The Two Faces of China - Part I

The hard thing about China is to truly comprehend what is really happening on the growth front. Are the statistics real? But most importantly, is this sustainable? Is China a lemon or a long-term high performer?

On the one hand, China has this amazing track record of very high growth for the last 30 years. Betting against it appears foolish. On the other hand, China is still, for the most part, a command economy which after a while, you would think, would stop allocating resources efficiently. And, as I recently exposed in Governance and Prosperity (http://scepticalmarketobserver.blogspot.com/2011/07/governance-and-pros…) and Small, Beautiful and Civilized (http://scepticalmarketobserver.blogspot.com/2011/07/small-beautiful-and…), there are also reasons to think that the quality of governance plays an important role in sustaining growth beyond a certain threshold.

At one point, it is difficult to say when and what will happen, the economic system in China is bound to derail and make the last global financial crisis look like a small storm in comparison. Otherwise, it could be the political system that will eventually crack and change to allow for real market reform. But I don’t think that this is likely and that it will happen soon.

We have seen this fast growth dynamic being interrupted before. Africa grew very fast in the sixties following the independence movements that sweep the countries of the continents. However, as early as the mid-seventies, most of their growth came to a screeching halt due to both a lack of markets discipline and terrible governance. The lack of institutions could not sustain their development. But China is past this stage.

Japan’s and South Korea’s economies also grew very fast for a few decades in their early growth phase only to slow down to more reasonable growth rates one they had reached a certain level of GDP per capita. Today, Japan has its own problems and a declining population while South Korea is growing more or less at the rate which is expected of a developed economy. However, these two countries are market economies and more or less let the price mechanism allocate its resources.

A better comparison is probably with Russia, the mother of all command economy for 75 years. Russia grew faster than the U.S. for several decades after WWII before it reached the abyss. Indeed until the mid-sixties, Russia was growing at a brisk pace. It was competing with the U.S. in most domains including technology. However, what a command economy could achieve quickly on a mass scale in terms of allocation of resources after a disastrous war, it could not do when it came time to marginally adjust to an evolving environment and unstable market place in the following years.

And already when Soviet leader Nikita Khrushchev visited the U.S. in September 1959, signs of the decline of the Soviet Union were already apparent. Khrushchev arrived confident following the successful launch of mission to the moon by the Soviets the day before his arrival in America, only to notice that New York and other U.S. cities were booming and prosperous.

It might have been easy for Soviet planners to “decide” to create a car industry but when it came time to innovate and improve upon their technology to satisfy consumers, the plan failed. And failure grew overtime as a result of the inertia of central planners.

Without incentives and pricing mechanisms, the old Lada remained the standard well into the nineties. And it took years for customers to get a car; if you had the means and the connections. Moreover, without incentives nor competition there was no productivity improvement and no ramping up of production. The same happened to Russian TV industry: Old black and white TVs with just a few channels were still the best the Russian could produce more than thirty after they were first introduced. Why should one have thought about improving the product anyways? There was no free media, no new channels were created beside the official ones created on day 1 by the planners of the system and the content was all black and white propaganda anyways.

Eventually, it was death by a thousand cuts for the Russian economy. You could probably compete with Ladas and a black and white TV sets in the early fifties. But as the products failed to change and adapt, they fell behind and eventually looked ridiculous; especially in comparison with what existed elsewhere. The whole Russian economy was stuck in time, unable to make productivity improvements and innovate.

What appeared to have been an excellent initial allocation of resources, after the revolution and then after WWWII, when Soviet planners first identified the macro needs of the Russian economy, gradually became inadequate as the industries created remained static and unable to evolve.

Admittedly, throughout the first half of this century, it probably took a lot of foresight to imagine that progress could happen so fast if you let markets and incentives take over the responsibility of allocation resources. After all, Russia had just come out of centuries of Tsarist rules where much of the population was living in serfdom. The Industrial Revolution was still quite new in the Western world and most people did not understand nor trust the power of incentives as much as we do today. For a while, especially after the Great Depression, businessmen were still treated with suspicion.

The problem in Russia at the time was that planners were unable to read the subtle changes occurring in the economy on a daily basis; in large part because it is impossible to do without market prices. The system was unable to maintain it resources allocation prowess when it came to small incremental changes required by markets that did not exist. Without incentives and pricing mechanism, reading the tea leaves was a much more difficult task than the initial resources allocation that have been decided after WWII.

The relevant question for all of us then becomes, in a world where we recognise the power of incentives, how to we harness this power to avoid crises like the one we recently had as it is clear that the last financial is the result of incentives gone wild?

So what about China? Certainly you will say that China has adopted market economy reforms to get to where it is today. And you would certainly be right. What China did following its reforms in the late seventies was to unleash incentives allowing many Chinese citizens to innovate and prosper. However, it also remains today a command economy where the price mechanism is still mostly absent. It had only adopted half the system. The incentives are there but not much prices are being discovered to guide these incentives and reallocate resources efficiently in the long run as these prices diverge from equilibrium as they unavoidably do over time.

Whatever market prices that China conforms to are formed externally on world markets; either for the commodities China buys on world markets or for the manufacturing products it sells abroad. However, for most of everything else, domestic prices remain artificially determined. According to me, this flaw contains the seeds of China’s demise.And as I will show you tomorrow, for those who want to see, the signs already exists in plain sight.

