54) Myths about China

Everything You Know About China Is Wrong
By Rana Foroohar
NEWSWEEK, Oct 26, 2009

The conventional wisdom is that China is steaming through the global financial crisis by building on the momentum generated by its 30-year boom. Indeed, ever since it sailed through the last big global crisis—the Asian contagion 10 years ago—Beijing has been feted for uniquely steady helmsmanship in financial storms. So perhaps it's natural for forecasters to assume that the Chinese supertanker of state is not turning sharply now, particularly since it continues to grow rapidly even as other economies sink in the recession. Yet this crisis is different—bigger and more damaging than any seen in generations—and it is exposing limits and forcing change in just about every key piece of the China model: the supremacy of the one-party state, the smart economic management, the export-driven growth, the emerging consumer class, the burgeoning private sector, the headlong focus on growth at any environmental cost, and the drive to build world-class companies. What follows is a look at why these common assumptions about China are increasingly inaccurate or just plain wrong.

Myth No. 1: THE COMMUNIST PARTY IS A MONOLITH.
No, the financial crisis is splitting the party, pitting the rural populists against the urban growth-firsters. The populists include the current top two, President Hu Jintao and Premier Wen Jiabao, who favor slower growth, distributed more evenly to poorer rural Western regions, governed with a more careful eye to protecting the environment and less devotion to the free market. Opposed to them are the elite factions based in urban coastal cities, led by Shanghai, who want high-speed growth, more freedom for the free market, and greater support for entrepreneurs and the private sector. While it's too early to tell which faction will win out, it's clear that the new leadership will take China in new and possibly unexpected directions. "Perhaps the biggest myth about China is that it is only developing economically," says Cheng Li, a China expert at the Brookings Institution in Washington. "In fact, it's also evolving politically."

Myth No. 2: THE COMMUNISTS ARE BRILLIANT ECONOMIC MANAGERS.
On the day in September 2008 when Lehman Brothers fell, China began planning the swift rollout of a $600 billion stimulus that would prove to be the largest (as a share of GDP), swiftest, and, many say, most effective in the world. The results—China continues to grow at a world-beating pace, now 8 percent—have confirmed the reputation of the party elders as macro maestros. While most economists agree that Beijing has done a strong job of solving the short-term problem, which was how to keep growth high enough to offset massive unemployment and subsequent political unrest, there is growing unease about how the massive stimulus could distort the economy in the long term. China has become an economy driven almost entirely by state investment, which in the first half of 2009 accounted for 88 percent of GDP growth—a share for which it is hard to find any parallel, in any country, at any time.
The dangers of this lopsided boom are real. The pro-market faction worries that the liberalization of financial markets and the privatization of strategic sectors (which include most of the richest industries such as banking, telecoms, and construction) are being forgotten in favor of "bridge to nowhere"–style projects. Even government officials now admit that 60 percent or more of the stimulus money has ended up in stock and real-estate markets, fueling worries about dangerous new asset bubbles. In some coastal cities, property sales are three times what they were last year; the Shanghai stock market is up over 60 percent this year. "It's just a stopgap measure—all the stimulus has been concentrated in building new infrastructure and reheating the property sector," says Chinese independent economist Andy Xie.
This could spell trouble for Hu and Wen. The Chinese government debt, once negligible, is now officially about 30 percent of GDP, but some Western economists put the real figure as high as 70 percent. While these figures are still low compared with Western nations (the U.S. debt-to-GDP ratio will reach about 100 percent next year), they have Chinese politicians fretting. Last month Wen told a group of VIPs at the World Economic Forum in Dalian that China's rebound was "unstable, unbalanced, and unconsolidated." A week earlier Chi Fulun, a member of the Chinese People's Political Consultative Conference was blunter: "Chinese leaders," he said in an interview, "should rethink the country's reform package."
China bulls would argue that China, where 40 percent of villages still have no paved roads to the nearest market, has a huge demand for more paving projects. Yet bears would ask how much China gains from connecting poor villagers (China's per capita GDP is still only $2,000, and much less in rural areas) to the market. "Take a drive on one of those new rural highways; you won't see many cars," says Ming Huang, a finance professor at Beijing's Cheung Kong business school and Cornell University. "It's going to take a long time for this sort of investment to result in any kind of consumption boost." Meanwhile, the stimulus is like steroids for the dominant state sector, which, according to Hudson Institute fellow John Lee, has received some 95 percent of the stimulus capital so far. If it falters, Hu and Wen will be held to account, not held up as brilliant managers.

