Has China’s economic development hit a glass ceiling?

Posted by Reading Time: 5 minutes

Commentary: Lack of stock market transparency, the one-party state and why Chinese companies are struggling overseas
By Chris Devonshire-Ellis

On the face of it, much in China over the past 20 years has appeared to be a pretty incredible success story. Other developing nations, from India to South America, Africa and elsewhere in Asia have all expressed admiration for the “Socialism with Chinese Characteristics” that has dominated much of the worlds media headlines. But what has actually changed?

In essense, China has consumed a large amount of foreign direct investment and purchasing power, and has produced as a result pretty much everything the world buying market requires in cheap product. Indeed, globally, we’ve probably never had it so good in terms of an on-going shopping spree with everything from plastic toys to computers now available, in the stores, and at affordable, everyman prices. Now it seems normal. But I believe it isn’t – that what has occured over the past 20 years is an aberration, and that the China model continously supplying the ever-increasing demand has just about hit a wall.

If true, there are three questions that spring to mind:

1) Why is the Chinese model unsustainable?

2) What needs to occur in China to correct this?

3) What are the emerging market alternatives to China in the global supply economy?

Lets deal with these one by one.

1) Why China’s Economic Model is Unsustainable
The main issue here is seperating the State from business, and the vested interests this inevitably brings. Add to that inefficient communications amongst Chinese businesses, a lack of understanding on what an efficient and well-managed business looks like, a massive reliance on inter-China guanxi and favors and it is obvious the China business model is incestous, ineffective and cannot compete globally. It short, China does business with itself, and whatever it can reap from the global market buying it’s products. For China to take the next step, and be a truly international player, it needs to get it’s corporates up to scratch and properly taking part in the global economy. Making cheap products is actually not that efficient for the Chinese collection of taxes from what should be booming local companies. Margins for the buying of cheap China products are made by the trader and retailer, not the manufacturer, meaning China is hit with a double whammy – a massive trade imbalance and no major taxable profits to show for it.

In reality, with intense competition for business, many Chinese companies can only get by with razor thin margins by acting as follows:

* Deliberate attempts to defraud investors in order to add to profit and sustainability
* Collusion with local tax bureau to minimise any actual taxable income
* Collusion with local government to obtain incentives at the state’s expense

Why does the State endorse this? Because unless it could free up investment, China’s population would have either been subject to harsh controls and cut off from the rest of the world, leading to potential revolution – and the alternative was to free up the population, give them something to do, make and sell, yet retain power. That “power at all cost” is the key to understanding modern China. Indeed, in most cases, the state colluding with business is normal in the PRC.

Take hapless foreign investors. Told by the local government ‘tax incentives’ exist, as it’s from the local government, these incentives are believed. But what happens when they fail to appear or dry up? Nothing. The investor is already committed, and has to make the best of a bad situation. It’s like walking into a venus fly trap. Local governments often deceive investors in order to meet their targets.

What about the stock exchanges? With nearly 1,200 listed companies in Shanghai and a ‘hot’ market, whose in charge? Ninety percent of listed companies on that bourse are state-owned, partially or completely, or have other government connections. Yet time and time again, in conducting professional due diligence on such businesses or their subsidiaries, we see major problems with the inflation of assets, sales and with receivables which anywhere else would qualify as bad debt. The regulatory authority cannot mete out punishments, and has to refer cases to the government. Yet the government owns the majority of the stock…and keeps hyping it up, and local investors keep playing the market. However the fundamental quality of many of those stocks are at best erratic and at worst, non-existent, listing assets that don’t even belong to them – such as a JV partners assets being included as their own. I suspect that Hong Kong is also not immune to this, and there are red chips there that are fundamentally unsound. The answer as to why lies with the government – it’s up to its neck in business, and controls and takes advantage as and when it can to keep itself in power. In a one-party state, there is little option.

The impact this has on the average Chinese businessman is immense. His business creed is “Do business with the government, use the local laws to discriminate against my competitors or any responsibility, use my guanxi to reduce taxes and regulatory obstacles, and take what I can.” It’s hardly a model that stands up to any scrutiny, and one that in the absence of any understanding of corporate governance, keeps them shackled and unable to compete truly in the global economy internationally. Case in point: Lenovo’s purchase of IBM. A US$1 billion dollar deal, and much hyped. But know any other M&A deals that do not involve the Chinese government that any Chinese companies have participated in? There aren’t any, and Chinese companies are not fit or able to be run or managed to international standards. They would die. Yet without making this leap, China will stagnate.

