A Different Way Of Looking At China
Hard landing, soft landing, civil unrest, dominant economic superpower – the forecasts flow freely regarding China.
The fact that good data is hard to come by regarding China does not seem to inhibit many outside observers. In this piece I will look at China through the lens of economic structure, Chinese history and culture—concepts which a number of observers often overlook. My general conclusion is that Chinese GDP growth rates are about to undergo a gradual but nevertheless perceptible decline. But I now believe a hard landing crash is unlikely, assuming that Europe does not totally disintegrate and the US does not roll over into a full scale recession.
The Minsky/KIndleberger bubble model is not generally applicable to China. Outside observers visit China and see empty cities and excesses in capital, infrastructure and real estate investments. They think they see Western style, market bubbles. The Minsky/Kindleberger model with its Financial Instability Hypothesis describes an environment where private investors become overenthused about a particular asset and become overleveraged. The ensuing bubble followed by collapse brings about distress and panic for indebted investors and the financial system which has extended them credit. This model describes what happened in the US and other Western countries very well. But it does not describe what is happening in China where the public rather than the private sector is doing the borrowing. You do not hear stories of private mortgagors overborrowing to buy houses as happened in the US. It is a foregone conclusion in China that the government will eventually pick up the tab for bad loans made to local public sector entities and bail out the banks if necessary. The Chinese economy is state (or more precisely Communist Party) directed, not market directed. Minsky/Kindleberger style bubbles and collapses are characteristics of Western market economies, not state directed ones where overleveraged private investors are not playing a major role in the process. As long as the state has the financial resources to cover these losses a bubble type collapse can be avoided. At this point in time, the Chinese state has those resources.
The Chinese economy is overallocating capital to investment in real estate, capital goods and infrastructure. But the result will not be the burst of a bubble but rather a longer term continuous decline in the marginal productivity of capital. As a result, the torrid GDP growth exhibited by China will gradually slow down. Countries can’t waste capital on the scale China apparently has and register torrid GDP growth. The future for China is therefore a protracted slowing as compared to the high growth of the recent past. The cost of empty buildings and overinvestment will not in general be borne by private investors but by the state. But all those empty buildings and overinvestment will produce low or negative returns. State owned companies that specialize in these industries as well as private companies which depend on them would seem to be poor long term investment candidates. Ditto for the state owned banks which play a primary role in this capital misallocation process.
China has benefitted from a massive shift of labor from the countryside to the city. These people moved from low to zero productivity activities to higher productivity activities. But this is a one time event. If it has not come to an end yet, it will soon. China is rapidly becoming an urban country.
China as a latecomer has benefitted from being able to import Western technology Examples abound in this area. Internet search, telecommunications, airlines, medicine—the list goes on. Many have argued that stealing Western technology has been a core part of the Chinese development strategy. I believe these charges have a great deal of truth. But some scholars, in China’s defense, have argued that the US did exactly the same thing by “stealing” British technology in the 19 th century. Information wants to be free, Stewart Brand famously said. Be that as it may, this phenomenon is also a one-time event although it probably has a longer “shelf life” than the urban migration phenomenon.
China’s one child policy and current trends will produce an unfavorable demographic situation in the long run. The Chinese worker/retired beneficiary ratio is projected to decline steadily from here on. Actually, attributing this entirely to the government directed one child policy may not be entirely correct. All the Asian Confucian societies—Hong Kong, Singapore, Japan, Korea and Taiwan – now exhibit birth rates at close to half the replacement rate of 2.1 children per woman. All face an unfavorable demographic future. Several of these countries – notably Singapore – have tried to encourage its citizens to have more children but to no avail.
The idea that China is about to disintegrate or be afflicted by serious public disorders is at variance with Chinese history Yes, there are thousands of local protests each year. Yes, China has its share of dissidents. But take a look at Chinese history. Chinese history has a twenty five hundred year pattern of Disorder, Ascending Dynasty( Increasing Order), Dynastic Peak, Declining Dynasty( Increasing Disorder), Disorder. I would argue that China is in the Ascending Dynasty phase at the moment. I would argue for example that the Bo Xilai incident is basically noise—not much different in significance than John Edwards’ problem with his mistress.
Some might argue that the current Communist regime is not a dynasty in its pure feudal sense. But I would argue that the differences between the current Communist “dynasty” and prior dynasties are basically superficial. For example, the country remains centrally controlled, thought is tightly managed, the thousand year old Imperial Examinations have simply been replaced by the Gao Kao college entrance exams. Yes succession is no longer hereditary – Hu Jintao’s son is not becoming the new emperor and, alas, the Communist emperor is not permitted at least in public a bevy of concubines. But even in the case of succession the leaders are chosen from a select group where having the right parents counts .(The Qing emperors’ sartorial choice of resplendent yellow robes puts the current Communist emperors’ choice of attire to shame! )
For the benefit of those unfamiliar with this, I will reproduce a simplified version of Chinese dynastic history. Note that the Qin and Sui Dynasties were short lived but were immediately replaced by another Chinese dynasty, not a period of Disorder. The relatively shorter lived Yuan Dynasty was one imposed on China by a foreign conqueror who did not fully “Sinicize” and was ultimately kicked out and replaced by the Chinese Ming Dynasty.