Myth No. 3: CAPITALISM IS FLOURISHING.
 That was partly true until this year. The number of private enterprises in China doubled from 20 million in 1990 to 40 million in 2008. Yet, according to Lee, that number will likely be down to about 38 million by the end of this year, as many private manufacturers go out of business. State enterprises enjoyed huge advantages, even before Beijing's stimulus started shifting more funds their way. State companies have easy access to 3 percent loans from state-owned banks, while private companies pay double-digit rates and are often forced to tap underground markets for funding. Since 1992, growth in private-sector fixed asset investment has been rising at about 10 percent per year, compared with state-sector growth of between 20 and 50 percent. Since the 1990s, the average size of a successful private business in China has flatlined at about 30 employees, due mainly to their difficulties raising capital. It's no surprise that recent market surveys show state companies are bullish on the future, while private-sector businesspeople are decidedly less so.
The last several years of boom growth have given the state little reason to ease its grip on the most lucrative industries, and the crisis may not be enough to force its hand. "Unfortunately, the low hanging fruit has been plucked," says Huang. "We've now hit a point where if you want to do more reform, you are going to have to really hurt some vested interests in the key parts of the economy—finance, telecoms, energy, government bodies, etc." The Chinese state owns more than two thirds of all fixed assets like telecommunications lines, power plants, and real estate in the country. State-controlled companies represent some 70 percent of the major stock markets. And while the private sector still controls a little more than half the total economy, most China watchers believe the stimulus package will turn the tables. "I have no doubt that after this crisis, the state will control a larger share of the overall economy," says Wang Shuo, managing editor of China's Caijing economic journal. "That's bad news for domestic demand, because it means that individuals will control a smaller share of the economy. Households are already supporting state-owned enterprises with their savings, which are given to these mostly inefficient businesses via state-owned banks at very low interest rates."
The crisis is exposing the hidden hand of the state. Back in 2007, the government listed three of its largest four banks on the Hong Kong Stock Exchange in what was described at the time as an effort to make them more commercial, less political. Yet as soon as the crisis hit, Beijing issued instructions to bank heads on how and when to start lending. That prevented the kind of credit-market heart attack that hit the West, but many analysts fear it will lead to a spike in nonperforming loans next year. Now Beijing is meddling in the market in all manner of ways—arresting executives of an Australian mining company after it jilted a Chinese merger partner, supporting state-owned firms that want to walk away from Western derivatives contracts, allowing state takeovers of more efficient private firms. China threw open its doors to capitalism under Deng Xiaoping in the early 1980s, but now "the open door has lost its momentum," says Wang.

Myth No. 4: CHINA IS AN EXPORT-DRIVEN ECONOMY.
 If that really were true, why is it that exports are down 20 percent this year, but the economy is still up by 8 percent? "While exports are important to China, in the same way that they are important to Japan or Germany, it's not the only thing going on here," says Fang Xinghai, director of the Shanghai Financial Services Office.
Take a close look at Chinese exports as a growth engine, and they begin to fall apart. While gross exports make up a bit less than 40 percent of the economy, that figure is misleading, says CLSA strategist Andy Rothman, because it overestimates the Chinese take on goods stamped made in china. Most of those goods are merely assembled in China from parts made in South Korea, Taiwan, and other richer countries. Consider a $299 iPod that sells wholesale from the Chinese assembly plant for $150. Only about 5 percent, or $7.50, of that wholesale price comes from Chinese parts and labor. That $7.50 is the net export value, and the real contribution to China's economy. Net exports account for just over 7 percent of China's GDP. That explains why China can still grow when its key Western export markets are in a deep recession.
China depends, as we've seen above, on state spending. The contribution of a growing consumer is real but widely overstated, as Morgan Stanley Asia chair Stephen Roach and many others like to point out. Chinese consumption makes up only 37 percent of the economy, the smallest share of any major nation. And to the extent that Chinese consumers are still more optimistic, and less heavily in debt than Western counterparts, that too has much to do with heavy state subsidies. Lately the middle class has been snapping up flats in Beijing and Shanghai, as well as furnishings and white goods, thanks to the massive, government-mandated increases in bank lending over the past year. Credit was up 32 percent in September, after similar rises over the past several months. Rothman's conclusion, which is increasingly supported by a number of other Chinese and Western economists, is that China can continue to grow at a 6 to 9 percent annual pace based on state and consumer spending "without any contribution from net exports." So much for China's export dependence.

