Editorials

By Anton Harder for China Brain.

Last month we argued that China was not developing into a cold war style superpower, but was in fact likely to be a defensive great power. Of course, any predictions, or even current assessments of international power, must be treated cautiously. After all the USSR was regarded as a superpower until it suddenly collapsed under the weight of what was only in hindsight recognised as economic incoherence. Japan also was imagined to be racing ahead of the West in economic growth until the engine stalled and has not recovered since. China is clearly at risk of falling into the much dreaded middle income trap as its growth slows, but even so and with a massive population of very poor people, China is and will remain a massive influence because of its absolute economic size.

However, the defensive nature of China will remain a key characteristic because for the governing elite of the Communist Party the central consideration will always be maintaining its own power. This does not mean pursuing popular policies but about pursuing policies that secure its own control over the economy while making sure that it protects the interests of economic elites who have benefitted so much from its rule. Furthermore, the Party is unlikely to challenge an international economic system which has enriched the elite that supports while enabling it also to lift millions out of poverty.

China, and the Communist Party, are therefore far more interdependent with the USA than is commonly realised. They are locked together in a financial embrace that if decoupled would ravage China’s economy possibly even more than it would the USA’s. Elites on both sides of the Atlantic have shared massive benefits since China’s US supported entrance to the WTO in 2001.

The Party is also very concerned with territorial integrity. This is a defensive not offensive mind-set. Military and intelligence resources are overwhelmingly dedicated to maintaining China’s current borders and holding down restive populations in Tibet and Xinjiang. Military development focuses on securing the island of Taiwan, rather than fighting major wars in distant arenas, as US strategic planners have traditionally done since 1945. China does not plan to build the capability to fight wars as far from its territories as the US has done in Korea, Vietnam, Iraq and Afghanistan. China’s more local defensive concerns regarding its own territorial integrity, and they are conceived of as defensive in China, including pacific island claims, limit attention that can be paid to global military and strategic scenarios.

So China might be cooperative economically and defensive and locally focused strategically and militarily, but it is certainly not submissive. China utterly rejects what Chomsky calls the “mafia principle” that global hegemony permits military and other action to keep others in line. China will not sit down and be quiet, even if its elites have benefitted a great deal from doing so. CCP legitimacy is hard to come by, especially as the economy slows. A major scholar of PRC foreign policy, Chen Jian, argues the central claim of the Party to power is in fact that the Chinese people have “stood up” in global politics. He further agues that China now pursues centrality rather than hegemony. The problem therefore lies with the West, and the USA, and how it defines its own power. Can the USA accept the implicit reduction in its absolute power that a powerful China at the centre of world politics implies? American rhetoric suggests it welcomes a powerful partner to tackle global issues, but the US has never before had to embrace a genuine partnership of equals.

As a defensive, domestically oriented power China embraces asymmetric doctrines to counter US threats. Cyber warfare, cheap technologies, strength in numbers and the US’s horror of military risk generally are all tools in China’s growing asymmetric strategy. This is not in fact a response to the new international situation but is traditional doctrine for the PRC based on Chairman Mao’s military thinking – he was undoubtedly one of the very pre-eminent military strategic thinkers of the twentieth century. China is not particularly working out ways to massively project power around the globe as the US does. It is rather seriously working out ways to make such projection more difficult for the US, especially in China’s own neighbourhood.

Another element of China’s defensive posture is that it is non-ideological. It no longer has any particular approach to promote internationally. In fact it has become extremely pragmatic, whatever works will do. This defensive posture has the beneficial corollary that it is seen as an example worth emulating in development terms, in the sense that one can avoid following any particular model but simply try what works on the ground. This compares rather well with the USA which can appear at times still bound by its free-market ideology, causing logjam in Washington over healthcare reform and other things. With no agenda to push on other countries, China’s new financial power is seen as less threatening in the developing world. Particularly in Africa, Chinese loans’ lack of conditionality makes them far more attractive than those from the World Bank and the congruent IMF policies attached that represent the West’s ideological preferences.

So we would characterise China on the whole as pursuing a conservative and defensive foreign policy, rather than an aggressive superpower one. Having said this, by the basic law that any action creates a reaction, even if China acts conservatively its influence will still be profound as one can observe from the attraction it exerts.

One warning note must perhaps be sounded to end this two part series however. History tells us that revolution occurs amongst populations not when they are oppressed and downtrodden, but in fact once expectations have been raised but are then not realised. We wonder if something similar might apply in the international sphere?  A poll was taken of Indian public opinion last year that showed the majority of its population ranked their country as second in global power only to the USA. This perception, probably at odds with the global consensus, might lead to a great deal of resentment in India if the population do not see that proud position delivering certain positive gains for the country. What pressure then might be caused in China if the population there, increasingly conscious of its national power, feels that some major concession to this new power is denied it?

With a 5 year ban now in operation for the construction of new Government buildings (including those of State Owned Enterprises) we have a look at a selection of some of the most spectacular Governmental buildings in China.

By Anton Harder for China Brain.

Discussion of the rise of China, India and Asia usually ends in the possibility of a new superpower emerging to challenge or even displace US hegemony. The analysis surrounding such discussion often seems simplistic and the possibility of such a development is usually overstated. More importantly the discussion itself seems to misunderstand the real changes occurring in the international system. In this two part series we will consider China emerging as a recognizable superpower. Following this we will consider what China might in fact be emerging as instead.

Setting aside questions of what would qualify as proof of China’s new superpower status, a sobering bucket of cold water can be emptied onto assessments of China’s current national power by an in-exhaustive summary of the country’s many weaknesses.

The first weakness might be, surprisingly, one of willpower. To be a superpower, if we understand that to be what the USA and USSR were during the Cold War, and the USA was – or is – in the post-Cold War era, surely that state would need to possess the strong desire to promote itself and its political-economic model abroad in the way that the USA, USSR and indeed the PRC were all committed to doing for much of the Cold War. China still prioritizes its domestic agenda. Indeed the Chinese Communist Party’s number one concern is intrinsically domestic, which is to preserve its own power. This is a defensive position that does not seem to fit the notion of a superpower’s desire to impose its system of beliefs on others.

Another sign of weakness is the elite’s apparent lack of faith in China. Bo Xilai, the erstwhile Mayor of Chongqing now incarcerated and under official investigation, was an example of this. A preference for overseas assets and a children educated in the  various institutions of elite Western education do not suggest confidence in either the present or the future of China. That this arrangement is a basic goal of all middle class Chinese, and would-be-elites, further underscores the lack of faith in China, and again suggests something other than the supreme self-confidence of a genuine superpower.

A general distrust of the outside world and a powerful victim mentality that gives China a tendency to blame others for its problems would also seem to mitigate any sense of China being an emergent superpower. This is rooted in a sense of history which as officially promoted reveals a once glorious, benign and tolerant empire having suffered gross humiliation at the hands of ruthless expansionary foreign powers by virtue of their acquisition of advanced technology. This view of history leaves China with a blind-spot for how others perceive it, as also at times aggressive, expansionary and bullying. This sense of indignation lends China a particularly strident, self-righteous tone in pursuing its claims. In the South China Sea, for example, this makes it increasingly difficult to talk rationally with those who dispute China’s claims, and perhaps worse, creates huge domestic political pressure to take a hard line, lest China be once again seen as weak or shamed by foreign powers.

The trouble China has in attracting serious allies must also be considered a factor undermining its international power. In the early and mid-twentieth century as British power faded it actively sought to smooth the US assumption of its former hegemonic role, in general confident that this would mean the continuation of a system beneficial to it. Europe on the whole has also sought very much to cooperate with US power. China simply does not have the same appeal to other significant powers in the international arena, and is more likely to aggravate than inspire admiration. The US has of course cooperated on China’s rise so far but that is on the condition that China does not challenge its direct interests. It is still the US that educates the global elite in its universities giving it an unparalleled cultural power and one that China is far from competing with. China simply does not offer an attractive alternative world view for global elites to embrace.

Another major weakness could be categorised as broadly economic. This may seem surprising considering China’s current dynamism compared with most of the rest of the world. This broad category, however, must include long term economic crises brewing in China such as the massive environmental damage already endured yet not accounted for, and environmental damage still to come from the development model that is currently deployed and likely to persist for some time to come. Another major economic problem facing China will be its changing demographics as it becomes an aging country with a massive dependant and unproductive elderly population in the 2020s. The vast labour pool that has supported China’s growth will be hugely diminished, and even less likely to pursue the higher consumption lifestyle that the economists and government all know is necessary to rebalance the economy. The reality of the current difficulties of this rebalancing, the massive financial inefficiencies supporting the economic system as it stands and huge industrial and manufacturing overcapacity is a further weakness, outlined on this site by Paul Harding.