Dynasty/Period Dates Number of Years
Qin Dynasty 221 BCE-206 BCE 15
Han Dynasty 206 BCE-220 427
Six Dynasty Period (Disorder) 220-589 369
Sui Dynasty 581-618 38
Tang Dynasty 618-906 288
Five Dynasty Period(Disorder) 907-960 53
Sung Dynasty 960-1279 319
Yuan Dynasty 1279-1368 89
Ming Dynasty 1368-1644 276
Qing Dynasty 1644-1911 267
Republic Period(Disorder) 1911-1949 38
Peoples Republic 1949-present 63
Note the long life of most of the dynasties. Four of them lasted longer than the entire life- span of the American Republic, which began operations under its Constitution in 1789. The current Communist Dynasty is a relative youngster, having been in power for only 63 years. Certainly China’s political system will change and evolve but anyone predicting its early demise or disintegration is going against the record of Chinese history. To repeat: China is in the Ascending period of a dynasty in which order increases.
China as currently structured is not suited to the needs o f a knowledge economy. Restraints on the flow of information is a major characteristic of the current regime. A knowledge society requires complete freedom of information and political freedom in general. One can argue that at lower levels of income and development that democracy is often an obstacle. India and its problems are cited as an example. But at higher levels of income and development, where knowledge plays an important role, the opposite is true. Moreover, Confucian culture with its emphasis on obedience is not necessarily compatible with a knowledge society. One may ask how a Steve Jobs – college dropout, drug user and one time hippie – would have fared growing up in China or even Singapore or Japan. Of course he would have been squashed. And not necessarily by any laws but rather by the culture itself. Apple would still be a fruit, not a company. One might ask why Sony could not maintain a culture of innovation. Is it a basic reverence for authority and stability built into Japan’s cultural DNA? Is Apple today a better bet to maintain its culture of innovation than Sony was?
The work ethic and the obsession with material improvement of the Chinese people are big investment pluses for China. Of course the current economic system in China is a major improvement over the Mao era. But it is still a highly defective protectionist state dominated system that misallocates resources. The work ethic, relatively high level of education and obsession with material improvement of the Chinese people have helped make China a success in spite of the current economic structure.
Investing in China—the Southeast Asian Alternative
Even a slowing China will be an economic powerhouse in Asia. I see the countries southeast Asia as primary beneficiaries of China’s ascent. These countries would include Singapore, Thailand, Philippines, Malaysia, Brunei, Indonesia, Vietnam, Cambodia, Laos and Myanmar. Those are the ASEAN countries. A broader definition would include Hong Kong, Macau and Taiwan. These countries (and territories) are growth centers in their own right. But they are major beneficiaries of burgeoning Chinese (and Indian) tourism, trade and investment. These countries, particularly Singapore, Malaysia, Hong Kong and even the Philippines, do not have China’s corporate governance issues. Gambling comes to mind as one area where the Chinese presence will be powerful and growing. Casinos do not exist in China, a puritanical holdover from the Mao early Communist days. The soaring towers of Marina Bay Sands integrated resort and casino have now become Singapore’s iconic buildings. Banking is another area. Southeast Asian banks will participate in the region’s growth but overall they are not overt instruments of government policy as in China. And the banks and the governments have learned important lessons in the Asian crisis of 1998. Singapore is the region’s emerging Switzerland and wealth management center. Hong Kong is becoming the preferred listing for IPOs from China and globally.
Many of the companies in this region are small, suggesting the use of ETFs although that would be less true in the case of Singapore and Hong Kong where larger companies are listed.
American Tech Companies – America’s Crown Jewels
In scanning companies around the world, nothing compares with the agglomeration of companies that comprise the American tech sector. Silicon Valley, and California in particular, is one of America’s gifts to the world. Freedom of information, a vast network of financing, a world class educational system and a positive attitude toward innovation have created the Apples, the Facebooks, the Googles, etc etc. In this time of economic turbulence, these companies have been a refuge for investors. No other country can equal this record(although adjusted for size little Israel is comparable.)
The major cloud on this horizon is America’s and particularly California’s budget issues. The starving for funds of the vaunted California higher educational system has now become a major problem. The New York Times just ran an article on how Apple had been able to avoid California’s punitive taxes. The question needs to be asked what would have happened if Apple had not been able to avoid these taxes. Would Apple have moved out of state or out of the US? When France under Louis XIV revoked the Edict of Nantes in 1685, talented French Protestants(Huguenots) moved out of France to more hospitable places like England and Holland. A devastating economic blow was dealt to France by this self-destructive act. Similarly, in the late fifteenth century Jews were driven from Spain and Portugal thus depriving those countries of another valuable and talented group. Will the US, with punitive taxation, deteriorating educational institutions and protectionist campaigns against outsourcing, do the same with its technology sector? Information may yearn to be free but capital goes where it is wanted.