Myth No. 5: CHINESE COMPANIES WILL RULE THE WORLD.
True, many big Chinese state companies are scouring the world, hunting for distressed properties, creating the illusion that the crisis is advancing China Inc.'s global ambition. But the buyers are mainly government-run oil and mining behemoths, seeking out cheap resources in other developing nations, and they have little potential to become global brands. "Quite simply, there is little real innovation or branding ability in China," says Beijing University professor Michael Pettis. The obstacles include weak legal protection for intellectual property and contracts, and an educational system focused on rote learning and metrics rather than creativity and innovation. In typical Chinese fashion, the financial crisis prompted edicts from Beijing that firms should go forth and innovate—subsidies are now being doled out for new patents filed. Yet as any economist or investor will tell you, patents rarely translate directly into real companies with new and unique technologies, and top-down efforts at creating startup companies can't compete with the sort of spontaneous germination of ideas that happens in places like Silicon Valley or Cambridge.
Meanwhile, China's Wild West atmosphere doesn't encourage the long-term thinking necessary for building global businesses and world-class research and development. "Blurry rules and corruption fosters short-term thinking here," says Huang. "Entrepreneurs don't feel safe—there are many examples of the government taking over private businesses or changing the legal landscape—so they take their profits as quickly as they can." Meanwhile, richer state companies (think Sinopec or Chinalco) use their giant war chests to make acquisitions to feed domestic demand, rather than investing in research or branding. Why spend money to become more globally competitive when you have a monopoly in the world's most populous country? Result: even China's 800-pound gorillas won't replace Western blue chips any time soon.

Myth No. 6: CHINA PUTS MONEY BEFORE THE ENVIRONMENT.
 China's growing tendency to ignore market forces is working in one surprising field: clean technology. For years China has resisted pressure to help control carbon emissions, insisting that it needs to develop first, and that its per capita emissions are far below those of the West. Now, as China has come to realize that its people could be among the hardest-hit victims of global warming, Beijing has mobilized its resources, as perhaps only China can. With the help of generous state subsidies, Chinese companies have, for example, taken the lead in solar cell production, and are powering ahead in many other areas. This fall Chinese leaders announced new targets for reducing carbon emissions, which, if met, would put the nation in the lead on combating climate change by 2020.
China has made green technology a national priority, launching major research initiatives on solar-powered batteries and wind technology. Its green stimulus package amounts to $218 billion, the largest in the world, resulting in the founding of dozens of alternative energy companies within the last year. China already produces more power from renewable energy than any other nation in the world. Meanwhile, the recession and uncertainty about the direction of oil prices has slowed the momentum of green investing in the West. This doesn't mean that China can clean up its own act soon: to meet energy demand, it continues to build old-fashioned coal-fired plants at the rate of one a week. But it may become the leading manufacturer of clean energy technology for the rest of the world.
None of these changes should come as a real surprise, on closer look. In past crises, China has always shown a bold willingness to adapt. Its original opening to global markets emerged from the turmoil of the Cultural Revolution. Its last big opening emerged from the Asian crisis, when it joined the World Trade Organization in 2001. Now the changes seem to be moving in the opposite direction, back toward a more insular economy, run by the state, less welcome to private and foreign business, and with one big surprise. If the ruling faction fails, there is an alternative waiting in the wings.

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