote region of China, it’s difficult to continue to argue the case for “developing nation” status. It appears to be the case that when China wants to invest in politics, the money is there, but when it comes to dealing with its poverty issues, the people remain a secondary concern.

As China therefore moves up in the world, the need for investment in its infrastructure is declining. Instead, as it rebalances what proved to be an out of balance economy, the onus is finally shifting to selling products and services to China’s massive population. The government also needs to boost domestic consumption. Here, the winners will prove to be the businesses that properly understand the myriad versions of what China actually is. A diverse collection of 34 provinces, autonomous regions, special administrative regions and municipalities, selling to China requires an understanding of its diversity of culture. Not for nothing does China, somewhat uniquely, feature eight different languages on its banknotes. Appreciating and adapting to the significance of this will mark out the winners and losers in the race to sell to “China.” Indeed, for many investors, it may be more useful to brand such a project with the provincial name rather than the national one. Selling goods and services to Sichuan concentrates the mind rather better on the local culture in hand.

Fiscal stimulus masks problems
In terms of overall performance in 2009, the Chinese government has been remarkably bullish about the growth of the economy the past twelve months. Personally, I doubt the published growth rates of 9 per cent or thereabouts. In simple terms, this was the rate the government was declaring in 2007 and 2008, prior to the global downturn. Yet there is no doubt that the downturn has affected China quite badly. The maintenance of such a growth rate therefore seems highly implausible, albeit with one caveat: 2009’s fiscal stimulus plan. This injected RMB4 trillion into the domestic economy which will have affected the GDP growth figures. Understanding China’s actual rate of growth therefore is rather like playing pin the tail on the donkey. Blindfolded, take a guess. Regardless of whether or not China’s growth was 9 percent, if true, the country will have a tough job of maintaining those figures in 2010 without another massive fiscal investment.

Worrying too is how much of the fiscal stimulus is being spent. Record surges in the stock markets, the continuing development of luxury property, inflated prices in real estate all would seem to indicate the money made available has not been spent in the most appropriate manner. Cue also a ban on mainland travelers to Macau, China’s only permitted destination for gambling. China’s central government is well aware if not introduced, a temptation on the part of local government officials to play high rolling stakes in Macau’s casino’s may have proved too much. Additionally, the Communist Party were not about to provide Steve Wynn and other foreign investors with a major league bonus from their state coffers. Still, the inability to properly direct and control where China’s fiscal stimulus is expended is a cause for concern – it indicates the government does not have the banking sector fully under control. Certainly, a continuing dogged hold onto the position against the US dollar does not indicate that all is well with the RMB. Inflation – ironically caused precisely because of China’s fiscal stimulus package – is going to remain and possibly develop as a serious issue, and I suspect other major challenges with China’s overall financial position are yet to emerge.

Rebalancing the economy
In terms of China manufacturing, more of an issue are the concerns I have heard several times in my travels to the United States, India and Africa the past few months. In Africa and India, the quality of Chinese products is starting to be questioned, and in an increasing number of cases, government intervention is stepping in to limit damage and prevent substandard product reaching the consumer. China’s typical reply is to accuse such stances of being nothing more than “trade protectionism.” However, in signs that the problem with Chinese quality control is going to take awhile to fix was the scandal over tainted milk and the melamine poisoning of thousands of Chinese infants on a massive scale.

While China continues to value cheap production at the expense of even basic standards, the nation will find its exports and domestic brand sales under increasing pressure. Prices, quite simply, have to rise to cater for this as standards need to improve. The United States meanwhile seems to be indicating that American homes are full to the rafters of cheap Chinese goods. Additional expenditure has to come from higher value products, and technology here leads the way. It’s interesting to note that the top U.S. companies are all involved in IT. In China, they are all low end producers, albeit on a massive scale, but low end just the same. China is lagging way behind, even against a resurgent India is the race to secure high end products and services in new technologies. It is still stuck in a rut of low end cheap manufacturing and massive construction projects. It will take some time to shift this upwards.

China has also come under fire for its masked export of labor on a giant scale. Fresh from major projects inland, China’s millions of construction workers are now part of package construction deals that see Chinese contractors winning projects to build dams, airports, roads and so on throughout the developing world. Yet with those projects comes political risk. As local workers in India and Africa are finding out, the silent export of Chinese workers to complete projects is costing them their jobs. Russian traders too have been affected; the closure of the Cherkizovsky market in Moscow revealing that 60,000 Chinese traders were working there illegally. Foreign governments then are wising up – India insisted that all foreigners working in the country had to have work visas. Over 250,000 Chinese construction workers left projects across India in November as a result. Those projects are now being completed by domestic crews. Political time has been called this year on the quiet migration of Chinese workers operating overseas. Displacing local labor, and evading income tax is never going to fly too far, and the regional backlash against China’s labor export has commenced. China will increasingly have to find domestic employment for their nationals instead of sending them overseas en masse.

