Only Excellence Can Save China

by BILL WADDELL

A few weeks back I wrote a post that included a remark about the powder keg I see in China that is not far from exploding.  Mark Welch commented with the question, "My impressions on China are that it is much more free and open society than it USED to be (still a long ways to go, though), with a growing economic engine rivaling ours in the U.S., but what is at play that makes you think it is an economic and social powder keg?  I haven't really seen it as volatile, but I'm interested to hear what makes you believe so."  I am long overdue answering that question.

In a nutshell, productivity matters - a lot.  And China has a serious productivity problem.

China plays pretty fast and lose with numbers.  Some of it is because the place is so big and out of control they don't really know what a lot of the numbers really are; and some of it is an outright lie.  Regardless, they claim to be growing their economy at about 8% this year in the face of a global recession.  At the same time, they acknowledge a drop in exports of about 25% or so from last year.  Whatever the difference between the big drop in exports and the 'growth' in the economy is, the gap is real and it has been filled with a gargantuan government stimulus package - makes Obama look stingy with the public purse strings by comparison.

The reason a drop in exports corresponds almost directly to a drop in the economy that has to be filled with government spending is because, for all practical purposes, there is no consumer economy in China.  Oh sure, there are millions of newly rich friends and kinfolk of the ruling class and upper management of the factories, but for every person in China making decent money, there are twenty or thirty making less than a dollar an hour.  They are the heart and soul of China's cheap labor economy.  And the heart and soul may well be capable of making iPods and Nikes, but they cannot afford to buy them in their wildest dreams.  One out of 25 with a little money to blow is hardly enough to prop up the Chinese economy when the bottom drops out of the export business.

So the Chinese government poured money into the usual stimulus things - roads, bridges, dams and wind farms.  Only the gap is so big between the real economy of China and the amount needed to keep things running that they built way more capacity for steel, concrete and windmill making than they can possibly hope to sustain.  Now they have had to throttle that way back.  "Chinese Premier Wen Jiabao recently warned the pick-up in growth this year 'remains unstable, unconsolidated, and imbalanced'." Roughly interpreted, that is Chinese for 'we don't know what in the heck to do next'.  The fact is, that without their own consumer demand, China is little more than a cheap supplier that lives and dies at the whims of its customers - and China produces a lot of stuff people want, but very little people need, so China is up a creek when their western customers decide to tighten their belts.

China will become the economic powerhouse the theorists wax so eloquently about only when they have their own demand, and the good people of the People's Republic are a consumer market of their own.  The Chinese know this full well; in fact their neighbors in Viet Nam, Thailand, Malaysia and Singapore know it too.  They also know that the terms 'cheap labor' and 'consumer economy' are polar opposites.  More ominous, they know that they had big unemployment problems before the global economy went south, and they have critical unemployment problems now.

China's solution - the only solution - is to pay people a lot more per hour, and correspondingly improve productivity to offset the increase - a la Henry Ford with his double the pay and blow productivity through the roof with the assembly line concept.  That creates a workforce capable of being consumers, while keeping the cost down.  Lord knows there is plenty of room in Chinese factories for tremendous productivity gains.  A typical Chinese factory operates at 20% or less productivity than their western counterpart.  But twice the pay and half the workers, while it would go a long way toward creating the essential consumer economy, would send unemployment skyrocketing for a period of time until the richer working folks spent enough money to create jobs for the half that got laid off.

With unemployment already a critical issue, policies to improve worker productivity - i.e. ratcheting up the minimum wage in China and driving down factory headcounts - would create economic hardships for so many millions that the prospect of a mass march on Beijing with torches and pitchforks is very real.  So what are the Chinese to do?

They have no choice, really.  They have to step up to the productivity issue in order to sustain. The bottom line is that no economy - not ours, theirs or anyone else's - can sustain without steady and substantial productivity.  That is the source of wealth.  Only excellent manufacturing practices will suffice, and so long as China operates with its cheap labor, shoddy quality economy aimed more at job creation than productivity, they cannot be more than the place on the other side of the world's railroad tracks where the dirty factories and rail yards operate.

