Global Trend

The Looming China Crisis

When Western executives and investors look at China, the first thing they see is opportunity. China’s population of 1.3 billion people seems to represent a spectacular potential market for American products and services. Every week, foreign companies pump another $1 billion into China, according to The Economist.

For example, China is the largest cell phone market in the world, with about 350 million users, according to The New York Times. Its life insurance market, valued at $39 billion in 2004, is expected to grow to $128 billion by 2008, according to a McKinsey consultant cited in Bloomberg News.

But if you look more closely at China’s economy, you’ll see more red flags waving than at a May Day parade. The reasons to be cautious about investing in China can be divided into four broad categories:

- China’s banking system.
- Its political unrest.
- Its shortage of workers.
- Its strained relations with the U.S.

The most immediate problems have to do with the banking system. China’s government has propped up its booming import/export industry by focusing on building up market share and cash flow ? at the expense of profitability.

It doesn’t matter whether Chinese companies are credit-worthy by American standards. The government gives them heavily subsidized loans ? regardless of whether they produce quality goods, whether they make money, or whether a market exists for their offerings.

This system was designed to ensure that Chinese businesses can compete in a global marketplace, but instead it has kept bad businesses alive, and it has encouraged entrepreneurs to launch new ventures that would fail in a free-market system. Essentially, it’s a license to steal: People start businesses to get their hands on the loans, knowing they won’t have to pay back the money, whether they succeed or fail. Companies build extra production capacity that isn’t needed, which leads to an avalanche of products that no one wants.

It won’t be long before the impact is felt on the nation’s economy. As an analysis by Peter Zeihan of Stratfor.com points out, until the past year, China has come perilously close to deflation for the past six years. When America was in the same situation three-quarters of a century ago, the economy collapsed into the Great Depression.

In March of last year, China tried to slow down its growth and prevent a deflationary spiral. It stopped granting loans for several days, and then it cut back on the loans it issued in overheated sectors such as the steel industry. For a while, the new policy worked ? inflation shot up to 5.3 percent, so the threat of deflation diminished.

But the companies that were affected by the new policy ? such as those in the steel industry ? were not pleased with the result. From their point of view, the only way to survive was to keep borrowing money ? and if they couldn’t get it from the Chinese government, they would get it from the international market.

This was exactly what the Chinese economy did not need. Its system only worked if it was not exposed to outside pressures. But in 2004, Chinese companies borrowed $228 billion from foreign lenders ? and nearly half of it was in short-term debt that matured in 12 months or less. The total value of all of those short-term loans equals more than 6 percent of China’s GDP.

Why is this such a major disaster in the making? Because as soon as U.S. interest rates rise, Chinese companies will have to pay a higher cost for capital ? a cost they aren’t likely to be able to afford. This scenario is already starting to unfold. U.S. Fed. fund rates have shot up by 300 percent in the past nine months, and Alan Greenspan has warned investors that he will continue to raise rates.

China’s banks are to blame for the turbulence that lies ahead for China’s economy. In addition to propping up the nation’s import/export industry, the banks support China’s industrial companies, known as state-owned enterprises, or SOEs. As Zeihan reminds us in his Stratfor report, SOEs are not expected to produce goods or profits. Instead, their purpose is to provide jobs for 40 percent of China’s urban population.

With this in mind, the banks don’t ask for business plans, and they don’t evaluate risks and rewards when they give the SOEs massive loans. As a result, the bad debt ratio for China’s four largest banks is 30 percent, according to official government statistics, and in reality it is likely to be higher than 50 percent.

To put that into perspective, consider that when U.S. savings and loans were failing in the 1980s, the government’s bailout equaled 3 percent of America’s GDP. If China bails its banks out of their bad loans, it would have to write off an amount equivalent to as much as 40 percent of its GDP.

China’s banks have survived by paying depositors next to nothing in interest on their savings accounts ? a system that works only because China’s banks hold a monopoly on the industry.

All that will change dramatically at the end of 2006. As part of the agreement that China must abide by to join the World Trade Organization, it must open up its economy to foreign competition. When overseas banks are allowed to target Chinese customers with higher interest rates, millions of them will close their accounts at Chinese banks. Deprived of this vast pool of money, the state banks won’t be able to fund the SOEs. At that point, the government would either have to subsidize the SOEs directly, or let the entire system crumble.

