CHINA: AFTER THE PARTY

It has been an extraordinary week. While the world’s attention focused on the US Congress passing a bill that, by Friday afternoon appeared to be a sad story of too late and too little, the commercial paper market seized up, leaving the companies around the world unable to borrow money for the most basic of transactions. As the markets are scratching their sweaty heads, some observers seek shades of hope in the economies whose liquidity does not depend directly on the smooth functioning of the global finance. But, as the meltdown in Russia’s financial system is now proving, ample foreign reserves are not necessary a bulwark against a global credit crunch.

Nowhere are those hopeful winks more prevalent than in the direction of China, an ever-growing juggernaut that only recently graced the world with nationalistic displays of organizational prowess and tetchy pride. Alas, these hopes will be disappointed because, with perverse timing, the Chinese miracle is now exhausted.

Last week I returned to China after almost a year. For nearly 15 years, I had been visiting the country with unplanned and surprising regularity. As I moved through careers and residencies, people around me always wanted to do business with China, or at the very least collect information about business opportunities in the seemingly unstoppable Middle Kingdom. Their optimistic charts would show various countries’ comparative GDP per capita on the horizontal axis and the same economies’ consumption of applicable good (steel, paper, beef, shoes and, yes, milk) on the vertical axis. Invariably, the business executives drew two conclusions. First, China’s GDP per capita would one day “catch up” with the advanced economies or at the very least with its rich neighbors in Asia. And, secondly, its intensity of consumption of those various goods and services would somehow follow the “natural” pattern of development, traced by Japan, the United States and Europe.

This a priori universalism, enshrined in the “world is flat” ideology, always grated. After all, even among developed economies we all differ in consumption patterns. The Japanese eat less meat, Americans travel less internationally and Europeans spend less on defense. Per capita. Somewhere beyond the awe that China’s undeniably rapid growth generated, there also lurked a suspicion that the country’s socio-political system may find it more difficult to ensure the flexibility required to modernize the economy to the level of a democratic South Korea or a democratic Taiwan. But it is a testimony to Chinese people’s extraordinary devotion to enrichment through personal (and family) effort that, on aggregate, PRC has achieved what it did over the last 30 years. Three decades since the opening of China’s economy, it is time to take stock of this remarkable development. But I would caution against such a ‘stock’ being taken on Shanghai Stock Exchange.

It was the collapsing commodity markets worldwide that drew me to China this time. Certainly, Hank Paulson’s efforts to reverse the “long commodity – short financials” trade in mid-July helped to deflate large fund positions in the former sector. But signals of softening demand for raw materials appeared already in May, when many of the commodity companies hit the all-time high market values, while still trailing their net present value, sometimes by as much as 20%. China – the world’s largest consumer of just about any commodity with the exception of oil – would certainly hold the key to understanding what is happening in the physical market. Admittedly, the notoriously unreliable data from the Middle Kingdom were made even more noisy this year – the extreme winter in much of mainland Asia, the devastating earthquakes in the Southwest and a clamp down on polluting industries and transportation during the Olympic Games have all conspired against a scientific approach to data collection.



END OF LABOR ARBITRAGE MODEL
There were surely signs of a significant slowdown since the beginning of the year. Between September 2007 and March 2008, the labor costs ran up by 40% in coastal areas, discontinuation of export tax rebates cancelled a further 13% of profits, raw materials added another 5% to costs, fuel and energy jumped up for all but the most shielded operators, and local currency appreciated by 15% against the dollar just when the American consumer felt the first effects of what back then was known as a “subprime” crisis. No wonder that upon their return from Chinese New Year holiday workers found that their Korean bosses in Shandong had simply closed shop. Taiwanese entrepreneurs in the South went even further. Unlike the Korean business owners, who used to rent out operating facilities, many Taiwanese capitalists invested into local assets, land and property. But they too decided to leave, preferring to write off the value of these assets rather than face onerous closure costs.

