China Boom CMS

<p>I differ from most China experts. They still believe that the Chinese Communist Party's legitimacy relies on economic growth. That was true in the past 27 years, but since 2003, it is no longer true, because Hu Jintao and Wen Jiabao believe that the most important thing for the country is the redistribution of wealth. It is social cohesion and environmental concern and energy consumption. This is the so-called scientific development, harmonious society. So, they want to build up their legitimacy not only with economic growth, but also with harmonious society and scientific development, which means they should pay more attention to social issues and distribution of wealth and environmental cost and energy consumption, rational consumption. So, again, it's a whole package, not only economic growth. If you look at the career background of Chinese leaders during the past 30 years, you will see two shifts. First, the rise of technocrats, meaning engineers turned political leaders. From the early 1980s, when Deng Xiaoping promoted people like Li Peng, Zhu Rongji and Jiang Zemin, they were all engineers by training. For the 16th Party Congress in 2002, 9 top leaders, members of the Standing Committee of the Politburo, were all engineers; Jiang Zemin, Zhu Rongji and Hu Jintao, etc. So, they're all engineers. But now, you see that it's started to change. If you look at the current, so-called fifth generation leadership, we refer to Mao the first generation, Deng as second, Jiang as third, Hu Jintao as fourth, the current leaders, like Xi Jinping and Li Keqiang and so-called fifth generation, there are eight of these leaders now in the Politburo and Secretariat, the six people's body. These are very powerful figures, in about four years they will become the most important leaders in the country. Look at their educational backgrounds, look at the highest degrees that they have received. None of them are from the area of engineering. So, usually, they studied law, politics, management and economics. And Wang Jisan, vice premier, studied history; Bo Xilai, the Party Secretary of Chongqing, also a Politburo member, studied journalism; Wang Funing is a member of the Secretariat and he studied political science. So, that, again, indicates a moving away from technocrats to a more diversified political leadership, mainly by economists, or people trained as lawyers, or those who studied politics. Now, that will have a profound impact on Chinese society. Early on, when I mentioned the rule of technocrats, the 1990s was characterized by the rule of technocrats. They ignored the environmental consequences, they decided to build the Three Gorges Dam. But, now, that era is coming to an end. There is more attention to social harmony, economic distribution, environmental protection and China's energy needs, etc. So, in many ways, the change of leadership also leads to a change in policies and politics. Again, going back to the early years, in the Mao era, the leaders were usually long marchers, they did not receive good education, so the constant scene in the Mao era was anti-intellectual. The Cultural Revolution was an example. So, because those leaders were insecure about the threat of the educated leaders, there was a famous line, &quot;Reds versus Experts,&quot; that reflected that kind of concern. But that change led to the economic reform and rise of technocrats. Now, in my view, the next phase will be political reform and I think that, sooner or later, it will take place.</p>

<p>Well, my view is that it isn&rsquo;t going back to the planned economy. Happily, the market competition and opening to the world is maintained, although we&rsquo;re keeping an eye on whether or not China develops more protectionist policies. So far it&rsquo;s still pretty good. But what you see is that the fruits of the boom are monopolized by a class of people who have political power, political influence, and important economic roles. So, the distribution of the benefits in the 80s, especially with the household responsibility system, you just saw the benefits to the rural population were huge, lifting all those people out of poverty, and that&rsquo;s kind of slowed down. The benefits seem more monopolized by people, business people, who&rsquo;ve been able to cultivate ties with political officials at the local level, provincial level, central level. And, of course, many of those business people were originally officials. And then, officials themselves who serve on the boards of these things, they get all sorts of corrupt benefits from their symbiotic relationship with the private capitalists. And the state-owned enterprises, the hundred plus big state-owned enterprises, are very, very powerful. Many of those managers now are in the Central Committee, they&rsquo;re appointed by the Center. We see the Party still, even with companies that are listed on stock markets outside of China -- in Hong Kong, New York, London -- still appointing the leaders of those SOEs. We saw with the telecom companies, they just rotated the executives of the telecom companies. &nbsp;This is another interesting puzzle. If I weren&rsquo;t working on other things now, I think I&rsquo;d want to try to understand how, despite the fact that China has become a vibrant market economy, the Communist Party retains such a strong influence over the economy. It&rsquo;s kind of an interesting puzzle and I think it&rsquo;s the power of appointment that remains very strong very significant. In other words, if all these guys owed their jobs and their salaries and their bonuses and their corrupt earnings to some Party guys, who appoint them, that makes them very deferential, very loyal, they&rsquo;re not going to make any trouble.</p>