China’s dilemma is that it can’t save one part of its economy without destroying the other. The only way it can save its import/export sector is to reform the banking system and allow foreign companies to compete in all of its industries. Foreign investments would deliver an infusion of capital and know-how that would help the import/export sector to thrive. But these reforms would come at a high cost. Shattering the country’s banking system would kill the unprofitable SOEs, and hundreds of millions of Chinese workers would lose their jobs.

If China tries to save the SOEs, it will have to withdraw from the World Trade Organization to protect its banks. It could also levy huge taxes on imports and exports to generate revenues to fund the SOEs. But this strategy would destroy the import/export sector and close China’s borders to foreign investors ? and their capital.

Either way, the outcome will be a disaster for foreign investors. If China abandons the SOEs, the social unrest caused by widespread unemployment could cause the economy to implode. And if it withdraws from the WTO to save its banking system, it will shut out the foreign banks that have been the most enthusiastic advocates for investing in China.

And no matter which direction it chooses, it must deal with the reality that it is a nation of two competing economies. At some point, they will either divide into separate entities, or an all-out war will erupt for control of the country. We only need to consider what happened four decades ago, when China faced a similar decision. At that time, part of its economy was trading with foreigners while the rest of the nation remained closed. Mao Tse-Tung realized China could not follow two strategies, so he put an end to trade. China survived, but its economy took a step backward.

This brings us to the second reason to be very wary of investing in China: political unrest. Only 16 years have passed since the government cracked down on student protests in Tiananmen Square, but the population’s willingness to engage openly in public demonstrations has come a long way in that time.

China’s own statistics reveal that between 1993 and 1999, the number of protests soared from 8,700 to 32,000, and outside observers estimate the number grew to 40,000 by 2000 and has risen steadily every year since then, according to the International Herald Tribune.

The more recent official figures that are available for individual regions are striking. For example, between January 2000 and September 2002, police reported 9,559 incidents involving more than 863,000 people ? an average of 10 incidents involving 90 people every single day ? in Liaoning Province alone.

This is significant because the protests are growing fastest in the regions where China’s cautious market reforms are trickling down to workers at SOEs. This is the reality that troubles China’s leaders. Any move that they make to reform the banks, cut off loans to unprofitable SOEs, and open China to foreign competition, carries the risk that it will put millions of Chinese workers out of their jobs ? and draw them into the streets for massive protests.

Already the government has seen the protests grow not only in number, but in size. A decade ago, Chinese protestors kept their demonstrations small to avoid provoking a violent response. Today, well-organized, large-scale protests combine people from various regions and factories.

Police are now less likely to break up demonstrations with force. Instead, they try to buy off leaders of the demonstrations, turn the leaders against each other, and make deals to permit smaller protests.

But the police haven’t had to confront the scale of protests that could erupt if the state-owned enterprises go out of business. If hundreds of millions of demonstrators hit the streets, China’s economy and the Communist political system could implode.

That political system has led to China’s third major problem: its shortage of qualified workers. According to a recent report in The Economist, the cost of doing business in China is going up because of problems recruiting and retaining workers, particularly skilled ones.

China’s factories already face a shortage of cheap manual laborers. But as China’s economy moves toward higher value-added work, it is becoming impossible to fill jobs with highly skilled employees. That means any company that wants to do business in China has to contend with the fact that it will be competing for scarce workers. “If you think that China is a cheap place for labor, think again,” warns Vincent Gauthier of Hewitt Associates.

China’s labor pool is particularly weak in the aptitudes that American companies are increasingly looking for in employees. There simply aren’t enough Chinese workers who can provide creativity, risk-taking, or managerial skills.

As The Economist points out, China’s culture prevents its workers from developing the skills that are needed in today’s knowledge-based economy:

Its schools train students to memorize answers, rather than to think for themselves.

Its one-child policy has resulted in generations of workers who grew up without siblings ? so they lack an understanding of the concepts of cooperation and teamwork, and they don’t have the experience needed to handle conflict. All of these capabilities are in great demand in today’s workplaces.

