China – Stepping Through the Looking Glass

China Through the Looking Glass - Alice's Adventures in Wonderland

By Richard L. Wottrich, CEO & Senior Consultant, International Services 

DSI White Paper – April 18, 2013, Chicago USA 

China has sustained a +10% annual growth rate for over 30 years, vaulting to the second largest GDP in the world at $8.2 trillion. China has become the world’s manufacturing hub, exporting $2 trillion in finished goods in 2012. In the process China has raised its citizens’ standard of living exponentially, and become an urbanized nation of 715 billion people living 658 cities. The byproduct of this success has been to amass over $3.3 trillion in foreign exchange reserves, dwarfing those of any other nation.

Singapore patriarch Lee Kuan Yew says of China, “Unlike other emergent countries, China wants to be China, not an honorary member of the West.” And unlike the “immediate gratification” culture of the West, China has the patience born of a 5,000-year-old culture coupled with a pool of talent 1.3 billion strong to draw upon.

China has a compelling story and one is tempted to suppose that nothing can slow down their rise to number one in Asia, and perhaps in 50 years it will become the world’s greatest superpower. China’s leadership refers to this as their “peaceful rise.” Their default assumption is premised upon the belief that China’s economic miracle is sustainable – that it will not go down. Human history suggests otherwise.

Debasement of the Environment

In stepping through the looking glass that is China the price it has paid for its peaceful rise becomes evident. China’s environment has been ravaged by unbridled mining, energy and manufacturing growth in myriad ways.

In the 2010 Global Burden of Disease Study, which was published in December in The Lancet, a British medical journal, its authors decided to break out results for specific countries and present their findings at international conferences. The China statistics were offered at a forum in Beijing on Sunday, March 31, 2013.

They estimated that outdoor air pollution contributed to 1.2 million premature deaths in China in 2010, nearly 40% of the global total. China’s toll from pollution represented the loss of 25 million healthy years of life from its population. These estimates did not address the terrible fresh water pollution issues facing China, or the industrial issues of exposure to dangerous chemicals and processes in its factories.

China has nearly 5 million workers in its coal industry, the burning of which is the main source of energy in China. In October 2008, Greenpeace, World Wildlife Fund, and The Energy Foundation published The True Cost of Coal, postulating that coal burning impacts on water pollution, air pollution and human costs such as mining deaths are costing China 7% of its annual GDP. Meanwhile China’s 3rd quarter GDP growth has slowed to 7.7%.

The emerging Chinese middle class, composed mostly of members of the Chinese Communist Party (CCP or the Party) or successful people beholding to their Party doppelgangers, have merged as a potent political force demanding accountability for the debasement of China’s environment. Recently, foreign companies have been experiencing difficulty in posting employees in Beijing and elsewhere, because of their abysmal air quality. Quality is life is becoming a major issue in China today.

For example, Delegates to China’s annual session of parliament recently issued a protest against the rising level of pollution in the country. Such votes are usually a unanimous “yes”, but in a move seen as a protest against the government, a number of delegates voted against a new committee. Out of the nearly 3,000 delegates, 850 voted against the new Environmental Protection and Resources Conservation Committee, while 120 abstained – representing almost 32% of the delegates. This magnitude of dissent in China is rare.

Graft and Corruption

China suffers from widespread corruption. In 2012, China was ranked 80th out of 176 countries in Transparency International’s Corruption Perceptions Index. China’s corruption spans graft, bribery, embezzlement, backdoor deals, nepotism, patronage, and fake statistics.

Moreover, China is in the midst of an immense real estate development bubble, based upon a procurement model of confiscation of land by local government units, in turn sold at enormous fees to developers, and in turn developed into massive real estate developments sold at inflated prices. The bottom of this Ponzi scheme is composed of the poorest of peasants in China, who are pushed off their land with little legal recourse.

This corruption is endemic to a Communist Party that is above the law and indeed legally untouchable, as its very existence does not appear in any government law, means of redress, or publication.

To be sure, China’s leaders are well aware of this. China’s new President Xi Jinping last March told these same 3,000 delegates gathered at Beijing’s massive Great Hall of the People that under his watch the government would “resolutely reject formalism, bureaucratism, hedonism and extravagance, and resolutely fight against corruption and other misconduct in all manifestations.” His rule may depend upon it.