<p>There was a consolidation of China's exchange rate in the early 90s, a unification, a sort of individual exchange rate which led to a significant depreciation of the RMB formally then and that was followed by a period of sustained export growth. But, I think I would differentiate the 90s from the period after 2002 for a couple of reasons. One, the pace of growth in the 90s was much slower on the export side -- I haven't looked at the domestic side, but it was slower -- and it was much more cyclical. There were ups and downs throughout the 1990s. There was an early boom and China slammed on the breaks when it looked like it was getting out of control. And the '97-'98 crisis led to another cycle in China's exports. And there was a 3rd cycle in 2000-2001 with the tech bust. So, over this period, China's exports and imports are growing, but at a slower pace and it is not a sort of a sustained increase, it's a very cyclical booms and bust. And I would differentiate that from the period from 2001, 2002 to now, where it is, in effect, both domestically and externally, one -- at least until now, now we're entering the bust phase -- sustained boom in exports. There was no real cyclicality, just continued upward momentum, tremendous acceleration in the pace of growth on the export side. Some people point to the WTO entry. I'm less convinced because the WTO entry kind of codified what was already happening. If you look at the US side, the US had already allowed most favored nation status to China -- that's subject to annual renewal -- but there wasn't a fundamental liberalization that coincided with WTO entry. I would tend to think it's actually something much simpler, well not simpler. I think it's the change in trajectory of China's currency, which wasn't tied to a change in China's currency so much as change in the trajectory of the dollar. So that, after the unification of China's exchange rate regime in the early 90s, the dollar started on fairly strong uptrend where the dollar was appreciating against most emerging currencies, but also the euro and the yen, from sort of '95, when it was sort of a dollar low to 2001-2002. And then, in 2002, the dollar starts on a sustained downtrend and China's real exchange rate goes from a trend appreciation to a pretty significant depreciation. Because those two events coincide, it's very hard to disentangle which is the more important factor. But, I would tend to think it's the change in the trajectory of the exchange rate.</p>

<p>I think what&rsquo;s more important than the speed of growth is the quality of that growth, from a resource standpoint. And so, the 9% growth between 1978 and 2001 was achieved while the energy intensity of growth declined. So, for every unit of economic growth, less oil and gas was needed, less coal was needed, because of all this restructuring in the economy, because all these bad habits of the Mao Zedong economy were getting worked out. And so, for 20 years, China was able to grow in a way that didn&rsquo;t really present significant energy and environmental challenges. And that changed in 2001, and it&rsquo;s not so much because the speed of economic growth increased, it did a little bit, but the quality of the growth changed significantly. So, China went from what had made it rich over the past 20 years, again, that labor-intensive manufacturing, doing what the rest of East Asia had done to develop, and moved back in an energy-intensive direction. So, instead of investing in light manufacturing facilities and service sector activities, China started investing in energy-intensive industry again, the same things that had bankrupted the country under Mao Zedong. So, more steel mills and more cement kilns. &nbsp;Now, the investment in those industries was driven by urbanization and a need for steel and cement to build out China&rsquo;s new cities. But, for the previous ten years, China had imported from abroad a lot of the steel and cement that it needed to urbanize. And starting in 2001, it not only began to produce all of that steel and cement for itself, but started to export it as well. And the energy implications of that on the country were massive. So, we went from each unit of economic growth only requiring half as much energy to each unit of economic growth requiring one and a half times as much energy, so a tripling of the amount of energy required for the economy to grow. And that was entirely because of a shift from less energy-intensive drivers of growth to more energy-intensive drivers of growth. And that&rsquo;s what caused the country&rsquo;s energy footprint, its environmental footprint, to double between 2001 and 2008. &nbsp;The country&rsquo;s leaders have recognized, and recognized two or three years ago, that this wasn&rsquo;t sustainable. If you took the past 7-year trend and you forecast it out over the next 30, you get to some pretty catastrophic implications both for China and for the world. And so, Beijing has been eager to try to, what they call, rebalance economic growth, to move it back towards more sustainable, more labor-intensive light industry and services, and away from that energy-intensive heavy industry. If they&rsquo;re able to do that, there&rsquo;s no reason why the economy can&rsquo;t grow at 8% or 9% for another decade while being environmentally and energy sustainable. It wasn&rsquo;t because the country&rsquo;s leadership decided, &quot;This is what we&rsquo;re going to do.&quot; It was very unlike Mao, where a couple of elite leaders said, &ldquo;We&rsquo;re going to make steel. We&rsquo;re going to make cement.&rdquo; It was, instead, hundreds of companies responding to incentives that they faced day to day, and doing what seemed profitable given their costs. And since environmental externalities, as economists say, aren&rsquo;t included in the cost of production in China, because environmental enforcement costs are low, because the cost of energy in a lot of places in the late 90s was very cheap, it made sense to do that type of activity. And you saw a lot of companies investing in it. In addition, local governors, at the provincial level and then local officials, at the township level, were eager to see these big, prestigious projects, like steel projects, and cement projects, take place in their province. Because they came with large price tags in terms of investment. And so, you would see governors and mayors trying to attract investment in these energy-intensive industries, even if investing in 1000 textile mills would have been more productive than investing in one steel mill. That one steel mill came with more prestige and it was an easier way to go collect taxes, rather than chasing around a 1000 small light manufacturers, you could just go to the one state-owned steel company and collect your taxes there.</p>