The exodus of the workforce from coastal China’s export centers back inland was also possible by the reduction in income gap between the coast and inland provinces. For as long as jobs are available in the inland provinces, a 1000 renminbi in Gansu goes much further than 1500 renminbi in Shenzhen and life feels safer in the family cocoon of the hometown, away from mechanistic and sterile dorm conditions of the coast.

The new Labor Law, introduced on January 1 this year broke the camel’s back. The wage pressures, first registered in the summer of 2006, had been eroding the labor arbitrage model for a while, especially among nimbly-fingered female workforce. Credit should be given to the government for realizing early on the dangers of overreliance on foreign demand. Not surprisingly, since at least 2003, Beijing pursued rapid industrialization and infrastructure development around the country. Real estate development blossomed, rendering China’s GDP less obviously reliant on exports, though at the price of exposing it to another form of dependency - on imported materials. However, at 36% of GDP, the post-WTO accession export boom continued to provide the source of coveted foreign exchange reserves, frequently pointed out by westerners as a source of potential trouble, but treated domestically as a war chest ready to shore up the most endangered sectors of the economy (e.g. banking in 2004).

Labor arbitrage is a finite game. China’s labor growth may peak as early as 2010, when it will reach 68% of the population (around 770m). The subsequent shrinking of the workforce will only add to the progressive loss of China’s competitive advantage in basic manufacturing. Already now, a worker in coastal China costs between $120 and $210 per month, compared to only $50 in Cambodia and $10 in parts of coastal India. Some of the production may be shifting inland, but the distance from the coastal export bases often cancels the advantages of lower unit costs.



China will find it problematic to shift from labor arbitrage to higher value added production and branding. 30 years since the opening, there is still no Sony, no Toyota and no Samsung. Corporate practices in China are not based on pursuit of excellence but have for years been developed around personal access to specific opportunities and intimate knowledge of the inner workings of the system. The success of many Chinese companies was made possible by the influence they could exert on the liberalization of specific markets, allowing them to reap rewards of first mover advantage and superior strategic positioning. In such circumstances, it is not entirely surprising that innovation and creativity have not been China’s strength.

The quality of workforce is one area hampering any repositioning of the labor arbitrage model. The pliable and hardworking workforce may be adequate for satisfactory task execution, but is not globally competitive in the context of modern-day organizational management. Only 9m Chinese enter university every year – a pitifully small number in a nation of 1.3bn. And many of these graduates lack communication skills, leadership skills, analytical skills, English, capacity to take initiative and find solutions. Not long ago, my company sought to hire a professional from one of the country’s top engineering school. Several hundred people came to our presentation on Friday afternoon – both students and graduates. Of 150 resumés we received, only about 20 made any sense. Having gone through interviews, we could barely hire one person. The ideal combination of adequate English and analytical skills is so hard to come by that the few people who do offer such highly sought after qualifications command a huge premium on the job market. No wonder that 30 years since the opening, most foreign invested companies still have to staff the top echelons with Hong Kong, Taiwanese and Singaporean professionals.

THE MIDDLE CLASS
The educational system and the internal migration patterns have wrought havoc with what was a generation ago a classless society. Today, China can be roughly divided into three strata – with the oft-lauded “middle class” separating the extremes of wealth and poverty. Depending on location, the core of this “middle class” earns between $10.5k and $21k per annum (all such comparisons need to take into account that the cost base in China is still about a third of the world’s largest dollarized economy). And although many college graduates initially earn less than this bracket would indicate, currently some 60% of Beijing households have an income of $12k.

People with incomes of at least around $30k per year are considered “rich”. These are not only entrepreneurs, but also the above-mentioned professionals hired by Western companies and earning sometimes several multiples of this figure. This is a successful, but greedy bunch, expecting a 25% - 30% pay raise each time they switch jobs. In effect, they do little else than arb the market for their ego-asset, shifting between short term owners. And although a 45% income tax applies to this income bracket, the gulf between them and China’s poor has been widening for several years now.