Transfer of Wealth

The rise of China has enriched a narrow band of elitists embedded in its population, as the real estate bubble has demonstrated. This represents a transfer of wealth driven by high rates of investment, which are created by a centralized government policy purposely geared toward investment, cheap workers, below-market interest rates, loose monetary policy, increasing debt, and currency market intervention.

China has not become rich despite low consumer consumption, but because of it. China has been systematically transferring income from households (the masses) to investors (the wealthy) for decades (some would opine that the U.S. Federal Reserve is doing the exact same thing) via:

  1. An undervalued currency, equivalent to a consumption tax on imports.
  2. Financial repression (extremely low interest rates), which taxes savers and retirees and subsidizes borrowers.
  3. Low-wage growth versus productivity, a gap that has widened greatly in the last decade (the difference between these is a tax on consumers).

The gap between rich and poor is widening in China, and this represents a political challenge and immense risk for its leadership.

Systemic Sovereign Debt

On April 9th Fitch Ratings cut China’s sovereign credit rating. Analysts at Fitch highlighted China’s growing debt burden on local governments. Meanwhile ratings agency Moody’s cut China’s credit outlook to stable from positive on Tuesday, April 16th, citing concerns regarding the country’s opaque local government debt, accelerating bank lending growth and stalled economic reforms.

Fitch estimates that total credit in China’s economy now exceeds 198% of GDP ($16.2 trillion credit vs. $8.2 trillion GDP), much of this is carried by government-sponsored entities and local governments. In addition, both credit agencies pointed to the growing problem of shadow banking in China.

Shadow banking covers the spectrum of private credit sources. The most egregious are illegal loan sharks who operate in China’s wealthy coastal regions, providing high-interest loans to small business owners who are ignored by mainstream banks.

But most of China’s shadow banking is legal. The biggest of the non-bank institutions are trusts, companies similar to hedge funds. They serve rich investors and promise high returns by lending to risky customers, especially real estate developers. A wide range of state-controlled industrial companies, from shipbuilders to oil majors, also engage in shadow banking as a sidecar investment.

The size of shadow banking system is unknowable, varying dramatically depending on how it is defined. UBS economist Wang Tao believes it is no smaller than Rmb13.6 trillion ($2 trillion), or about 25% of China’s 2012 gross domestic product, and conceivably as big as Rmb24.4 trillion ($3.9 trillion), or nearly 50% of GDP.

China’s central bank governor, Zhou Xiaochuan, insists that, “The vast majority of the financial activities conducted by China’s non-bank institutions are regulated. It’s not like other countries where they completely escaped regulation.”

This is the Party line of course, but the depth and effectiveness of regulatory control over shadow banking is a matter of open controversy. Chairman Xiao Gang of the Bank of China was far more candid recently about the potential hazards of shadow banking when he wrote in China Daily, “To some extent, this is fundamentally a Ponzi scheme. The music may stop when investors lose confidence.”

4,000 Years of Epigrams

Perhaps more fundamental than any of these issues is the Chinese language and culture. Singapore’s Lee Kuan Yew had the genius to adopt English as its language. English is the international language of business and is the key to creativity in its versatility and fluidity of concept. Singapore has flourished as a city-state.

Chinese learn Chinese first – an opaque written  language representing 4,000 years of epigrams, plus a standardized form of spoken Chinese based on the Beijing dialect of Mandarin Chinese. Very few outsiders can master both, meaning that China cannot easily integrate outside talent into its economy.

Moreover, Chinese history is the history of Dynasties – central authority with absolute power over all citizens. This is not conducive to creativity, but rather to imitation.  In the last half century the Communist Party has emulated this dynastic heritage, and to remain in power they have unleashed the communist equivalent of the hounds of hell – capitalism.

As a child I read Alice’s Adventures in Wonderland. To this day I think of the conversation between Alice and the King where Alice is asked if she can see anyone coming along the road. Alice replies, “I see no-one on the road”, and the King replies, “what eyes you must have, to be able to see ‘no-one’ on the road, I have trouble just seeing ‘someone’ on the road.”

China would be King and China sees no-one on the road ahead. We shall see… 

Richard Wottrich, Blog Author – Richard.Wottrich@dsiglobalview.com