<p>What happened after 2001, and the big surprise, if I may so, is that the world economic growth was based on this extraordinary symbiotic relationship between China and the United States. The US was able to sustain high growth, with the exception of the post-September 11 recession, which was short and shallow recession. But, it was highly leveraged growth, and now, with the hindsight, we can say that this growth was fueled by very, very lax monetary policy, low interest rates, an almost irresponsible abundance of credit, a lot of debt, a highly leveraged economy, and cheap consumer goods provided by China, together with the financing for these imports of Made-in-China goods. So, China began accumulating huge trade surpluses, with the US even more than with the European Union. The trade surpluses became important with the European Union only later on, but with the US, almost immediately. At the same time, these surpluses were recycled through the reinvestment of currency reserves into US dollar-denominated securities, mainly Treasury bonds. So, this was rather extraordinary. You don&rsquo;t find in world economic history a precedent of the most advanced and richest economy running a structural deficit and becoming a structural net importer of capital from an emerging country. This is a very, very strange situation. Britain, at the apex of its empire, was a net exporter of capital. Britain was a net investor in the rest of the world. So, it is a very, very exceptional situation, and this was certainly one of the recipes of the boom.</p>

<p>He saw WTO as a way to accelerate domestic economic reform. As a way to cement it and hold China accountable for it, internationally, which puts additional pressure on China simply as a matter of face. He certainly believed in a more rapid acceleration in growth. I don&rsquo;t know that even he could have seen how rapid that acceleration was. I always thought, in line with this, that there would be an acceleration in growth. I didn&rsquo;t see how extraordinarily rapid and robust it would be.</p>

<p>I'm an economist by training and for 25 years headed up Morgan Stanley's Global Economics Team. And it was probably the Asian financial crisis of '97-'98, when the region that was supposed to be the new miracle for the global economy was in shambles, and our economics team, like most, we were just behind the curve, we had no idea what was going on. We were marking our forecast for Asia and for the global economy down by a significant amount literally every week and one of these sparkling gems after another toppled: Thailand, Korea, Indonesia, Hong Kong. You name it, it was in trouble and it quickly became evident to me that China would hold the key to the endgame. I don't know why I thought that, but I felt it in my gut. That if China went the way of Thailand, Indonesia, Korea, who's to say what would stop this crisis? So, I'd been to China a few times before the late 90s, but in '97, I just was determined to bore into China and started going there every other month. And it became evident to me very, very quickly that China was cut from a totally different cloth than the rest of Asia, that it was not going to go down the road of currency devaluation, reserve depletion, going to the IMF for adjustment assistance. That China was going to stand on its own, hold the line on the currency, actually accelerate the pace of many of its reforms and use its large saving as a reservoir to stimulate counter-cyclical fiscal spending. So, I got really hooked on China, saw what they did, and I think, to this day, their actions were decisive in arresting a very powerful pan-regional contagion.</p>