This very discussion is premised on the idea that it is the normal state of affairs to have a superpower or two defining major international issues. However, although history inclines us to look for patterns, it does not evolve in predictable cycles. Many of the issues indicated above that would seem to disfavour a conclusion for China emerging as a new superpower, at the same time appear somewhat tied to a very twentieth century view of international relations. It is still possible that a new paradigm will emerge. China is very unlikely to emerge as a US or Soviet style superpower, but at the same time it is contributing to a massive transformation of global power dynamics. US power across all spheres, and European economic and trade power, are all in relative decline vis a vis the various large and rapidly growing economies of the developing world. An under-appreciated difference between our century and the last will also be the power of non-state actors, corporations and the like. US decline prompts anxiety, leading to discussion of new potential superpowers, and China will certainly be a massive part of any new structure, but it is only one aspect of a far more complex and multi-polar picture. What follows is rarely what came before and China is a symbol of this changing world. However, it will not be setting global agendas and making unilateral overseas military commitments à la Moscow and Washington during the Cold War.

The next piece in this series will consider what China is becoming, if it is not superpower status as we understand that term. It will be argued that China is far more defensive and insecure than it is commonly portrayed. The major concern of China is not to install global hegemony but rather to assert independence from the domination the West has exerted over the international system for the last two hundred years.

By Paul Harding for China Brain

Another month, another set of disappointing data. This month’s releases from the People’s Bank of China (PBOC), the National Bureau of Statistics (NBS) and other government departments continued to paint a worrying picture about the state of China’s economy. The much touted third quarter recovery failed to materialize.

With July Consumer Price Index (CPI) inflation down to 1.8%YonY and the producer price index hitting -2.9%YonY, an impressive array of headlines in financial newspapers stressed that these stats leave room for “further easing”, seen now as all the more necessary given slowing FAI, IP, Export and Import growth and below consensus new lending (at 540bn RMB).  There was even some expectation that the PBOC would cut the Required Reserve Ratio (RRR) over the weekend, effectively freeing up hundreds of billions of RMB of the commercial banks’ cash.  This failed to materialize.

Despite a lot of optimism primarily amongst sell side analysts and foreign media about the government riding to the rescue, the data continues to show that what little efforts have been made (two interest cuts, an RRR decrease, talk) are not yielding the expected results.  The narrative has been disrupted.  Hints at further action from the State Council continue to offer hope, but the interest rate cuts failed to stoke up a significant increase in lending for July.

There are several reasons why the government hasn’t stepped harder on the accelerator.  They can be roughly divided into three categories: Inflation, Property, and Systemic Risk.

Inflation

The PBOC remains worried about re-emerging inflation.  PPI and CPI are not presently a problem, but the dramatic US drought combined with unusually hot weather in Russia, Ukraine and Kazakhstan are poised to cause a dramatic rise in wheat, corn and soya bean prices. Futures contracts have already spiked and the prospect of another food crisis is very real.  China is in danger as corn prices feed literally into pork prices, making hog rearing unprofitable and decreasing supply as producers shift from the market.  There is also the risk of food oil prices rising.

Food makes up roughly 30% of China’s CPI basket, and is a key issue to many of the country’s poor.  The government has no choice but to remain sensitive to any upward food prices pressure and there are already local signs of food prices picking up.

Property Prices

The very slight recovery in the property sector has also caused the government to reiterate its determination to keep controls in place. The State Council has dispatched teams to study how measures are working and government announcements / pieces in official papers suggest that there is no intention to ease off the property market.   A major easing could automatically bring further significant upward pressure onto property prices.

Serious overinvestment in property has seen a growing number of “ghost towns”, famously in Ordos but also in many other locations around the country.  Overly bubbly property prices increases risk of a meltdown and stoke fears of social unrest. The government remains sensitive to both issues. The market is aware of the risk.

Stock markets on 20^th Aug hit their lowest levels since early 2009 on news that home prices have risen in the majority of large cities monitored.  Market players are obviously taking the government very seriously.  

Systemic Limits

The third issue, the main focus of this piece, is the systemic problems which are simultaneously discouraging the government from easing whilst also creating drags on growth. Property is one manifestation of these systemic problems, but is being treated separately here due to the government stress on house prices. 

Diagram 1 is a (very simplified) model seeking to incorporate the main policy dilemmas facing the Chinese government – particularly in the post 2008 period.  The starting point should be growth, seen as paramount to creating employment and thus limiting public unrest - and also being necessary to maintain China’s rise back to its perceived position of global dominance.  Growth must come from net exports (i.e. a trade surplus), investment (here divided into stimulus infrastructure projects and investment generally) or consumption.  

Investment after a certain limit (which China with its near 50% investment share GDP has certainly passed) requires ever more liquidity and lending, even as it faces diminishing returns and increasing waste.  The resulting non-performing loans (NPLs) and decreasing returns should automatically “correct” this. However, in China this reckoning has been delayed through the suppressed financial system, by which savings, trapped in a closed capital system (both household, corporate and government), earn unnaturally low or even negative real rates of interest. This allows borrowers (mostly corporate and especially State Owned Enterprises (SOEs), and Local Government Financing Platforms (LGVPs)) to obtain subsidized financing and capital.  This financial repression “tax” falls disproportionately on households and limits consumption, whilst inflation further subsidizes borrowers and punishes depositors. The subsidised borrowing predisposes companies to rely more on capital than they otherwise would; meaning more investment.  The result is repressed consumption, but also the ability of the financial system to carry on functioning.

Meanwhile the trade surplus also relies on the RMB peg, which distorts monetary policy and again punishes the majority of Chinese who are not exporters. China is a net energy importer whose import bills are now unnaturally high.  Again consumption suffers.

Low household incomes are also a product of the toothless trade unions, which are legally prevented from being independent and functioning as trade unions normally do.  Despite some headline making local wage growth over the last 2 years, these wages are starting from a very low base.  Workers work at low wages, and companies again reap the benefits through lower labor costs.

This model has resulted in consumption shrinking as a share of GDP. As the economy relies ever more heavily on investment and exports, the efforts required to reverse the model increase, and the pain that must be experienced to do so increases correspondingly.   Chinese consumption is at an almost record low share of GDP for any major economy.

With the collapse in external demand caused by the unravelling of credit fuelled consumption in the US and the pursuant EURO crisis, China has been ever more reliant on investment to fuel growth. It was investment that made up the bulk of the massive 2008/9 stimulus – further unbalancing the China’s GDP.  The flip side to most investment is debt, as subsidised borrowing make this much more attractive to financial managers than it should be. The following chart (reference Alsosprach analyst) shows just how much increasing lending has been necessary to maintain China’s growth.  The difference between pre and post 2008 is particularly stark, and reflects the loss of exports as a major growth driver.  Meanwhile not shown on the chart, the amount of non-official lending in the economy has dramatically grown, including shadow banking, underground lending, private lending etc.

Investment often experiences diminishing returns, as the “low hanging fruit” opportunities are taken up first, investments become ever more risky, and increasingly unlikely to realise real economic benefits (this is not the same as social benefits).  As total GDP increases, the amount of new lending (debt) required to support investment heavy GDP growth increases exponentially (10% growth on a $50billion economy means $5billion of new output is required, whilst 10% growth on a $5billion economy requires only $500million of new output.).  China has already been experiencing diminishing returns and a rapidly expanding credit/GDP ratio (60%+ trough to peak by some counts).   Repressed consumption is still lagging investment, and will continue to do so until household incomes grow at rates higher than GDP (and investment) over many years. Absent that, there is nothing to take over the growth mantle and we are left with MORE investment and debt – just as investment returns are diminishing.  It is not hard to see how debt can increase so dramatically under such circumstances.

The IMF has recently estimated that Chinese capacity usage has fallen to just 60%, which for many manufacturers and producers suggests that more investment cannot be profitable.  Infrastructure projects may produce social and perhaps economic benefits in the future, but again the likelihood of making real economic returns is decreasing when cash flow is appropriately discounted.

The decreasing returns on an increasing pile of lending are producing more and more non-performing debt. This is occurring just as the economy slows (a pro-cyclical problem).  Whether or not the debt is recognized as such, much is not performing in terms of generating real economic benefits. Banks require continued financial repression to be able to keep forgiving / rolling over / restructuring / writing down the NPLs, and this limits consumption.  

It is clear from many recent central government statements that the government is entirely aware of the danger these imbalances are creating.  They are reluctant to push more investment for the reasons given above; more investment is going to make the rebalancing even more painful.  In this environment, there are few alternatives to slowing growth.

It is slowing growth that we are now experiencing, and the central government have been disappointing those who are not listening to / believing their announcements about policy. The plethora of local government stimulus project announcements generated a lot of optimism, but there are serious concerns about how cities such as Changsha can finance such vast stimulus plans as land sale and corporation tax revenues fall.  Due to China’s system of transferring local government officials to new locations / posts every few years, local governments face different dynamics – small picture and shorter term.  However they still rely on Beijing for project approval and to make credit available.  