Can China Evolve?
Another way of asking this is: “Can the Chinese government accept independent regulatory bodies?” That in effect means a more democratic process and the weaning off government interference and involvement in business. Is it likely? My view is that the Chinese government themselves don’t feel this is likely, yet without it cannot progress their economy. Yet what can you do about it except – wait and see, and hope someone has a good idea to get out of this rut. China Corp meanwhile will continue to do business with itself, and be denied the opportunity to compete in global terms, because it cannot compete with those standards. There is the glass ceiling.

The Alternatives
China at present will remain as is, incessently feeding off its own body. Rich in China, but poor outside, until it either goes into a serious recession, there is a revolution, or a mass sea change to democracy, and non-government interfered with regulatory bodies. Which, and when, are open to conjecture. But the ceiling has been arrived at, it’s a matter now of bumping along it. Is China part of the true global economy? Is it creating global wealth? Until it’s companies can stand up to international standards and truly take their place at the high table of multinationals, the answer has to be “No.”

Yet global manufacturers, or indeed certain other nations are not tethered to the chains of birthplace in order to develop their economies. Other developing nations are also rising, such as India, albeit with it’s own irony of having too much democracy, but relatively unfettered by government interference – meaning by comparison with China, its home grown companies are major players in global M&A, spreading their wealth and creating new wealth, and the impact on India Inc and the global order of wealth creation is likely to be immense.

The golden entry rule into the global economy is as follows: “Does your government have
independent financial and legal regulatory regimes in place?” If so, then standards are set and rules of fair trade are applied. If not, then it is impossible to break into that club, and until China changes, it’s economic development has now just reached that huge barrier.

3 thoughts on “Has China’s economic development hit a glass ceiling?

    Todd Platek says:

    Excellent post, Chris.

    I wonder whether there is also another pan-Chinese problem at work. In the US, and likely UK and Europe, I am unaware of any Chinese companies which did well in the mainstream of those countries. Back in the 1980’s, Taiwan’s well-known and respected electric appliance manufacturer, Da Tong, set up shop in Atlanta, Georgia, I believe, in order to market its trusty TVs, fans, small refrigerators, etc. A total flop. Yet, in Taiwan, this brand was tops, and not just in name but actually in quality; it also was very wealthy, and likely had KMT-backing. A Da Tong TV or fan would last 20+ years. I thought Da Tong could be the next SONY. Wow, how dumb of me. Instead, just a flash in the pan, and no bullet coming forth.

    OK, Formosa Plastics set up shop/factory in Texas, but I have no idea how that is doing.
    And Acer computer is a powerful, albeit low-end, name in PCs and laptops.

    The only other Chinese companies which make headway appear to be those which serve the Chinese communities, such as Taiwan’s Wei Chuan (food).

    Although we have called the Japanese and Koreans “insular” for so long, they have had remarkable success in adapting their local (i.e. non-Japan) management and operations away from strictly Japanese and Korean models.

    Taiwan’s Evergreen Marine, and China’s COSCO and China Shipping, however, although located around the world, look like transplanted offices, even with desks arranged and office smocks color-coded as they are in Taiwan.

    It seems the Chinese have a real problem in moving “outside themselves” and trusting foreigners to run the foreign ops. Perhaps it’s their “control freak” nature, which is usually micro-management.

    Frankly, I don’t know many Chinese who believe that Chinese enterprises, even huge ones, can compete with US, European and Japanese companies. And that may be one of the most compelling indicators, i.e. their own lack of real confidence and mission.

    Todd Platek

    Chris’ assessment is a highly accurate exposition of what is happening in China today.

    What was probably beyond the scope of his article, and what caught my attention is that his prediction for the future in the section: “Can China Evolve” is embodied in the phrase, “wait and see, and hope someone has a good idea to get out of this rut.”

    The topic itself requires a more thorough study of the economic and industrial development of nations, which seem to follow a relatively similar pattern. England and the US, after the second World War embraced a policy of export at all cost. England, particularly. The process itself required an more international monetary system, which prompted the Bretton Woods Agreement whereas the International Monetary Fund and the International Bank for Reconstruction and Development were established in pursuance of agreements drawn up at the United Nations Monetary and Financial Conference held at Bretton Woods in New Hampshire in the United States of America in July 1944.

    Basic economic science should make anyone aware that an economic system must be monitored to maintain a reasonable balance between production and currency available to facilitate the exchanges thereof. This is one of the reasons the system was created. However, another more compelling political concept was a significant underpinning motivation: “Who controls currency, controls.” This placed the two major powers at the helm of international currency management. The losers of the war had to embrace the system and their recommendations, or face failed economies.