What is astounding is that much of this wealth is concentrated in the hands of young people – between 24 and 31 years old. Their consumer behavior is the single most promising feature of China’s economic life AD 2008. It is also in the naïve optimism of this acquisitive group that a palliative to the economy’s current woes can be sought. More than 2 years ago, Goldman Sachs published a groundbreaking paper on “China becoming old before it becomes rich”. The findings, based on the observation of the unusual demographic pyramid, pointed to a scenario of inevitable slowdown in internal demand, to some degree replicating the pattern exemplified earlier by Japan. Two years later, exactly the opposite is happening.



Amazingly, a youngster earning RMB5000 per month (some $8760 annually) can no only afford a RMB120000 car, but also 90 square meter apartment, which on Beijing’s fifth ringroad would cost around $175k. How is this possible? The demography, and modern China’s family structure provide answers. The youngster in question – invariably a single child - may dispose not only of his own revenue, but also of his (usually working) parents’. S/he may even dip into grandparents’ savings, for whom little is more important than the gratitude offered further down the (thin) bloodline. As a consequence, a young Beijinger would have access to not one but up to seven sources of revenue and savings. A young couple could even double this number. Their spending power is unparalleled among “middle classes” elsewhere. Importantly, it has been entirely shunned from exposure to credit.

IRRATIONAL OPTIMISM
But the expectation of “gratitude” that lineage-obsessed elderly Chinese expect – at the very least in the form of prayer for deceased ancestors – may prove a little overoptimistic. These young emperors and empresses are so used to be on the receiving end of family’s attention that reciprocating the favor comes with great difficulty. It is, therefore, not surprising that the divorce rate has skyrocketed in China. The relative scarcity of available women due to the still prevalent infanticide in the late 1970s and in 1980s has created an imbalance that subverts the forces of traditional patriarchalism. Young men are poorly prepared to deal with this challenge, but little in China is sexier than money, a fact that propels many young men to pursue material goals with even greater zeal.

These young people, and especially young women, are hugely optimistic about their future not only thanks to their spending power and exclusive memory of ever improving economic conditions, but also because they are shielded from the negativity that inundates the media in many other countries. Beijing’s full media and internet control ensures not only the ubiquity of ludicrously crass and inane entertainment, but also channels local aspirations into a very selective targets of consumerism – a car (to show off), an apartment (to brag about), and electronic appliances (to boast upon). Conspicuous consumption defines much of the behavior of the converts to born-again materialism.

How different is this experience from Japan’s… I visited my Japanese friends in Tokyo this week to learn that similarly childless society can find itself in an entirely different situation. Japan’s problem is that its society is too healthy. Unlike in China, people here usually eat safe food, breathe clean air and generally enjoy the fruits of their past hard work. But they live too long. Former sarariman accumulated only one revenue per family and usually had more than one child. Retired today, and facing life expectancy of around 80 years, such people have to dip into their savings and do so uncomfortably, with little, if anything to bequeath to the next generation which has been segmented into fairly stable professionals and precarious part-timers. Asset values in Japan have been depressed for almost 2 decades and there is little faith in future increases of the market value. Whereas the Chinese government’s ubiquitous “propaganda of success” convinces people that Beijing would eventually step in to bail out investors, homeowners and consumers, Japanese viewers watch TV news replete with depressing stories of accidents, suicides, rapes and disasters. And while the Chinese people are continually reminded of the nation’s putative greatness by stunts ranging from sports events to space missions, Tokyoites scowl at Mayor Ishihara’s ambitious plans to organize second Olympic Games in the city.



Japan's combination of obsessive pessimism and world record beating life expectancy could appear oxymoronic. Yet it is in contrast with China’s ignorant optimism that the Japanese phenomenon can be understood. During the first three days of my visit to China, 67 people died in 2 separate coal mine accidents in Shaanxi, 8 people died in a typhoon in Guangdong, 8 people were killed and 38 missing after a landslide in Sichuan, 72 youngsters died in the fire of a dance club in Shenzhen, 267 people died in a mudslide in Xiangfen county. The official death toll in the "milk with plastic" scandal was 4, but 53000 infants had been infected. Pessimism and excessive life expectancy are none of China’s worries. For now.