To return to the diagram, we should remember that growth is not a goal for its own sake. It is employment generation that stood behind the “magic” 8% growth figure (now 7.5%).  As of now, employment seems resilient. We have not heard the stories of mass layoffs that came in early 2009.  Employment levels going forward are more important to central policy makers than simply maintaining growth for the leadership transition or for headline making stats.   The official unemployment figure is generally considered to be nonsense, so a true employment picture depends on reports of layoffs, factory closures, applicant/job ratios, and wage increase demands / deals.

Given the systemic problems in China, as well as the fears over property prices and general inflation, We should not be focusing on how lower CPI is giving the government room to ease more (as has been the fashion in the FT, WSJ, Bloomberg, SCMP, Reuters, Caixin, and various investment bank research divisions). Rather, it would be better to see the situation thus: The resilient employment situation is giving the government room NOT to ease.  If employment starts to collapse, the central government must react.

The lower growth target suggests that lower growth is acceptable from the employment perspective.  The fact that (so far) we have not heard of mass firings or layoffs despite the lower growth rates validates this belief. Before the current slowdown, reports were of structural / demographic tightness beginning to hit labour markets in key regions.  This tightness is providing a cushion of sorts.  This is by no means guaranteed to continue, it just hasn’t become an issue so far.

Hence we are left with a near future of “half” measures.  Investment can be propped up somewhat, whilst not being allowed to increase too dramatically. Property curbs can be strengthened ahead of any further easing that may be necessary – to limit the bubble’s return.  NPLs can be gradually dealt with on the sly, whilst financial system reforms creep forward.  SOEs and their value destroying models can be slowly reformed (especially once Li Keqiang arrives as Premier) whilst continuing their role of providing “social welfare” by employing people for no economic reason – even at consumption reducing suppressed salaries.   Future strategic industries can be given a boost, etc.  Absent a dramatic deterioration in the picture, these can produce a moderate and temporary stabilization or pick up by year end, but will only be enough to buy time until the external environment improves…perhaps too long a wait given current overseas dynamics.

Anything other than these limited measures in 2H 2012 will strongly suggest that things are getting much worse.  This could be due to an employment crisis, a serious financial meltdown in a locale which threatens systemic contagion, or a further deterioration in the Balance of Payments situation – which complicates liquidity operations.  External factors are another key area. If the Eurozone fails to improve, China’s rebalancing situation becomes much more painful, and the growth environment toughens.

It's trade that fosters peaceful neighbors, not sanctions and it seems that China will continue in its engagement of N.Korea in this way. Last week saw the signing of the Joint Development Zones plan that covers the setting up and operation of management committees in the zones in North Korea, electricity supply in one of them, and agricultural cooperation.

The Hwanggumphyong and Wihwado zones will focus on sectors including information and tourism to “gradually become an intelligence-intensive emerging economic zone of North Korea.”

The Rason zone  will focus on areas including raw materials, equipment manufacturing, high-tech, apparel and high-efficiency agriculture. Rason will “gradually develop into an advanced manufacturing base for North Korea and an international logistics center and regional tourist center for Northeast Asia”.

Combined with the special dispensation given to North Korean migrant workers in the border areas of China, Beijing see's trade and development as the chief tool for peaceful dialogue.

Now the question to be answered is: Will China use its Economical leverage to put the Nuclear issue back in the bottle? Any sanctions do carry significant risks for China, if China were to cut off food or fuel shipments, the North's economy would be crippled and its government might even collapse. The resulting situation (refugees and boarder security issues) could be very destabilizing for China.

China's policy toward North Korea's nuclear program has long been based on two principles: that the Korean peninsula must be free of nuclear weapons, and that the dispute over the North's nuclear policies must be resolved peacefully. The strategic stakes involved with North Korea going nuclear are extremely high. A nuclear-armed North could produce a cascade effect, leading South Korea, Japan, and even Taiwan to consider developing nuclear weapons programs.

Of primary importance to China is the security of its border and Economic Stability hence any moves by the West will be carefully considered with respect to these two issues. Eventually N.Korea will have no option but to embark on Chinese style economic reforms and It would be China that dictated the pace of these with support and technology transfer.

Moving forward the question remains: Where will N.Korea fall in the development of the alliances that Beijing is currently building across Asia and the Brick countries?

By Paul Harding for China Brain

The idea of a Chinese slowdown has gone from the isolated warnings of a few academic economists a few years ago to a generally held consensus today. Even the normally bullish sell side analysis teams at investment banks are acknowledging the situation.  Annualized quarter-on-quarter growth rates have been below 8% for 3 consecutive quarters, meaning absent a strong rebound, annual growth will come in below 8% too.  

Currently, the most bullish scenario is for a “soft landing”, which was originally supposed to see Chinese growth bottom out in the second quarter 2012, and then recover through the second half of the year as government stimulus policies take effect.  This timeframe is now gradually beginning to creep backwards due to weaker than expected monthly data since Chinese New Year, but signs of a pickup are already emerging.

Certain stresses in the Chinese economy are now so well known that casual newspaper readers across the world are familiar with them, including difficulties facing the property sector, domestic demand and consumption, along with last year’s struggle against inflation.

The news of the collapse of Zhejiang Zhongjiang Holding Co Ltd, a conglomerate with over 5billion RMB of debt outstanding, has brought the issue of China’s non-performing loans (NPLs) back into the limelight. The case in question is relatively small - China Construction Bank (CCB) has 3billion RMB at risk, while Bank of China (BOC) is owed 1billion RMB.  However, aside from this case, and a few signs of trouble from Wenzhou along with other distress reported in Hangzhou, the issue of NPLs has been getting little attention. This is probably due to two reasons; firstly, there seems to be little sign that they are emerging on a significant scale yet; secondly there is a totally false, yet widely held, perception that “last time around” China dealt with a relatively large NPL problem painlessly, and can thus do so again.  

NPLs are difficult because they emerge just when an economy is least able to deal with them. Equally, they become submerged when an economy is strong and there is ample credit, growth and profits in the system.  Added to this, complicated credit structures between borrowers, lenders, collateral and guarantee companies in the unofficial lending system obfuscate risk and make it hard to predict how any shock from a crisis might be transmitted through the economy.

Last Time

As mentioned above, one of the reasons that NPLs are often not accepted as a danger to China’s economy is the way in which they were resolved “last time” around. Beginning in 1999, and essentially carrying on over the following 6 years, (longer if you include the final cleaning of the Agricultural Bank of China), a huge portfolio of NPLs were removed from the balance sheets of China’s Big 4 banks’ and “sold” to four Asset Management Companies (AMCs). These AMCs paid face value for the loans, and did so with some government capital injections and also through issuing 10 year bonds, which were purchased by the corresponding bank whose bad assets they were buying.

The AMCs were supposed to chop down the bad debt portfolios with restructuring, debt-equity swap deals and the involvement of foreign distressed debt players, etc. In reality these bonds could never be repaid, and even the interest on them had to be guaranteed by the Ministry of Finance when the banks listed.  When the bonds matured in 2009 /2010, they were simply rolled over for another ten years.

The trouble of course, is that nothing comes for free. Accounting alchemy such as this does not mean that China magically resolved the bad debts. They still exist, and have been dragging on the system ever since. Banks have to be given unnaturally large interest margins (by decree) to help them deal with NPLs resulting from politically motivated lending. This financial repression punishes savers, undermines consumption, and acts as a large block on financial liberalisation and reform, exacerbating dependence on investment and exports.  Equally importantly, it under-prices capital – by how much remains unclear - meaning that the true economic value of many projects, even those showing “book profits”, is unknown. Any business only able to make profits due to these repressed interest rates is actually destroying value for the Chinese economy.

In exchange for this “bailout” Chinese banks were supposed to improve their risk management and lending practices. Whether or not this happened is hotly debated, during the good times (until late 2008) the answer seemed irrelevant, bank profits ballooned as international expansion and internal modernizations continued. The crisis of 2008 / 9, however, saw a tidal wave of credit released in what seemed to be a return to the “old ways”. In fact the crisis of 2008 and the impressive Chinese reaction may well have sowed the seeds of a much more serious problem in the future.

The New Wave

As the world fell into a credit crunch and recession in late 2008, China responded to a serious downturn (which may have seen growth fall to zero for one quarter) by unleashing a massive wave of new credit as the following chart shows:

This shot of adrenalin was at first provided by the state owned banking sector. Projects were approved with lightning speed and needed quick financing which the banks provided at high speed. Fixed asset investment (both corporate and government infrastructure) and capacity expansion boomed, real estate investment exploded. Exports picked up, with cheap financing, cheap labour, political pressure on companies to keep operating despite having to slash prices for sales, and the “Wal-Mart Effect” meaning that China’s exports flooded world markets even more than previously – taking up a larger share of falling net global demand.  Investment levels had already been high, but even these increased and China’s growth became even more reliant on investment and the debt that lurks behind it.