Political bruising
Overseas, the development of China is increasingly being called into question or is raising hackles. The United States continues to be patient over trade and the currency issue, while India continues to have problems with China’s prodding of its borders. Elsewhere, smaller neighbors and regional players seem to becoming close to vassal states as China’s financial clout secures both political security and natural resources. Not all of these have been achieved diplomatically; China seems to have grown more petulant in 2009. While India’s beef with China is almost certainly related to the Dalai Lama question, protocol has been lacking in dealing with a number of countries this year. Germany was called into a row over the appearance of overseas Chinese dissidents at the Frankfurt book fair, a literary event, and more than a whiff of brimstone was detected in China’s displeasure of the breakdown over buying into Australia’s national mining industry. While the mess of Copenhagen was pretty much everyone’s fault, China this year dug its heels in and didn’t want to play unless on its own terms. That also coincided with a retreat into the insecurities of old, the blocking of social media sites, censorship of imported newspapers, blocking of TV broadcasts. A conflict has arisen between the new member of the World Trade Organization and much of the rest of the world. Swaggering with weight, China has acted clumsily this year, and it has been a disturbing development. Let’s hope the pressures of several sensitive anniversaries in 2009 were the primary cause, and not a deeper malaise.

In terms of looking forward in 2010, I don’t expect much change in performance. In many respects I suspect 2010 in China will be a mirror image of 2009. A major problem could arise should the Dalai Lama die – he is currently 74 and rumored to be ill. How China handles that situation will stretch its patience, diplomacy and security forces to the limit, and is set to be the next major internal and international political challenge the Chinese government will have to face. Trade will bumble along, probably with a couple of major quality and corruption scandals along the way, while any rethink in the position of the RMB against the dollar – which I think unlikely to occur – would be announced quickly, quietly and would be immediately effective. China essentially is in a period of transition. The government’s own stated primary aim is to maintain social stability. This means that while the economy is being recalibrated, boom times will remain a thing of the past. China’s challenge during this period is to manage such change without too many bumps along the way. The success of China in 2010 will be in limiting these to the bare minimum.

Predictions

  • Actual 2010 GDP Growth: 4 percent to 5 percent
  • No movement against the U.S. dollar unless a banking problem emerges
  • Internal security and censorship to remain high due to Dalai Lama issues
  • Real estate bubble problems to surface in Shanghai and many 2TC
  • Foreign investment opportunities: Buying out JV partners at reasonable prices, developing or acquiring distribution channels, developing second and third tier city sales channels
  • Foreign investors will need to become more aware of cultural diversity across China as economy begins to open up nationwide

Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and lived in China for 21 years. He is now based in Mumbai.

6 Responses

  • Andreas says:

    Excellent analysis and summary Chris!

  • Chris Devonshire-Ellis says:

    Thanks Andreas – look forward to sailing with you next year. My essay on India in 2009 is here incidentally:

    http://www.india-briefing.com/news/indias-unique-chance-finally-stand-1721.html/

    And to all our readers at China Briefing – My very best wishes and have a great 2010! – Chris

  • Tom Mason says:

    Of the validity of your comments, well taken, but I am afraid a huge gap exists between reality and the ivory tower. For example. A small manufacturing town in the southern part of Fujian Province, Dehua sits between the mountains, and is bustling with factories pumping out goods for the US, Eastern and Western Europe, Middle East, Russia, Asian, and African customers, and you know what??? It is all cash, it is all about piece work, it is all about the local bosses, the local economy and it is a town of “brothers in arms”

    In China, the first rule, the only rule to follow, is “buyer beware” and that is why the statement “China is no longer the cheap option when it comes to hiring labor. As the pendulum swings in China between rampant socialism, socialism with Chinese characteristics and rampant capitalism, the country needs to find a common ground to treat businesses equally” will never fly in Dehua, and a thousand other Dehua’s.

  • Chris Devonshire-Ellis says:

    Thanks for your comments Tom. I agree – China is more the sum of a myriad of parts than one whole. My article was from a generic perspective however. Dehua, the city of purely cash transactions, and the others like it, remain in many aspects completely out of any national system of governance, tax or registration-wise. Its convenient while everyones happy, but rapidly unravels when it all goes to pot (like the entire dairy farming industry). Appreciate your feedback. – Chris

  • Hello Chris,
    Excellent information, great insight, please keep up this valuable resource all us Expats sorely need while working in China.
    Cordially,
    Karl J. Weaver 魏卡爾
    OEM/ODM Handset Biz Dev Mgr
    Gemalto Beijing 金雅拓北京
    Mobile: 138-1078-0592

  • Digby Ross says:

    Very good analysis Chris, I do enoy reading your insights.

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