    That brings us to focus on Japan in relationship to the west. China enthusiasts often praise the gigantic advances made by this juggernaut like something that has never been seen before in the history of man. Of course, when we look at the last 20 years, we can’t but be awed by the numbers and sheer volume of growth.

    But in reality, China is today with relationship to the west where Japan was in the 40’s and 50’s. There are significant parallels, such as Japan became a workshop to the western world. Workers and employees became the children of the corporations for which they worked, were housed and fed by them, and were the benevolent yet strict social patriarchs. The major corporations were government invested, and heavily contributed by the government. Japan was also the source of cheap goods, generally poor quality (except where foreign owners and managers). Rampant violations of Intellectual property, copies and contraband or copied goods. Thousands of suits in Japanese and American court defending and battling IP. In the sixties and seventies the US sent several thousand banking and financial managers to help Japan straighten out its internal financial system.

    When the west’s tolerance for cheap, low quality good came to a gradual end, Japan was forced to take a new tack in technology and production, and the political machinery and the large corporations gradually disassembled the traditional setting, and moved towards a less regulated market and reduced control on all levels.

    What Chris exposes is the coming to an end of the west’s tolerance of China’s lack of western education in business, technology, and financial systems. China is being forced by these international pressures to accept and embrace western banking. In the last few years we’ve seen how China has sold interests in their banking system to western multinational banking, for example, Citibank, who now owns a meaningful percentage of China’s banking interests; with China’s desire to have its banking system managed more in line with international systems.

    The time frame for all this to sort out is at least a generation; and I think Beijing, aware of this, is attempting to cover the potential economic gap and possible depression by courting Africa, and other underdeveloped nations, where I suspect the hope is will be the new importing centers for Chinese products.

    A significant difference is, however, the political systems. What type of outcome is forced upon the population by the current Chinese system?

    The revolution has began. I suspect it began maybe about ten years ago, but I only witnessed the changes when I came to China about five years ago. This is a silent revolution, an subtle, unexpressed refusal to cooperate at the rank and file level.

    These are the symptoms: In the seventies, when China was first beginning to open up and establish cooperation with western nations, I remember high quality equipment and machinery produced in China with the help and supervision of western technology. However, the various trade agreements between China, thirsty for western investment, and western corporation, hungry for bigger profits and cheap labor, have changed the focus to where China entered into export at all cost, at the cheapest price.

    It had become obvious to me when I first arrived, that businessmen and workers alike, felt very insecure in their position, and the focus was to make big profits today, since we don’t know what will happen tomorrow… We made it, you buy it…

    Workers put in 12 and 14 hours a day, with maybe one or two days off per month… but their productivity is significantly lower than western nations on a per capital basis. The workers’ attitude is, I’ll do what my boss tells me and nothing else. No initiative, no care about the work. In general they will do what I would call, ‘the irreducible minimum,’ which if they did less, it would be discovered they were not doing anything.

    The Central government issues highly intelligent and well crafted laws, and the provinces work out their own ways of only implementing that which suits them. The central government making desperate efforts to retain control (closing of more than a thousand communist party offices throughout provinces); trying to control the rampant corruption.

    The public no longer whispers their mistrust, and their disbelief of what the government tells in the media. Their only defense is to feather their nests with enough savings to be prepared for eventual uncertainties. People make a difference by changing the only thing they feel they can change, and that is, their personal reactions to respond to the best of their abilities to the urgencies of the time. Yes… the revolution has began. In a number of instances these outbursts have become visible by street demonstrations… which are not widely publicized… but do take place with some noticeable frequency.

    The outcome will be a breakdown of the political institutions, where Beijing will have to allow greater freedom to independent organization to help provide the public many of the things the various governments can’t or won’t, giving them at least some authority to influence their sphere, and some measure of enforcement ability, if only albeit publishing their findings. The beginning of such organizations has already started with “consumer protection and information” types, which at present have little enforcement clout. But the old philosophical saw tells us, “When you take responsibility, you acquire the power that comes with it.” So it’s a natural outcome that NGO will fill the gap that can’t be managed by governments.

    It’s natural evolution, and in many instances it will be painful; but people, the rank and file, know more than they are given credit for.

    emmett-john says:

    You forgot to mention that chinese banks, for the most part, have been in a “financial crisis” for nearly 2 decades with an estimated $700 billion in bad debt from guanxi related loans. In fact, one can say that now American and European banks look just like chinese banks.

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