In fact, despite accusations that loose US monetary policy was fuelling commodity bubbles and price booms, data shows that it was in fact the People’s Bank of China and the Chinese Banking system that was responsible for nearly half of all world liquidity (M2) growth in 2009, 2010 and 2011.

With the massive boom in investment, seemingly politically directed lending practices re-emerging, and a scary build up of debt in local government financing platforms (linked to property by the use of land sales to capitalize borrowing entities) and the Ministry of Railways, it is inevitable that China’s banks were again creating an NPL headache.  An apparent property bubble and blatant overcapacity in certain sectors only highlighted the problems.  The authorities were well aware of these risks, along with the remerging threat of inflation, and in 2010 started trying to rein in lending and ordering provision ratios to be increased.

As the government reined in formal lending, the economy’s thirst for credit began to shift to the shadow banking sector and underground lending.  Off-balance sheet lending, private lending, trust products, re-lending by SOEs and entities with access to credit, loan guarantee companies, etc all kept the credit boom going, even as formal lending declined (although not to pre-crisis levels). Debt creation was continuing, but now was more opaque, with risks diffused around the economy.  Innovations that are still not completely understood were spreading – particularly in the area of trust products and the innovative use of various forms of collateral, China was responding to a crisis sparked by subprime lending and financial innovation in the West with a boom of “subprime” lending and innovation of its own.

The property bubble and CPI inflation came to be the focus of attention. Bubbling property markets in several cities were seeing prices climb so far beyond the means of average citizens that social unrest was feared. The market became a frenzy, with totally unrelated but cash rich companies becoming property developers, and “prices will never fall” exuberance spreading at an alarming rate.  Asset booms in markets with such high barriers to entry can only increase wealth gaps, as only the richest can play. Related land seizures in many cities were another cause of social distress.  So the government stepped in, introducing a host of administrative measures against the property sector, and leaning on banks to control lending to property developers. Whilst the US housing boom saw the mortgage holders taking on worrying amounts of debt, in China it is the developers themselves who are worryingly reliant on borrowing.

As with their ill timed 2008 anti-inflation tightening, the 2011 tightening emphasis came at just the wrong moment. As tightening measures began to bite, the Euro crisis worsened, global stimulus measures were becoming exhausted amidst anaemic recoveries and a return to austerity. China’s growth fell several percentage points, and too much for comfort. Today we find ourselves with the government “pushing on the accelerator again”, although with much more caution than in the 2009-2010 period. Lending is picking up, (and seems set to increase further through July) and property prices have lifted again.

Yet the title question remains: “Where have all the NPLs gone?”

In 2009, during the height of the lending binge, even bullish analysts were predicting an NPL uptick by year end 2011.   We know they must exist, given the massive surge in credit after 2008 which was poured onto an economy already seeing record high levels of investment to GDP. What we don’t know is how many of them there are, beyond dubious classifications in bank results – where ratios are generally low and total acknowledged NPLs have only increased modestly to 438.2billion RMB at the end of March 2012.

There are several possible reasons as to why the inevitable uptick in NPLs is yet to show up in accounts books.

1 – There are no significant NPLs. 

This is surely a poor explanation, at least in terms of actual non performance.  The huge credit / liquidity binge since 2008 would make a total absence of actual nonperforming assets extremely unlikely at best. 

2 – There are non performing loans, but…

…Borrowers are following the unsustainable practice of borrowing more to pay off interest and/or principal on existing debt.  The corporate equivalent of an individual using one credit card to pay off another, this could explain why the emergence of an NPL problem has been delayed. This practice was probably reaching its limits early 2012, but may get a new lease of life if another bout of credit easing (as appears to be underway) emerges to combat the current slowdown. In buying time however, borrowers following this practice are increasing the end cost to the system.

3 – There are non performing loans, but…

…lenders are colluding with borrowers (as the CBRC pushed them to do last year) to restructure debt in the Special Mention category (special mention loans are not classified non-performing) before it migrates to the non-performing classifications.  Restructuring in such a way involves de facto partial debt forgiveness, which eventually must be paid for by households (since government entities are by far the largest shareholder of Chinese banks.) Of course this motivation may be true for banks the world over, however in China the political dynamic and financial system’s structure make it much more likely, especially with dubious accounting practices being an issue.

4 – There are non performing loans, but…

…local governments (especially) are shuffling assets, revenues and funds to delay / hide their emergence.  During the investment binge, local governments often offered implicit guarantees or joint debt servicing promises along with their local government financing platforms (LGFPs), which banks were happy to accept since local governments had real assets – land, and tax revenues both at present and in the future.  This model came under stress as central level restrictions on property threatened land sale revenues (note some governments were relying on land sales for 50%+ of their revenues – and there are reports that revenues from land sales are plummeting in certain cities / provinces.. There is speculation from within certain state owned banks that local governments have been skirting these restrictions for months already, following the greater need of preventing defaults by their LGFPs.  Most local government officials shuffle around every few years, so have little incentive to make sure their area finances are sustainable in the long run.

Future implications

With the apparent ease with which China “resolved” its previous NPL build-up, there is little attention or worry being paid to the possibility of future NPLs emerging in the economy. However, as explained above, not only has the previous NPL build up NOT been fully resolved, but its partial resolution has nonetheless created a drag on China’s economy, mainly by delaying and increasing the pain of urgently needed rebalancing and effectively transferring wealth from households and workers to companies. 

The argument that with GDP growth rates of 10% or more, any debt burden rapidly shrinks is a valid one. There are however, three reservations. The first is that it is generally accepted that when Debt /GDP ratios reach a certain level (possibly around 70%) then the debt itself becomes a drag on GDP - swallowing up an increasing amount of corporate or government revenues. Adding together China’s MOF, MOR, Local Government, AMC, State Owned Enterprise and potential bad bank debt produces an implicit central government debt responsibility at well north of 70% of GDP.

The second problem is the implications of the debt / investment build up. As examined above, the debt / investment model is hindering economic rebalancing, which in a climate of falling external demand is slowing growth rates anyway.   Unable to substitute consumption for investment, due partly to the issues mentioned above surrounding debt, China’s growth can only rely on more investment or the now weakening export markets.  Slower growth, even if not a hard landing, seems inevitable, which in turn weakens the process of “growing out of the debt”, just at time when more debt seems necessary to maintain much of what growth there is.

The third problem is that GDP growth and value / wealth creation are not the same thing. With financial repression and China’s skewed economic system, over-investment can often create GDP without actually increasing real wealth (and sometimes destroying it).  Empty apartments, industrial overcapacity creation and even some infrastructure are all positive for GDP, yet are not so positive for “wealth”.

This process can go on for a long time, unless there is a significant emergence of NPLs, which would sever the link between debt and investment led growth, further delay / reverse rebalancing, and ultimately put government finances under stress.  Reforming an economic model is easiest at times when the motivation to do so is least (for China this would have been between 2003 and 2007).  Now the government’s general desire to do so is clear to see, yet policy has become increasingly short term in the face of this year’s leadership change and quarter after quarter of slowing growth.  The struggle to rebalance China’s economy will be tough enough in any case, but an emergence of NPLs (acknowledged or otherwise) will complicate matters greatly.  Analysts would do well do keep a close eye on the issue over the coming 12 months.

Just two weekends ago, Shanghai saw the 15^th opening of its International Film Festival, which ran through June 24 and attracted a parade of international stars to more than 400 screenings in over 20 venues. The juried competition was overseen by Jean-Jacques Annaud (The Bear), and the red carpet populated with actors such as Jackie Chan, Aaron Eckhart, Heather Graham and China’s own Tony Leung. Hong Kong action star Chow Yun-Fat (The Killer, Crouching Tiger Hidden Dragon) received the Outstanding Chinese Film Achievement Award for his contributions to Chinese cinema since the 1980s.

As a veteran standing at this year’s award ceremony, we imagine that Chow must have been thinking one thing: “How things have changed”. In the early 1980s, the Chinese film industry struggled both as a result of competition from other forms of entertainment, and because of the government’s concern that popular action and martial arts films had a negative social influence. Now fast forward to February 2012, and you have Disney announcing plans to co-produce some of its highest budget thrillers in Mainland China. The first film it plans to produce in the Asian country? Iron Man 3.

According to reports published by PRNewswire in 2011, China is currently the third largest film industry in the world by number of feature films produce annually. In 2010, China produced 526 feature films and generated approximately 12 billion RMB in revenue from its film industry. Box office sales are still the main revenue source and impetus for growth: in 2011, Chinese box-office receipts grew by 33% to earn 54% of a total box office of 2.06 billion US. By the end of 2012’s first quarter, China overtook Japan to become the world’s second largest cinema market, with an estimated market value of 17.25 billion RMB. At a conference in April 2012, Mike Ellis, Asia-Pacific President of Motion Picture Association of America, announced that China’s cinema screens had increased from 4,753 in 2006 to 10,700 in 2011. On average, that is eight new screens a day. China already has the largest number of digital screens in the world after the U.S., and 35mm will probably die out sometime next year.