<p>In this particular instance, China&rsquo;s opacity, lack of transparency, and lack of openness, worked to its advantage. These are banks that are, to this day, heavily controlled by the government. They might have foreign partners, some of them might have spun off shares, but they are basically still, and they certainly were back in '96-'97, dominated by national government policy. So, it was really not a betting against them, there was really not a breaking of the banks or of the currency. Now, the government did something else that turned out to be quite memorable for the rest of Asia, which was that in the face of these torrents working their way through the financial system, there was a temptation to devalue your currency as a way of continuing to be competitive in global markets through your exports. And China, for a lot of different reasons, did not do so. I think it was seen as a position of strength, or a move by China to try to forestall further devaluations that might have happened by other countries to remain competitive with China were it to have devalued. I think to a certain part, this was really just realpolitik.&nbsp;To alter the value of your currency is a traumatic event, particularly in economies with profoundly rickety financial systems. And, even today, China has a rickety financial system. And back in '96-'97, the shocks and aftershocks that it might have caused, and the dislocations in the banking system, or in the export market, if it were to have taken a sort of radical step with its currency, might have been highly counterproductive, so it chose not to. But that was seen as a bulwark in Asia and something that China got some good PR points for.</p>

<p>I think that, generally, we can say that China was lucky. But, simply using the word lucky doesn't explain the processes behind the growth. The core of it is that the 1997 Asian crisis had a huge impact on the region. But, at that time, on the one hand, China did not have a floating exchange rate regime, so the impact on China was not direct. In the first half of 1997, China started to adopt active fiscal policies, similar to what you'd call stimulus plans. From '98, it started to adopt active monetary policies. These macroeconomic policies had important effects. At the same time, China went through two major reforms, and these reforms helped, because China's fiscal and monetary policies directed investment towards manufacturing, the production of goods. But what about demand? Who is going to buy these products? In 1989, China started housing privatization. As you know, outside of the villages and countryside, most of the housing in the cities was distributed by the government, it was government owned, and living spaces were very small. So, from 1989, when they started the privatization of housing, on the one hand, the existing houses were privatized, and on the other, this stimulated demand for housing; people discovered that they could buy a house and the government would even provide them with subsidies. A huge impulse was domestic demand [due to housing privatization]. Another aspect was that in 1999, China began talks on the General Agreement on Tariff and Trade, and in 2000, formally joined the WTO. After that, China benefited hugely from being open to the world, Chinese products could now enter into the markets of various countries. This period of development occurred almost exactly when China had accumulated the productivity of the past 20 years of Reform, so China's economy, in recent years, has been very strong, especially in the past 10 years. Last year was the 30th anniversary of the Reform and Opening, but it was in the past 10 years, amid the many problems faced by the Asian region, that China, alone, performed well.</p>

<p>I returned to mainland China in the early 1990s, and when I was in China, the Chinese had no concept of what a company was, they only had enterprises. And, at that time, a state-owned enterprise was really just an arm of the state, and they fulfilled the designed role by the state for each of the enterprises. Which was, of course, a very different notion than what a company is all about. But, over time, many of the Chinese enterprises turned into companies. But, when they interact with multinationals they actually find out that, &quot;Hey, there's actually another way of running a business.&quot; And so, the Chinese companies were trying to learn from the foreign companies in many different ways, not only about technology and about products and services and so on, but, importantly, the Chinese were trying to learn about management practices, about corporate governance and the legal aspects and so on and so forth. And Chinese companies are very curious about this, they are eager to learn, because the very best Chinese companies are actually very ambitious. Many of them, of course, want to be the leaders in their industries in China and also, an increasing number of them would like to become international companies of their own right. And, in the Chinese way of saying, they want to go outside. So, more and more Chinese companies are coming to us asking us to help them design their globalization strategy. How should they internationalize? Which markets should they go to? How should they set up their product strategy? Should they form local partnerships when they go outside? And so on and so forth. So, the Chinese are learning a lot, and they continue to be very ambitious. They are believers in a lot of experimentation. They don't necessarily want to get everything sort of precise and right. They'd much rather try something, if it's 80% right and see how the market responds and then adapt. So, they work at a rythm that is much faster than the usual competitor in western multinationals. Whereas typical multinationals would typically operate in this manner, the Chinese would typically operate in a much faster rhythm. So, by the time the multinationals are ready to make decisions, the Chinese have already made cycles of decisions and have learned a great deal through their experimentation. So it's very dynamic, but we've seen more and more Chinese companies who are able to leverage this kind of model to grow very fast and more and more of them have become bonafide competitors to the multinationals and the multinationals have found it, in many cases, very surprising to see this kind of new competitor which operates in a very different way than the traditional multinational competitor.</p>