China offers only a few MBA programs, so it is not exactly churning out managerial candidates.

Chinese workers have no idea what a modern corporate executive should do. As Jeff Barnes, “Chief Learning Officer” at General Electric in China, says, the “issue we have is finding mid-level and top-level leadership. The Chinese talent is first-generation. They don’t have role models. Their parents worked for state-owned companies.”

And finally, Chinese employees were raised in a society that taught them that capitalism meant oppression. One foreign manager who does business in China sums up the problem this way: “The talent pool consists either of managers from state firms who are too bureaucratic, or entrepreneurs who have come up through the private sector and are unconstrained by capital or the law.”

The shortage of workers in China is preventing foreign companies from investing as aggressively as they had planned. Recently, Oracle and Ernst & Young have announced that they are cutting back on their Chinese operations because they can’t find adequate staff there.

The challenge is compounded by the fact that the most talented and qualified Chinese workers tend to overinflate their worth when they are recruited by overseas firms. And foreign companies must increasingly compete for the top talent with Chinese companies that are trying to upgrade their staffs to compete internationally.

Even when a company succeeds in hiring good workers, it often can’t keep them. Turnover rates are astronomical. In Beijing, one in 12 executives defected from their employers last year. In Shenzhen, one in 10 changed jobs. Nationwide, the turnover rate was 11.3 percent in 2004, an increase from 8.3 percent just three years earlier, according to research by Hewitt. At lower levels, companies like L’Oreal lose 15 percent of its workers every year, and at smaller companies the churn rate reaches 30 percent.

Because of the intense competition for employees, salaries and benefits are skyrocketing. While China’s inflation rate is about 2 percent, mid-level and senior managers command raises of between 6 percent and 10 percent each year. In some professions, salaries are rising even faster. For example, accountants are getting annual pay increases of 14 percent. Middle managers earn an average of $30,000, while top executives collect $85,000 or more.

The cost of hiring Chinese workers isn’t limited to pay, however. To compete for employees, many companies now offer bonuses and stock options, plus free housing, meals, company cars, and mobile phones. When you factor in the contributions that employers must pay to China’s national security fund system, the true cost of an employee is roughly twice his salary.

Finally, all of the reasons to be cautious about investing in China so far ? its banking system, political unrest, and labor shortage ? are less of a threat than the fourth reason: China’s fragile relationship with the U.S.

If the hostility between the two countries heats up, foreign investors could lose everything.

At issue here is America’s alliance with Japan in the war on terror. China’s leaders have demanded that the Japanese apologize for war atrocities they committed in the 1930s and ‘40s. In Hong Kong and Shanghai, Chinese demonstrations against Japan have occurred regularly.

But as Lawrence Kudlow explains, this isn’t the real issue. The biggest source of tension is that China sees the friendliness between America and Japan as a sign that the two countries will unite against China’s political interests. For example, Japan is siding with the U.S. in calling for North Korea to halt its nuclear weapons program. China has not delivered on its promises to put pressure on North Korea.

Also, China fears that the U.S. and Japan will protect Taiwan from its “anti-secession” law, which Beijing passed in March. The law authorizes an attack on Taiwan if it becomes too independent. The New York Times recently reported that China has been building up its navy to exploit weaknesses in the U.S. military’s ability to defend Taiwan from an attack.

According to some military observers, China has amassed enough amphibious assault ships, submarines, fighter jets, and short-range missiles to make a quick strike on Taiwan and win the battle before the U.S. could mount a defense.

In response, both the U.S. and Japan have demanded that the European Union keep its arms embargo against China intact, and they jointly listed peace in Taiwan as a “common strategic objective.” China criticized the countries for interfering in its domestic affairs.

According to an American intelligence analyst quoted in The New York Times, “The potential for a miscalculation or an incident here has actually increased, just based on the rhetoric over the past six months to a year.”

Robert Karniol, an expert on Asia at Jane’s Defence Weekly, sums up the situation this way: “The Chinese understand that if their ambition is to become the dominant power in Asia ? well, who can disrupt that? The United States and Japan.”