Unlike most areas of the Chinese economy, which still exhibit significant state involvement, the film industry is dominated by private firms. Around 70% of content is made by private film production companies, and of the 300 film distributors in Mainland China private companies figure in at 90%. The largest 10 film distribution companies, China Film Group, Huayi Brothers and Shanghai Film Group among others, form an ‘oligopoly’ with over 80% of market share (PRNewswire 2011). Their control of the market is aided by the fact that foreign firms are not yet allowed to participate in this area outside of ventures with Chinese firms. PolyBona Films is the largest film distribution company; in 2011, its net income reached US 1.35 million.

To top it all off, growth in the film industry does not appear to be slated to stop anytime soon. Since China joined the WTO in 2001, box office growth has averaged 30% annually (a record in world movie history). China has now become the fastest growing market in the world for IMAX – 48 theatres had been built by mid-2011, and the number is expected to reach 180 by 2015. Within the next 5 years, government forecasts predict that China will catch up to the US as a market for Hollywood films. Foreign investors have predictably picked up on these growth trends, and recently there have been an increasing number of attempts by Hollywood studios to break into China’s highly regulated entertainment market. In May 2012, Rupert Murdoch’s News Corp. (parent of 20^th Century Fox Entertainment) agreed to purchase a 19.9% share of Bona Film Group. Dreamworks Animation and Walt Disney Co. have also organized minority stake purchases with China Media Capital and the Ministry of Culture and Tencent. According to an interview featured in the LA Times (15 May 2012) with David Wolf, an independent media analyst in Beijing, “What we are seeing is a new willingness by the big Hollywood studios to come into China with a minority stake, hoping to gain a foothold and leverage up over time.”

For its part, the Chinese government has recently undertaken efforts to heal a relationship between Hollywood and Beijing that has historically been strained. Sources of friction between the two have been limits on the number of foreign films that could be imported each year into Chinese markets, rigid censorship rules, and what Hollywood has always considered to be a much-too-lenient approach by the Chinese towards piracy. In February of 2012, China increased the annual limit of foreign films allowed into the country from 20 to 34; ticket revenue was also increased for foreign studios from a previous 13% to a max of 25%. It is no coincidence that negotiations concerning the aforementioned joint venture between Dreamworks Animation and China Media Capital began the same day.

Nevertheless, for many Chinese filmmakers increased internationalization is no cause to celebrate. Even though Chinese moviegoers spent 10.17 billion RMB at the box office in 2010, about 20% of net revenue was generated by two Hollywood blockbusters: Avatar and Inception. In May of this year, Disney’s The Avengers grossed 640 million RMB – in the same month, domestic productions collectively took in only 150 million yuan.

Many Chinese directors blame unequal content censorship between local films and their Hollywood rivals. According to director Lu Chuan (The Last Supper), “[How] could we compete under the same standard? In Hollywood films, Washington could be flooded and Los Angeles blown up, but to damage any signature building in Chinese cities is almost impossible [for domestic filmmakers].” Professor Fan Zhizhong of Zhejiang University attributes many of China’s film market woes to the industry’s long-standing trend of undervaluing screenwriters: “China’s film industry has been embedded in a culture that attaches more importance to visual effects than narratives since the 1980’s, which has, to a certain degree, led to the decline in status of screenwriters” (Xinhua News, December 2010). On the other hand, during the SIFF, many directors expressed the hope that an increased amount of foreign films would motivate Chinese filmmakers to rely less on state protectionist measures and to create more competitive films.

As the burgeoning Chinese film market continues to boom, and foreign firms are lured East by the promise of hundreds of millions of moviegoers, it is hard to predict how what is in many ways a still-undeveloped industry will evolve. One thing, however, is for certain: if Chinese films are already finding it challenging to compete with Western blockbusters, increased integration will only make their job that much more difficult. According to Yin Hong, professor of film studies at Tsinghua University, “only about 100 of the 500-plus movies China produced last year have met acceptable art standards” (Xinhua News, June 2011). As for the others, well, perhaps they should start by following the advice of Mark Osborne, one of the directors of box-office hit Kung Fu Panda: learn how to tell an interesting story.

Update: An interesting short report on the China Film Industry from the New York Times: http://video.nytimes.com/video/2012/07/10/business/100000001655019/hollywood-thrives-in-china.html

On June 27^th, Chinese Premier Wen Jiabao arrived in Santiago for his first official visit to Chile. The stop was the last of his recent, four-country South American tour, which also took him to Argentina, Brazil and Uruguay, and another indicator of deepening economic and political ties between China and Latin America. Upon his arrival in Chile, Wen said “China treats its relationship with Chile from a strategic perspective and will work with Chile to bolster exchanges and cooperation.” The trip was concluded with Wen pledging $10 billion in credit towards infrastructure projects and for a joint initiative to combat trade protectionism between the two countries.

What is China doing in Latin America? This is a big question, and one that is proving to be increasingly important for policymakers and analysts around the world. After all, China’s interest in the world across the Atlantic is barely a decade old – for years if it did have any involvement in the Americas and the Caribbean, it was only to lure its nations away from supporting Taiwan.

This has changed in recent years. Since President Jiang Zemin’s two-week visit to Latin America in 2001, and subsequent trips by Hu Jintao in 2004 and 2011, China’s presence in the region has become a firm reality. In 2003, the year before Hu’s first stopover, China’s annual investments in all of Latin America totaled just over a billion. Today, China is the top trade partner of Brazil and Chile, and the second largest export destination of Argentina, Cuba and Peru. According to China’s National Development and Reform Commission, China had invested almost $45 billion in Latin America by 2010. It is currently the third-largest investor in the region, with 9% of FDI (foreign direct investment); the US is still on top with 17%. Between 2000 and 2008, trade between China and the Latin American region grew at an average annual rate of 31%.

The political forces underlying China’s recent bids are by now fairly clear. In order to maintain the economic supremacy that is has enjoyed for the past three decades – average GDP growth of 9.8% annually from 1979-2009 and a strong showing in 2009 despite global economic collapse – China has undertaken a global search for the natural resources that it needs to ensure sustained growth. By the end of 2011, more than $3 trillion in foreign exchange reserves had been set aside by China’s leaders to assure its continued acquisition of primary commodities around the world. This search has extended from South-East Asia to Africa, Latin America and even Iceland (Wen Jiabao met his Artic counterpart, Johanna Sigurdardottir in April of 2012). Efforts to ‘purchase’ political stability at home through foreign investment will likely become even more frequent as China approaches its next leadership transition in the fall.

Nevertheless, unlike China-Africa relations, which have raised more than a few questions from concerned countries in the West, Asia-Pacific (AP)-Latin America (LAC) trade may actually result in a win-win situation for both regions. In May of 2012, Fitch Ratings released a special report stating that Latin America has generally benefitted from China’s economic rise through increased bilateral trade, FDI and commodity-backed loans (Close-Up Media, Inc., 2012). China’s growing trade and investment with Latin America have also helped cushion the latter against weaker export markets in both Europe and the US as a result of the recent global recession. Seeing as how both the AP and LAC regions stand to lose from a disorderly sovereign debt default in Europe and rising oil prices (a report released by the UN Economic and Social Commission for Asia and the Pacific (ESCAP) in May of 2012 held that a $25 hike in international oil prices would reduce growth in AP by at least 0.8% that year) improved bi-lateral relations will be crucial for their continued growth.

As China continues what has become the largest urbanization drive in history, it will only need more food to satisfy the appetites of a population that its scarce resources already fail to fully nourish. The emergence of a burgeoning middle class in China will only exacerbate this food demand, as increased wealth traditionally leads to demands for food in wider varieties. Queue in Latin America’s clean water and arable land, and we have a match made in heaven. For its part in helping to satisfy China’s insatiable appetite for raw materials and commodities, Latin America is paid handsomely: FDI, loans and endowments for infrastructure building flow freely into the region from the East. Although 85% of Chinese FDI and 60% of its loans are funneled into extractive industries, the money has nevertheless allowed finance-constrained firms in LAC to undertake large energy and infrastructure projects that would not have been possible otherwise. Furthermore, we really cannot stress enough the importance of China’s role in shielding LAC from Europe’s renewed austerity. In addition to weakened demand for exports, many of Europe’s top banks have reduced lending to Latin America as part of their attempts to weather contractions back home. For example, Spain’s Santander bank has large operations in Brazil, and is the #1 bank in Chile. Barring stimulus from AP, sizable credit cuts could seriously hamper growth initiatives in the region.

