There and back again: Observations on China

Hello again!  It has been a few weeks since my last post, and during that time I was fortunate to travel to Asia with my MBA classmates and generally have a tremendously good time.  This is also a shameless plug for you to take advantage of the Post 9/11 GI Bill and pursue an education beyond your military service.  You will meet great people, learn a ton about things completely unrelated to bayonets, machine guns, fighter jets, or aircraft carriers.  You might even get a chance to travel abroad without carrying a sidearm- trust me, it is a great experience!

Anyhow, the purpose of our trip to Beijing was to familiarize us  with the business environment in China by introducing us to a variety of companies.  We also were fortunate to see some of the true wonders of the world, such as the Great Wall of China and the imperial Forbidden City.  It proved to be a very insightful and interesting trip.

We spent the duration of our stay in the capital city of Beijing.  The city is enormous, with a population of some 20 million residents, and sadly modern, with mile after mile of largely uninteresting and recently constructed apartment and office buildings set atop former villages, farms, and historical streets of ancient Peking.  Sadly, the rush for modernization comes at a high cultural cost.

It also comes with an astonishing impact on the environment, most evident by the astounding level of air pollution that blankets the city.  It is like a fog that obscures buildings from view even though they are only a few blocks away.  The air quality is so poor that many residents wear surgical masks to protect themselves, and after being there for a week and suffering from a sore throat and sinus problems it seemed to be a pretty good idea.

Pollution aside, the insights on business and government in China were very valuable.  I learned more about how China works during that one week than I did in years of reading and studying the country.  As MBA candidates we critically observed the business environment in China, and here are some impressions that I came away with (and please note, these are my opinions):

China has enjoyed tremendous financial growth largely though revenue garnered by the privatization of land (well, the pseudo-privatization of land, as all land is owned by the government but can be “sold” in the context of a very long term lease) in urban areas.  In effect, cities are growing by usurping lands previously held by villagers or farmers, with those hapless former inhabitants being relocated into towering and identical blocks of high rise apartments.  The displaced persons are compensated and provided a place to live, but the difference in the amount of compensation that is provided is a pittance in comparison to the price the land commands when privatized.

This model has a serious problem, however, in that there is only so much land that is valuable enough to generate the revenue required to keep growth at a high level.  This will result in a gradual decrease in revenue from land sales and a corresponding negative effect on growth.

We received an insightful briefing from a financial manager, who pointed out the problems with financing growth through land privatization.  He showed, however, that there exists a revenue stream that will supplant and possibly exceed the real estate market: the spinoff of State Owned Enterprises (SOEs) to the private sector.

The definition for State Owned Enterprise that I am using includes those companies that are wholly owned by the government or those that receive investment in the form of capital or other resources from the government.  In essence, the SOEs are provided a distinct competitive advantage because they are the beneficiaries of the Controlled State Economy; they can receive investment from the government without the expectations that come from traditional Western investors, such as financial returns or other shareholder rights.

Anyhow, the government can earn somewhere in the realm of 30 –  40 trillion yuan (their currency, which equates to somewhere in the 5 – 6 trillion U. S. Dollar range) in revenue from spinning off these enterprises.

Or so they believe.  I don’t think so, and here is my opinion as to why:

1.  A significant consideration for the Chinese government is employment.  They have 1.3 billion people in the country, and in order to keep everyone happy they need to have jobs.  This leads to programmatic inefficiency in Chinese industry and government, with the choice to employ people over employing automation or seeking other efficiencies.  That is perfectly fine when firms are receiving investment funds from the government (which is happy to allow inefficiency as long as people are employed) but not so much when a SOE is spun off and must compete in a free marketplace.

Here is an example from a computer chip manufacturing firm that we visited during our trip:  The company, which is a SOE that receives a significant amount of capital from the government, manufactures chips that are used in mobile phones.  The facility has “clean room” manufacturing areas on three floors of the building.  The entry into the clean rooms is monitored by a young man or woman, who spends his or her entire day standing at the door and running an Electrostatic Discharge detection wand over each employee as they enter the room (this is important because any stray static electricity introduced during the manufacturing process can damage or fry the chips).  If my memory is correct I think that there were two entrances per floor, with a helpful wand bearer at each one.  Since the firm runs two shifts per day, and operates on a four day on, four day off schedule, this yields a requirement for four complete sets of employees.