Comments

[Mark Welch]

Thanks for your explanation of this, Bill. Well-thought out. I have absolutely no feel for the likelihood of a mass march on Beijing, which would be the flashpoint of the powder keg you described, but my guess is that we'd have Tiananmen Square X 1,000,000, only to have the Communist Party crush it in the end. Their economic engine could sure be crippled, though,if the workers stood firm in a strike, illegal or not - no question. "The People's Revolution, Part II."

[Tony]

More questions and comments:

1. Long term the biggest problem for China is demographics (most rapidly aging population "getting old before getting rich", male/female imbalance, etc) and the sense of entitlement (at least in urban families) that only children have. Only children are almost always spoiled, and China is no different.

2. Doesn't higher productivity typically require a lot of capital investment? Is China's financial system ready to supply the needed capital, especially to those without government/party connections?

3. I suspect that Chinese in general have cultural problems (many resulting from their recent tumultuous history, e.g. parents tell their kids "lie to everybody except us") that prevent them from following in the footsteps of Japan, Singapore, and Korea.

4. What effect can the "sea turtles" (returning expatriates) have on Chinese companies?

5. Other sources I've seen claim there is a significant Chinese middle class (maybe 300 million). Who is right?

[Bill Waddell]

You make many good points, Tony. Concerning the 300 million middle class Chinese, I guess it all depends on what your definition of 'middle class' is, but the notion that 1 out of every 4 Chinese citizens has any disposable income to speak of defies common sense (at least common sense for those who have spent any time in China outside of Beijing, Shanghai or Hong Kong).

[HJG]

Tisk tisk... I have heard the "collapse is coming", "explosion is nigh" story for the past 20 years :) Just another one.

[Bill Waddell]

Really? Twenty years ago the GDP of China was only 4% of what it is today. Hong Kong was part of the UK. I didn't think anyone was predicting that China would be a global economic power twenty years ago, let alone predicting the collapse. I also doubt that those whose predictions you listened to anticipated the collapse of the US and Western Europe credit and consumer markets, and I certainly don't think the Chinese planned for it either, but maybe your logical, fact based criticism of my point of view is correct. Time will tell, I suppose.

[Chris]

I am far from an expert on China, and I have heard that there are regional divides in China, but wouldn't an internal structure of state like regions go a long way to helping their economy flourish whether the government was democratic or not? ANd wouldn't this help them establish a "consumer based" population?

[Preston Sumner]

Many good points but there seems to be an economic inconsistency. You talk about the high level of unemployment then talk about the solution being to pay people more. Now I realize you speak to these issues in the context of creating domestic demand (which will improve unemployment) and improving productivity (which will allow higher wages). Because unemployment is so high and yet the savings rate (of the employed) is so high there is ample opportunity to increase employment in the face of sharp reduction in exports. Also because unemployment is so high they can easily continue to offer cheap labor. This is not to ignore productivity. What I describe is not sustainable when employment reaches a more reasonable level but there is significant time until that occurs. Between now and then productivity must be addressed. They key to another decade of strong growth is the current high unemployment rate coupled with the capacity to grow domestic demand based on the current high savings rate.

[Tony]

Some links that touch upon my earlier comment:

http://www.timesonline.co.uk/tol/news/world/asia/article6726244.ece

http://www.chinalawblog.com/2008/02/why_chinese_companies_fail_in.html

Especially note this comment from the first link:
Many young couples are willing to have one child to continue the family line, but they let the grandparents raise it so that they can go to bars and restaurants and go shopping and travelling without being restricted by the responsibilities of children.

[mike]

The workers need to reduce their savings rate and start spending their money themselves, right now their the big lenders of the world to US and now their government.

[Renaud]

Good points, Bill (and also Tony in the comments section). I live in China and I am amazed by the optimism of the locals... It seems they all believe in their bright future so much that they won't make efforts to correct the way they work (no interest in foreign best practices, low training, no transparency, etc.).
Only the central government is scratching its head about what to do. Their advantage is the number of "buttons" they can push (taxes, controls...). Their problem is the freedom taken by local officials (bad debts in the banks' books, corruption...).