The key challenges that China and Latin America face now lie in increasing the scope of their co-operation without LAC countries perceiving themselves merely as food for the hungry Dragon. Those countries that do have an abundance of natural resources would like to escape the China-trap of commodities-for-manufacturing goods trading, either by producing their own manufacturing exports or by expanding into more diverse industry. For those countries not in the Southern Cone (i.e. Mexico, Central America), which supplies approximately 90% of LAC’s exports to China, the issue is more one-sided. Without any commodities to offer China, they gain little and lose much by having to compete with low-priced Chinese imports. These have triggered both resentment from the local populations, and calls for protectionist measures to be introduced. In order to find a healthy medium, efforts must furthermore be undertaken to diversify composition of trade. Although LAC imports a wide range of manufacturing goods from China, almost 80% of exports heading East account for only 10 different products: Soya beans, copper and alloys, iron ore and concentrates, petroleum and oils, crude oil, paper pulp, flours, meals and fish, iron ore, copper waste and lead ore (IDB 2010).

In addition to diversifying trade, efforts must also be made to reduce trade costs between AP-LAC, which are currently much higher than OECD norms. Although average tariffs on exports were reduced from 40-50% in 1980 to just under 10% in 2010, most exporters in LAC and China still face double-digit tariffs on virtually all of their goods. Particularly high tariffs on manufacturing goods and agriculture will further hinder attempts by LAC to expand beyond commodities-based trading. Elevated trade costs are also influenced by the presence of Non-Tariff Barriers on both sides, which, although they are not ‘official’ tariffs, have similar effects once enacted. Typical examples include anti-dumping measures (predatory pricing policies where a country charges less for a good in foreign markets than it would in its home country) and countervailing duties (when an exporting country is found to subsidize its goods at the expense of the importer’s domestic producers). Even though China has made significant efforts to remove NTBs since its WTO entry in 2001, it still levies sizable quotas on LAC’s agricultural exports (of which the money is sent to state companies). On LAC’s part, the goodwill that accompanied China’s WTO entry has actually deteriorated in recent years: rather than afford China market economy status, many countries have begun to rely upon the WTO’s China-specific antidumping and safeguard provisions, which are generally more severe. To address these concerns, China must continue to improve bilateral relations with the countries of the LAC region by signing Free Trade Agreements (FTAs) such as the ones with Chile, Peru and Costa Rica (2005-2010). Efforts should center around countries like Brazil, Argentina, Colombia and Mexico – those that stand to lose most from aforementioned competitive Chinese manufacturing imports.

Finally, China-LAC’s weakest area of cooperation seems to be investment, on both sides. Although Chinese investment in LAC has been steadily rising since 2001, it only represented 0.3% of worldwide Chinese FDI on average between 2005-2010. Like trade, investment is heavily concentrated in Brazil (41%), Argentina (11%), Peru (12%) and Chile (2%), in order to extract resources more efficiently from mines and agricultural land (IDB 2010). Despite signs of increased outwards investment beginning in 2010 (China announced initial investment projections of US $15.6 billion in the LAC region), new stimuli have not been accompanied by major sectoral shifts. Burgeoned by Mexico and Brazil, LAC’s FDI abroad still surpassed that of China as of 2010. Nevertheless, its FDI in China is still modest, irregular, and accounts for less than 1% of investments abroad. Furthermore, nearly 40% originates solely from Brazil.

Ultimately, China and Latin America must overcome certain, key challenges, as they move forward with what appears to be the framework for a long-term relationship. This relationship extends beyond mere economics: Latin Americans have begun attending Chinese language classes in droves, and Confucius Institutes throughout the region are fast becoming a normal sight. More bilateral trade agreements must be signed, cooperation must extend beyond the realm of commodities vs. manufactured goods, LAC firms should establish a larger presence within China, and likewise a larger, more diverse portfolio of Chinese investment in the LAC region should be created as well. Although bringing down the costs of trade is important, it is equally important to remember that trade costs will not be the end-all, be-all of this complex regional partnership. Nevertheless, both parties have demonstrated a willfulness to cement future agreements, and recent policy initiatives hint at a bright future for China-Latin America relations.

The automotive market in the People’s Republic of China has been the largest in the world since 2008, as measured by single unit production. Propelled by government incentives, the China Association of Automobile Manufacturers reported that, in 2009, vehicle sales in China reached a record 13.6 million sales. Of these roughly 44% were produced by local brands (BYD, Lifan, Chang’An etc.), while the rest were produced by JVs with foreign carmakers, such as Volkswagen, General Motors and Suzuki. Like most joint ventures in China, foreign ownership in the auto industry is capped at 50%. Although most of the cars manufactured in China are sold domestically, automobile exports still topped 800,000 units in 2011.

If you briefly consider the history of Chinese auto manufacturing, one thing is certainly clear: growth has been breathtakingly rapid in recent years. Between the years of the Cultural Revolution (1966) and Mao Zedong’s death (1976), China’s self-imposed 10-year isolation from the world ensured that little to no technological advancement was made in the stagnating auto industry. As such, it was not until 1986, when a combination of Deng Xiaoping-initiated reforms and a shortage of foreign currency prompted the Ministry of Machine Building to authorize the creation of six JVs with foreign carmakers, that the Chinese auto industry took off. This progress was officially cemented in February 1994, when the Party enumerated a set of key objectives in the Implementation Policy of the Motor Industry (IPMI).

Although initial goals were ambitious – 1.2m annual passenger car production by 2000 and 6m target for 2010 – production targets have not just been met, they have been completely outstripped. China’s entry into the WTO in 2001 marks the point at which development acceleration reached critical levels: between 2002 and 2007 China’s automotive market grew by an annual average of 21%; in 2010, China both sold and produced the largest number of cars by any country in history (18m). Of these, 13.76m were passenger vehicles – over twice the 1994 target. The number of registered Chinese vehicles (ranging from cars to buses and trucks) on the road reached 62 million in 2009, and projections estimate almost 200 million by 2020.

The majority of China’s automobile production takes place along the Eastern coast, notably in factories in or around Shanghai, Tianjin, Beijing and Changchun, as well as Shenzhen and Guangzhou in the South. Two other regions of significant concentration are Hubei Province in central China and Chongqing in the West. Although greater regional consolidation in the market through the creation of automotive ‘hubs’ could reduce operating costs, demand in recent years has been so great that the disappearance of any one of the existing production centers seems unlikely. According to China Automotive Market Review in 2010 (Mark Bursa; just – auto), the six major regions are as follows:

1. The Shanghai / Nanjing region on the East coast (300 suppliers; SAIC & local carmakers)
2. Wuhan Province (over 300 suppliers; home of Dongfeng Motor)
3. Beijing / Tianjin (~130 suppliers; Beijing Auto Industry Corporation & Tianjin Automotive)
4. Guangdong Province and Shenzhen (Gangzhou Automotive)
5. Jilin Province, specifically the capital Changchun (220 suppliers centered around First Automotive Works)
6. Chongqing (home of ChangAn Motor)

As elucidated above, the Eastern coast remains the single biggest center for automobile and component manufacturing, accounting for nearly 45% of national production in 2010. Growth in Shanghai, home to SAIC and its notable JVs with Volkswagen and GM, as well as in neighboring provinces (Zhejiang and Jiangsu) has been particularly rapid. For its part, Shanghai proper has announced GDP growth surpassing 10% a year for roughly 15 years now; its GDP per capita is now 50% higher than Beijing’s, and double that of Tianjin. After Shanghai, Changchun is the second largest production center, accounting for roughly 20% of national output yearly. It is home to First Automobile Works, one of China’s biggest car producers and a JV-partner of Volkswagen and Toyota. Guangdong Province (notably its capital, Guangzhou) is China’s third-largest automotive production hub. The region’s largest vehicle producer is Guangzhou Automotive, which has partnered with Honda and Toyota.

China’s largest domestic manufacturers, in order, are Shanghai Automotive Industry Corp (SAIC), First Automobile Works (FAW), Dongfeng Motor Group, Guangzhou Automobile Industry Group (GAIG) and Beijing Automobile Industries Holding Corp (BAIHC). All of these firms, specifically the “Big Three” (SAIC, FAW and Dongfeng), have been aggressive in forming partnerships with foreign automakers. Although they are essentially regional powerhouses in China, attempts to grow internationally have so far been only moderately successful. Nevertheless, overseas investment plans are constantly being announced: Dongfeng Motor most recently announced plans to invest $250m US in a Turkish plant with an annual production capacity of 52,000 units.

In contrast with its largest, foreign-aligned carmakers, China has additionally seen a ‘second wave’ of industry growth over the last ten years, which is composed primarily of non-aligned, independent Chinese manufacturers. Of these, the two most high profile firms are Chery Automobile (founded in 1997 by Yin Tongyao and with operation bases in Anhui) and Geely (formed late 1990s; based in the Eastern province of Zhejiang). Despite their initial lack of major foreign partners, Chery and Geely aren’t doing too badly – Chery has been busy setting up overseas plants in Iran, Russia, Indonesia, Ukraine, Uruguay and Egypt, while Geely signed an agreement in December of 2009 to purchase Volvo Car Corporation from Ford. The deal was expected to cost around $2 billion US.