By doing the math (six employees per shift times four shifts equals 24 employees) it is evident that a large number of people are doing something that in a western facility would be performed by an automated sensor.  While labor is cheap in China, the cost of labor is rising with the emergent middle class.  That said, the inefficiency is acceptable for a SOE because the costs are absorbed or mitigated by government investment.

Governmental mitigation only works with true SOEs – if the goal is to harvest revenue by spinning SOEs off into the free marketplace, then the valuation of the companies will suffer because no western investor will accept the inefficiencies of a SOE after acquiring the firm.  In the free marketplace costs must be reduced in order to increase the bottom line, and labor that can be replaced with automation will be replaced.  I believe that this ingrained level of inefficiency will devalue the companies that the government spins off.

Getting back to employment, though, is important.  If these firms are spun off and the personnel inefficiencies are corrected with automation it will result in an aggregate increase in unemployment, which is counter to the government’s goal to keep the people happy through work.  An increase in unemployment means an increase in disgruntled citizens, and the magnitude of such an increase in unemployment will be enormous if so many SOEs are spun off.  What, then, will the government do with all of the unemployed people?  I don’t know, but whatever they do it will have a negative effect on economic growth.

2.  Healthcare, the environment, and everything else.  It is ironic that capitalist societies have managed healthcare for their citizens but communist China does not.  Healthcare in China is largely a cash driven model for the bulk of the citizenry.  As the country modernizes the antiquated healthcare system, it will result in a major drag on economic growth, as will the need to clean up the environmental problems that have emerged as a result of industrialization.  The problems of pollution and the negative impact of industrialization on the environment have only now begun to be addressed in China, and the costs associated with these problems will be profound.  Again, this will result on a drag on economic growth.

China is experiencing an industrial and economic revolution in a span of a few decades that the west took over a century and a half to get through.  As such, they have maximized the ability to capture and hold market space in manufacturing due to their cheap labor and lax regulations, but as labor costs increase and the need to clean up and regulate industry grows there will be a slowdown on the trajectory of growth for the nation.  The country is plowing an unbelievable amount of money into infrastructure, with planned cities growing by millions of people per year, bullet train lines linking population centers, and road networks expanding to meet the explosion in car ownership.  These things cost money, which will only cost more as labor costs grow and the need for infrastructure increases.

So, in conclusion, I think that China has some serious hurdles to jump over in the near- and mid-terms, but I think that they will overcome the challenges and thrive in the long term.  It will just take a considerable amount of time, treasure, and collective pain to get there.  I came away from my visit to China convinced that the country is in for rough seas ahead, and I am unwilling to place my personal investment dollars on their ship of state until they weather the storm.  After they reach their nadir, however, I believe that the opportunity for investment is tremendous.

With that, I will leave my trip to China and get back to the exciting world of transition as we dive into the wonderful world of job interviews….

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4 responses to “There and back again: Observations on China

  1. Mike,

    I wanted to tell you how much you nailed it in your observation of China. I have traveled to China several times, as my wife is from Beijing and her parents still live there. Your impression of how modernity has altered the cultural landscape is so true. I was there in 2004, and again in 09 and 11, and the change was amazing but bittersweet to anyone who loves historical things. My wife visited last month and complained that the polution and traffic was even worse that last year.

    Excellent observation about labor and the need to keep the lid on the population from boiling over by having some kind of job for everyone. You should see how they clean the streets of Beijing after a snow storm, thousands of people with brooms and shovels, flood the avenues.

    Enjoyed the post!

  2. Interesting perspective, Mike. I also found the city very bland and charmless. Wish we had gone to Shanghai (especially after seeing Shanghai in the movie skyfall). Your article was definitely thought provoking and has made me wonder about China’s financial future. But, why would China ever spun off SOEs and lose its control being a communist country? Biggest lure for China is cheap labor and therefore you don’t see much automation there in every company we visited and as you rightly pointed out. I believe that cheap labor will still prevail due to large population and necessity to survive. The other temptation is large consumer market which will also prevail as long as there is flow of money. However, I would be wary too as I sight a point of inflection as well.

    • It will be interesting to see how it goes. I think they will need to spin of SOEs in order to keep their economy growing at the high rate that it has enjoyed for the last few years….and they seem to be more capitalist in many ways than we are!

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