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.