With billions of domestic and foreign capital flowing in, the real question now is when will the market reach peak growth? Well the answer is that it’s hard to tell. Emerging fears of overcapacity led the Chinese government to choke credit after sales doubled in 2003, leading to much slower growth in 2004. But concerns are being raised again by the fact that, despite expected downturns as a result of 2008, demand seems to be picking up once more. Emerging 2^nd and 3^rd tier cities in the Western interior have yet to fully develop as automotive markets, and will likely continue to stimulate growth over the next 10-15 years. Additional factors contributing to sustained growth are the emergence of a middle class in smaller cities as wealth spreads throughout the country, as well as sales boosts powered by global economic recovery. As reported by businessGreen in 2009, the consultancy McKinsey estimates that China’s car market will expand tenfold between 2005 and 2030, driving up diesel and petrol demand from 110 to 550m tonnes. Barring serious advancements in green technology (a hope that actually appears to have substance based on recent trends in Chinese investment), this would mean a sharp rise in carbon emissions from a country that is already the world’s biggest polluter (in terms of annual CO2).

Faced with a building surge by foreign companies like Volkswagen, GM, Ford, Toyota and the group composed of Hyundai and Kia, many experts warn that Beijing’s attempts to mitigate overcapacity will not be completely successful. And this renewed, expected demand will have some big implications. Established automakers will continue to come to China to capitalize on what seems like market growth with no end in sight – General Motors’ China sales overtook its US sales for the first time last year. As the market continues to take into account the rising demand of new cities in the interior, production will likely begin to focus more on smaller, cheaper units. This will benefit local independents Chery and Geely, who specialize in making smaller cars. At the same time, the big foreign firms should focus on their own niche: luxury vehicles. Although they are tiny vs. the SAIC’s of the world, wealthy Chinese consumers are likely to pay huge premiums for established luxury brands. Sustained demand in China will, for the most part, keep domestic producers occupied with their own country in the near future. As such, seriously ambitious expansion plans into foreign markets are likely to be shelved for the time being.

Exports will additionally remain affected by the fact that Chinese crash testing and emission levels still do not hold up to developed world standards (this is not to say that Chinese exports are enjoying more success in less sophisticated markets, however, where their brands are both unappealing and confusingly unpronounceable). Chinese manufacturers will not see success in Western markets until they take an active interest in making their brands and products appealing to Western customers: at overseas motor shows vehicles are often still given mistranslated names (e.g. Geely PU Rural Nanny), but owners seem hesitant to hire experts who could help them breach the culture gap.

In the interim, increases in local demand promise to drain already scarce global resources – both in terms of physical manufacturing materials and in terms of fossil fuel resources. In addition, overcapacity threatens to strangle attempts by local expertise to initiate a shift to electric power, which might be a necessary game changer in the auto industry. Of interest is local Chinese manufacturer BYD, or Build Your Dreams, which may become one of the first victims of a glut of small commercial vehicles (despite its funding from high-profile investor, Warren Buffet). “The company took off like an eagle, but is now flapping like a chicken”, said Ferdinand Dudenhoeffer, director of the US-based Center for Automotive Research, in reference to the struggling automaker. Unfortunately, problems of overcapacity may not go away anytime soon. Although the Chinese government wants to build an industry around SAIC, Dongfeng and FAW, we are now in an age where entrepreneurial spirit can trump central planning: despite the Party’s intent, local and provincial governments are more than willing to bankroll their own, smaller firms.

As of now, the unstable market position of manufacturers, low prices caused by increased competition, restrictions on car ownership, overcapacity and continued dependency on depleting oil reserves continue to pose major challenges for the Chinese automotive market in the years ahead. At the same time, several important obstacles to the industry that were prevalent a few years ago (such as lookalike models) have become less of an issue currently. Market growth expectations should be sizable enough for all of the players involved (both domestic and foreign) to prosper, and it should be remembered that the Chinese market has yet to fully form. But if Chinese automakers continue to believe that they can follow the business model of the Japanese in the ‘70s (i.e. breaching the market with cheaper cars and building brand value over time), then they are sorely mistaken. The same opportunities do not exist today – there are no weak firms in the market, and to enter by virtue of low-cost alone would make Chinese operations intrinsically unprofitable. There is big room in the market for expansion, but the big boys are also well established. Anyone considering entering the market will need to carve out a niche position and a strong brand to compete. Ultimately, more significant corporate consolidation and stronger brand-building policy are two initiatives that will eventually become necessary for future growth.

“Corruption is an inevitable accompaniment to social progress,” said the People’s Daily in the late 1990s. Whilst times have changed for businesses operating in China, navigating the intricate web of personal connections and business bureaucracy remains paramount to success and daunting to most foreign small and medium-sized enterprises (SMEs).

During China`s first boom in the 1990s, it was almost impossible to secure a loan outside the aegis of a state-owned enterprise. Individuals who wanted to try something entrepreneurial used their mutual support network – known as guanxi – to obtain chops and permits, borrowed money from their direct families, and closed deals with “gifts” to the right officials. The process was tightly controlled by local, provincial and central governments and their SOEs.

One of the few private companies to find legitimate ways of raising capital was Orient Group, which in 1994 became the first private company to be allowed to list shares. The group’s founder, Zhang Hongwei, said that in China, “…..doing business is different from doing business in other places: you only spend 30% of your effort on business. The other 70% is spent with dealing with all kinds of inter-personal relationships”.

Fast forward to 2012 and how much has really changed? State owned enterprises are still at a major advantage versus their smaller, private sector competitors when it comes to accessing credit from the banks. When the government turns off the credit taps, it’s always the smaller firms that suffer first, and yet, these are the companies that contribute most to China’s GDP growth. In June 2012, Andrew Wedeman released a series of analysis on corruption data in China since the early 1980s. Citing data on cases involving mid-level to senior officials and significant sums of money, Wedeman reconfirmed what other studiers of Chinese corruption have been saying for years: since the early 1990s, the regime has only become more corrupt.

The questions at hand, then, are twofold. First, how can we explain the paradox of sustained economic growth under a regime that practices predatory corruption? And second, what type of corruption is China really plagued by? According to the annual Corruption Perceptions Index published by Transparency International (TI), the Republic of China was ranked well under countries like Canada (#8) and the US (#24), coming in at a clean #32. Although the use of third-party survey data will always call an index’s results into question, public perception in 2011 seemed to lean towards a moderate stance on shadowy practices in the Great Republic. How then, does this corruption go unnoticed?

Some scholars have argued that one of China’s saving graces was to undertake economic reform before corruption got too bad. Because the transition to a market economy was initiated in the 1980s (when corruption was limited to petty plunder), dynamic growth was achieved before significant corruption set in. As to the intensification of corruption in recent decades, many blame the sale of land-use rights and privatization of state-owned enterprises (Wederman, 2012). Although privatization continues to allow previously inefficient areas of the Chinese economy to flourish, the transition process is filled with opportunities for officials to pocket a quai. Effects on growth seem negligible in the short-term: as the Chinese government continues to allocate trillions of dollars in fixed investments towards development, what does a few million here or there matter? Unfortunately, the long-term costs of this scenario are borne by the state-owned banking system, which is forced to back poor, corrupted investments like high-speed railways.

So what does this all mean? Well, not very much in the near future. Although the Party has promised to assume a stronger stance on corruption, we all know not to put too much faith in abstract vows. China’s export sector still accounts for roughly 2-3% GDP growth annually – money that is out of the reach of Chinese officials, and just about enough to offset the price of corruption. Unlike many corrupt governments that became progressively cleaner as democratization and development followed their natural course, China is an autocracy unimpeded by legalities. Finally, as TI’s index indicates, corruption in China is often viewed as merely one more element of the status quo.

Ultimately, it’s a one sided game. The fact that one can’t win in China without effectively navigating the different relationship structures and favours that are expected is well known. While the government talks a good game about wishing to stamp out corruption at all levels, its corridors are stuffed with individuals who would be far from exonerated during any full-scale investigation. In fact, studies have shown that the Party’s corruption prosecution rates have actually fallen relatively since 2000 (although the bureaucracy has expanded, prosecution numbers have remained roughly the same 2,500 each year).

Instead, the government can wield the corruption axe at will. Got a rowdy, trouble making provincial governor who is getting above his station? Kaboom! Corruption charges, life in prison. Got a multinational organization that isn’t playing by the rules or is winning a bit too much market share from local players? Kaboom! Senior managers are found to be currying favour illegally via corruption. Ten years each inside a Chinese prison, or deportation and disgrace for their company. Got a major scandal on your hands that you need someone to blame for (here queue a railway accident or earthquake)? Kaboom! The Minister for X is to blame due to his gross mishandling of his office and, yup, you guessed it, corruption.

Corruption is certainly not unique to China, nor are Western organizations the saints that they proclaim themselves to be. But as development persists, and corruption continues to make food unsafe, exacerbate uneven development and threaten sustainability, the time may come for China’s Premier to persecute its looters more severely. 