This may not matter much for now, as long as China is still growing fast. It might still be in its early growth phase were big resource allocation decision are efficient and contribute to growth in a very significantly fashion. In this case, markets would probably be much slower at achieving the same results. This the case made by Robert Herbold in the article below. He argues that “From new roads to wise leadership, sound financials and five-year plans, Beijing has the winning approach”. Mr. Herbold is a former COO of Microsoft and is today the managing director of The Herbold Group. He is also the author of "What's Holding You Back? Ten Bold Steps That Define Gutsy Leaders" recently published.

However, the lessons of history should not be forgotten. In a few days, I will publish the darker side of the story of China’s economic development. It will be for you to decide, if China’s story will end like Cinderella or Armageddon.


Here is the piece, China vs. America: Which Is the Developing Country? (http://online.wsj.com/article/SB100014240527023035446045764301621950570…). It was published in The Wall Street Journal recently:

“Recently I flew from Los Angeles to China to attend a corporate board-of-directors meeting in Shanghai, as well as customer and government visits there and in Beijing. After the trip was over, in thinking about the United States and China, it was not clear to me which is the developed, and which is the developing, country.

“Infrastructure: Let's face it, Los Angeles is decaying. Its airport is cramped and dirty, too small for the volume it tries to handle and in a state of disrepair. In contrast, the airports in Beijing and Shanghai are brand new, clean and incredibly spacious, with friendly, courteous staff galore. They are extremely well-designed to handle the large volume of air traffic needed to carry out global business these days.

“In traveling the highways around Los Angeles to get to the airport, you are struck by the state of disrepair there, too. Of course, everyone knows California is bankrupt and that is probably the reason why. In contrast, the infrastructure in the major Chinese cities such as Shanghai and Beijing is absolute state-of-the-art and relatively new.

“The congestion in the two cities is similar. In China, consumers are buying 18 million cars per year compared to 11 million in the U.S. China is working hard building roads to keep up with the gigantic demand for the automobile.

“The just-completed Beijing to Shanghai high-speed rail link, which takes less than five hours for the 800-mile trip, is the crown jewel of China's current 5,000 miles of rail, set to grow to 10,000 miles in 2020. Compare that to decaying Amtrak.

“Government Leadership: Here the differences are staggering. In every meeting we attended, with four different customers of our company as well as representatives from four different arms of the Chinese government, our hosts began their presentation with a brief discussion of China's new five-year-plan. This is the 12th five-year plan and it was announced in March 2011. Each of these groups reminded us that the new five-year plan is primarily focused on three things: 1) improving innovation in the country; 2) making significant improvements in the environmental footprint of China; and 3) continuing to create jobs to employ large numbers of people moving from rural to urban areas. Can you imagine the U.S. Congress and president emerging with a unified five-year plan that they actually achieve (like China typically does)?

“The specificity of China's goals in each element of the five-year plan is impressive. For example, China plans to cut carbon emissions by 17% by 2016. In the same time frame, China's high-tech industries are to grow to 15% of the economy from 3% today.

“Government Finances: This topic is, frankly, embarrassing. China manages its economy with incredible care and is sitting on trillions of dollars of reserves. In contrast, the U.S. government has managed its financials very poorly over the years and is flirting with a Greece-like catastrophe.

“Human Rights/Free Speech: In this area, our American view is that China has a ton of work to do. Their view is that we are nuts for not blocking pornography and antigovernment points-of-view from our youth and citizens.

“Technology and Innovation: To give you a feel for China's determination to become globally competitive in technology innovation, let me cite some statistics from two facilities we visited. Over the last 10 years, the Institute of Biophysics, an arm of the Chinese Academy of Science, has received very significant investment by the Chinese government. Today it consists of more than 3,000 talented scientists focused on doing world-class research in areas such as protein science, and brain and cognitive sciences.

“We also visited the new Shanghai Advanced Research Institute, another arm of the Chinese Academy of Science. This gigantic science and technology park is under construction and today consists of four buildings, but it will grow to over 60 buildings on a large piece of land equivalent to about a third of a square mile. It is being staffed by Ph.D.-caliber researchers. Their goal statement is fairly straightforward: "To be a pioneer in the development of new technologies relevant to business."

“All of the various institutes being run by the Chinese Academy of Science are going to be significantly increased in size, and staffing will be aided by a new recruiting program called "Ten Thousand Talents." This is an effort by the Chinese government to reach out to Chinese individuals who have been trained, and currently reside, outside China. They are focusing on those who are world-class in their technical abilities, primarily at the Ph.D. level, at work in various universities and science institutes abroad. In each year of this new five-year plan, the goal is to recruit 2,000 of these individuals to return to China.

“Reasons and Cure: Given all of the above, I think you can see why I pose the fundamental question: Which is the developing country and which is the developed country? The next questions are: Why is this occurring and what should the U.S. do?

“Let's face it—we are getting beaten because the U.S. government can't seem to make big improvements. Issues quickly get polarized, and then further polarized by the media, which needs extreme viewpoints to draw attention and increase audience size. The autocratic Chinese leadership gets things done fast (currently the autocrats seem to be highly effective).

"What is the cure? Washington politicians and American voters need to snap to and realize they are getting beaten—and make big changes that put the U.S. back on track: Fix the budget and the burden of entitlements; implement an aggressive five-year debt-reduction plan, and start approving some winning plans. Wake up, America!”

 

Via The Sceptical Market Observer.