China is also bitter about recent developments on the economic front. The U.S. and Japan are among the countries that are pushing China to revalue its currency, the yuan, and stop pegging its value to the U.S. dollar. The goal is to fix the trade imbalance that favors China’s inexpensive exports.

But if China agrees, it would have to revalue the yuan by at least 25 percent. As Kudlow points out, it could only do this if it tightened its monetary policy, and that would slow down the growth of China’s economy. It would also slow down the growth of the U.S. economy by at least 1 percent. The biggest impact would be felt in sectors like raw materials, technology, and transportation, where stocks have been particularly hurt during the market downturn.

Based on all of these reasons, China is a much riskier place for U.S. investments than most executives realize. Looking ahead, we offer the following five forecasts:

First, China’s economy is likely to undergo great stress, starting in 2007. As we’ve explained, China will have to open its banking industry to foreign competition by the end of 2006. Chinese investors will move their savings to foreign banks that can offer higher interest rates than the Chinese banks, which must keep rates low to offset their loans to state-owned enterprises. Ultimately, as deposits dry up, the banks will be forced to cut back on lending to the SOEs, which will force many of those businesses to let millions of workers go.

Second, even though China’s central government will make a bold effort to reform its economy, it is likely to fail. A major obstacle is the fact that local and provincial leaders are more loyal to their own regions than to Beijing. They are simply not going to comply with orders to close a state-run factory that would put thousands of people out of work.

Third, the widespread loss of jobs will fuel the political unrest that Chinese leaders fear. Demonstrators have already proven that they know how to organize large-scale protests, and they have made it clear that they are not going to be intimidated by police oppression. The government has inadvertently made the threat of protests even greater by encouraging the anti-Japanese demonstrations earlier this year. And if China focuses on its import/export sector, which already receives 87 percent of foreign direct investment, at the expense of the banks and SOEs, it will create a tremendous imbalance of wealth between those who benefit from that sector and those who do not.

Fourth, the shortage of skilled workers in China and the specter of a military confrontation over Taiwan will increasingly drive away foreign investors. Given a choice between investing in China, with its overpriced workers, and India, where there is an ample supply of skilled professionals, many companies will choose the latter. And the anxiety over China’s military buildup, and the heated rhetoric over the independence of Taiwan and the EU’s arms embargo, will add an escalating level of risk that will be impossible for wise foreign CEOs to ignore.

Fifth, the United States will remain the world’s only superpower. No matter which move it makes ? withdrawing from the WTO to support its banks and state-owned enterprises, or abandoning its banks and SOEs to back its import-export business ? China’s economic “miracle” will wither for all of the reason’s we’ve just outlined. It will ultimately cede its dominance over Asia to Japan, which has aligned itself with the U.S.

References List :
1. The Economist, April 16, 2005, “Chinas People Problem.” ⓒ Copyright 2005 by The Economist Newspaper Limited. All rights reserved.2. New York Times, April 25, 2005, “A Hundred Cellphones Bloom, and Chinese Take to the Streets,” by Jim Yardley. ⓒ Copyright 2005 by The New York Times Company. All rights reserved.3. Bloomberg.com, May 9, 2005, “HSBC Pays $1.1 Billion to Raise Stake in Ping An,” by Michele Batchelor. ⓒ Copyright 2005 Bloomberg L.P. All rights reserved.4. Stratfor.com, March 23, 2005, “Chinas Long March to Bankruptcy,” by Peter Zeihan. ⓒ Copyright 2005 by Strategic Forecasting, Inc. All rights reserved.5. International Herald Tribune, June 3, 2004, “Protests Now Flourish in China; Shades of Tiananmen,” by Murray Scot Tanner. ⓒ Copyright 2004 by the International Herald Tribune. All rights reserved.6. The Economist, April 16, 2005, “Chinas People Problem.” ⓒ Copyright 2005 by The Economist Newspaper Limited. All rights reserved.7. To access Larry Kudlows commentary “China Card,” visit the American Skandia website at:www.americanskandia.prudential.com/page/0,2225,5434,00.html8. The New York Times, April 8, 2005, “Chinese Navy Buildup Gives Pentagon New Worries,” by Jim Yardley and Thom Shanker. ⓒ Copyright 2005 by The New York Times Company. All rights reserved.9. ibid.