Over the last generation, the greatest wave of internal migration in human history has transformed China’s cities, and with it the global economy. Although estimates vary, studies report that up to a staggering 103 million urban migrants currently exist in China. This number could increase to 243 million by 2025 – catapulting the urban population to nearly 1 billion and dramatically shifting city demographics. Already, estimates show that migrant workers compose nearly 40% of Shanghai proper’s 23 million people.

Critics of Chinese migration, most notably from the West, have historically been plenty. These stem primarily from the Chinese government’s tendency to use the hukou system (a permanent residence registration system that dates back to ancient China) to restrict internal movement by denying rural migrants certain amenities within its coastal cities. For example, children born to rurally registered parents will themselves count as ‘rural’, even if their parents migrated years before and they were born in urban centers. Like their parents, their lack of a hukou for where they live will make it more difficult for them to get a driver’s license, or even purchase a house and car. Escaping this cycle is, for most, nearly impossible.

All evidence shows that these trends are unlikely to change anytime soon. One reason is that China’s growing factories still benefit by employing large numbers of cheap migrants – a supply that the current system guarantees. Another significant force is the cities’ lack of educational resources for non-locals. In Shanghai, migrant children are eligible to attend local primary and middle schools, but are denied access to high schools. In lieu, some of the smartest migrant children attend vocational, or trade, schools. Although Premier Wen Jiabao criticized the hukou system on March 5^th of this year, promising that “migrant workers will become permanent urban residents in an orderly manner”, we all know how reliable these types of governmental promises are.

But here’s the catch: this year, for the first time in nearly three decades of rising coastal migration, studies show that the inland population is starting to work closer to home. This is a big change, and potentially a sign that recent floods of government investment in the Western interior are working. As inland cities like Sichuan’s capital, Chengdu, improve their infrastructure, many Chinese firms have begun to transfer some manufacturing away from Eastern cities in search of cheaper operating costs. This price disparity reflects both initial signs of development in the West, as well as potential signs of “over-development” in the East, leading to wage costs above the developing country norm. Another potential cause is the recent, 2008-induced downturn in European demand for coastal produced exports.

For their part, provincial officials have begun what would have ten years been unthinkable: luring migrant workers home. The Chinese government recently abolished agricultural taxes and began subsidizing rural areas. In Chongqing, a photo was even published of policemen carrying bags for migrant workers who were returning home for the New Year holiday. As domestic demand begins to account for progressively larger shares of Chinese GDP each year, firms do not necessarily need to make their homes close to a port anymore. The result is a steady influx of new factories in the interior.

Some scholars associated with the Chinese Communist Party have argued that this pattern additionally reflects shifts in China’s socio-political infrastructure. For example, some have posited that this reaction represents China’s attempt to avoid the phenomenon of “Latin Americanization” – that is, “highly unequal megacities and their attendant crime, slums and social instability” (Wallace 2009). This might seem inconsistent with typical development patterns though, as emerging economies traditionally give preferential treatment to cities. Others have argued that this trend is merely the result of changing demographics within Chinese society: according to UN estimates, the number of 15-29 year olds in China peaked in 2011. This means that the population will only continue to age from this point onwards, reducing the supply of young workers even within the country’s innermost provinces.

Regardless of the reasons behind it, China’s new, changing patterns of migration will assuredly influence the country’s development profoundly over the next few years. Already since 2010, Chongqing has allotted full social benefits to nearly 3 million migrants who had previously been categorized as immigrants from the hinterlands. Chengdu has announced plans to repeal amenities-related barriers to migration within the next year. In this way, migrants in urban areas will be able to enjoy the same social benefits as registered city-dwellers. Access to urban schools in particular will allow them to bring their children with them, in place of the current practice of leaving them with grandparents or other relatives in the village.

Although these omens point to hope for China’s glaring regional imbalances, however, it remains to be seen how these added financial burdens will be carried by local governments. In 2011, many of China’s interior provincial areas reported GDP growth exceeding 15% (Chengdu reported a healthy 15.2%, while Chongqing clocked in at 16.4%). Once this growth slows down, will government officials display the same zeal for social reform? We’ll have to wait and see.

Since the beginning of reform and opening up in the late 1970s, China has consistently been in the world’s eye as a major tourist destination. Rather than convince you with words, we’ll let the figures do the talking: China is the third most visited country in the world; in 2010, 55.98 million overseas tourists made their way to the Middle Kingdom; total income from inbound tourists has reached yearly estimates of 777 billion Yuan.

Although at China Brain we pride ourselves on not being overly superstitious, we thought it interesting to point out that, in Chinese culture, the number 7 symbolizes “togetherness” and is a lucky number for relationships. It is also notably one of the rare numbers that is considered harmonious by both China and the West. We’ll leave it to the readers to draw their own further conclusions.

Despite sustained development in the inbound sector, however, the number of tourists heading to China each year continues, in fact, to be outpaced by those heading out. Over the last few years, Chinese outbound tourism has been way ahead in comparison with inbound tourist arrivals – simply put growth is absolutely phenomenal. During the 2004-2008 period, the total number of annual Chinese outbound tourists grew by 12% CAGR to reach 45 million. In 2011, a research report published by RNCOS estimated that nearly 61.9 million Chinese crossed the border to see the world. The China National Tourism Administration (CNTA) predicts that by 2015 100 million travelers spending 100 billion US$ on outbound tourism will turn China into the world’s #1 international tourism source market.

Ongoing government programs and an increasing number of international agreements between Asian countries and the West, coupled with Internet penetration and incessant economic development, suggest that this trend will only continue in the near future. For its part, the Chinese government has been active in signing bilateral agreements with neighboring countries and relaxing visa restrictions, making it easier than ever for Chinese citizens to explore life outside the Great Wall. Although these efforts have been mirrored by foreign governments (the U.S. was among the last Western countries in obtaining Approved Destination Status (ADS) in December 2007), there is still room for improvement. It remains especially difficult for some independent travelers to obtain visa permission for travel, leaving little choice but to engage the often-expensive services of an established travel agency.

Who are these travelers, what do they expect, and what does this mean for the rest of the world? For starters, rising Chinese outbound tourism will only continue to facilitate a marked Chinese global presence – one that will become a much firmer reality for many in the West, as those who have fueled the export-driven Chinese economy for years finally ‘meet their makers’. As the Chinese tourism industry expands beyond leisure vacations to include industrial technology and cultural tourism, medical tourism and investment tourism – areas of tourism that are currently still undeveloped – how will the rest of the world react?

Many studies argue that rising outbound tourism may be a key factor in solving what has often been a turbulent relationship between China and the rest of the world. Rather than occurring at the intergovernmental level, these authors believe that successful cooperation between the people of China and those of the West, Asia and even India will be founded upon the construction of mutual social and cultural bridges. This type of dissemination usually works both ways, and as a whole generation of Chinese teens mature in a country distinctly more open to the world than their parents’ ever was, we remain optimistic of future collaboration. Could Mark Zuckerberg’s March 2012 visit to China be the first of many? It is still too early to predict.

Regardless, the question of the moment for American tourism and hospitality practitioners is increasingly becoming: What kind of services should we supply to Chinese tourists? Initial studies published in Tourism Management (Vol. 32, Issue 4, 2011) have yielded interesting results. For instance, findings suggest that “the major benefits sought by Chinese visitors in a pleasure trip include scenic beauty, safety, famous attractions, different cultures, and services in hotels and restaurants among others” (Yu and Weiler 2001). Mainland tourists also seem to prefer package tours involving multiple destination countries to a single-destination package. This reasoning stems from the common belief that, with a package tour, you are getting a better bang for your quai. As for shopping, analysts found that Chinese tourists are most inclined towards purchasing electronics and famous brand-name items, often as gifts for relatives.

The most common complaints registered by Chinese travelers targeted the lack of certain amenities at Western destinations, which would typically be found in China. Visitors to hotels in the US frequently criticized the lack of hot drinking water and Chinese tea, as well as the absence of one-use toiletries (e.g. toothpaste, toothbrush, comb) that Chinese hotels generally provide. Concerning food and restaurants, one study’s participants found that Western food was either too sweet or unhealthy (fried food and high calories), or it surpassed their approximate food budgets of 10-30 US$ per day. Almost every participant expressed a desire for more readily available, authentic Chinese food.

While the phenomenon of Chinese outbound tourism is still in its infancy, Chinese visitors to the West are rapidly developing into a large and sophisticated group of consumers – one for whom travel will only continue to become more affordable as the Chinese government allows further re-evaluation of the Yuan. Satisfying and meeting these tourists’ needs, as well as treating them with the cultural understanding and respect that they expect, will be a crucial task for Western marketers in the years to come. A better understanding of Chinese outbound tourists and their intrinsic cultural values will result in a more pleasant stay for all those involved.