Investors,
For the past two weeks I backpacked along the southern and eastern coast of China and found a very different country than I expected, simultaneously more modern and more authoritarian and culturally isolated. My tour included the wealthier and more modern areas of Guilin and Yangshuo in Guanxi, Shanghai and nearby Nanjing and Suzhou, and Beijing. I focused on trying to understand modern China from a business and investment perspective. The basic themes prevalent at every level of society and business were cultural isolation, materialism, and exploiting the outside world by any means necessary. I'm more confident than ever that China's domestic demand will grow exponentially and the Chinese people will quickly gain managerial, marketing, and engineering expertise...but this will not necessarily translate into returns to foreigners. The Chinese Communist Party (CCP) and People's Liberation Army (PLA) play a deeper role in commerce and the public markets than many suspect. The government is pursuing policies to exploit western commerce while remaining economically and culturally isolated in critical ways. China is a dazzlingly large and complex place; with 1/4 of the world's population and the largest economy within a generation, we have every reason to try to understand it.
Infrastructure and Travel Limitations My first surprise was both the success and authoritarian nature of China's investment in infrastructure. China's highways, airports, long-distance buses, and high speed trains all put the US to shame. Shanghai's subway system was second only to Tokyo among the cities I've visited, and the regional airports and train stations were highly efficient. The authoritarian counterpoint was that China has extreme restrictions on travel for domestic citizens under the Hukou (household registration) system. ID cards and intense security are employed for all inter-city travel. Poor Chinese are basically forbidden from traveling to major cities. For much of the trip, I traveled with my friend, the brilliant UCLA MBA student Arun; he's spent a great deal of time in India and contrasted Shanghai with cities like Mumbai or Delhi where beggars fill the streets. Throughout my travels in China I encountered virtually zero begging and almost no homelessness. This reflects the travel restrictions, and quick action of the police to relocate the beggars away from prosperous areas. Putting aside the question of morality, this has helped attract foreign capital and modernize cities like Shanghai with remarkable speed.
The epitome of China's recent construction is Pudong, the new financial district in east Shanghai. Twenty years ago, Pudong was literally boggy farmland. Now it hosts a modern financial center (likely to become Asia's predominant center of finance within a decade) and some of the most impressive architecture in the world. The eastern part of Pudong consists of residential compounds for the very wealthy. I briefly stayed with my friend's family in this area and was surprised by the isolation. Within these new gated communities sits mansion after mansion with a surrounding tiny 0.5 acre yard, live-in help and paid driver; in front of many houses were two or three ultra luxury European cars. The mansions are occupied by a mix of rich Hong Kongkese, Communist Party bigwigs, foreign executives, and a few rich mainlanders. While the mansions all look gorgeous, they are poorly constructed and epitomize a theme of Chinese production; shoddy craftsmanship is considered the rule, even for luxury goods. I should note that Shanghai's gleaming modern skyline was constructed mostly by state owned companies; the holy grail of Chinese modernization is more like Singapore on steroids than western style capitalism.
Cultural Isolation and Chinese Youth While most Chinese study English in school, the young Chinese told me that they felt it was perfunctory; the government actually discouraged serious attempts at fluency. Western English media is either censored or strongly discouraged, and most Chinese feel like English is unlikely to be useful for them. This made communication difficult; my attempts at speaking a handful of Mandarin words from my guidebook were mostly met with blank stares, probably because of my poor use of tones and the limited experience of the Chinese at hearing their language mangled by foreigners. The lack of English language is likely to be a persistent obstacle to China's international economic growth. English has become firmly entrenched as the international language of business, and China has among the lowest English fluency of any country in the world, (maybe excepting countries with mastery of other imperial languages, like Angola).
Economic inequality in China is a cliche, but I was surprised to find a stark three tier system of both income inequality and economic freedom. First are the rural (and semi-industrial) poor. The poorest farmers (more than 1/4 of the country) use primarily 18th century technology to farm small plots of land in a lifestyle that is probably not all that different from two thousand years ago. Bridging the gap to modernity are the temporary factory workers; young women in particular move to factory towns (and live in factory dorms and eat factory cafeteria food) for a few years and then return home with their saved money. These people are restricted in their movements and live in under the thumb of CCP authoritarian rule. The second tier are the educated "middle class." Generally young, well educated, ambitious, and materialistic, these people live primarily along the coast. I believe one of China's biggest problems is the perceived ceiling at the top of this class. I spoke to a twenty-something accountant working for Deloitte in Shanghai. He said that if he works hard and does a good job he can achieve a comfortable middle class lifestyle, but without family connections in the Communist Party he will hit a wall. Because of this, he and many other people like him feel that the best opportunities are outside of China; he wants to move to the US, New Zealand, or Australia. As an aside, he said that middle class Chinese don't want to move to Europe because they view it as a "sunset society." The middle class is carefully monitored but generally enjoy free movement and can easily evade authoritarian limitations like the Great Firewall and capital controls (more on this later). The third tier, a tiny proportion of the population, probably less than 0.10%, is composed of the very rich. These are Hong Kongkese, foreigners, top Party Officials, and Red Guard elite; they are functionally exempt from all authoritarian controls as long as they avoid displeasing any political leaders. At this level, political connections and wealth are easily converted from one to the other. Political "entrepreneurs" have purchased the title of provincial party secretary for as much as $500,000; the few cases we learn about are of entrepreneurs who were later convicted for corruption, usually taking several million dollars in bribes within a few years of gaining their new post.
Young Chinese care little for politics. They share a general pessimism about the structure of Chinese society and view the Party as monolithic and unbeatable in the medium-term. In the words of one Chinese professor, "[The youth] may risk their lives to steal money, but they will not do it to attend a political demonstration." The Chinese twenty-somethings I spoke with all shrugged when asked about the long-term prospects for reform. Their focus is on advancing their own position and that means cozying up to the party or leaving China. One young Chinese professional told me that in college, talk of politics was discouraged and students were generally uninterested. The Chinese youth are conservative in other ways as well; pre-marital sex is uncommon, drug use is unheard of, and alcohol and tobacco play a very minor role. When asked about China's economy, they were optimistic, but less so than most westerners. They think a significant portion of China's recent growth has come from unsustainable government spending on infrastructure.
I ran into the "Great Firewall", China's method of controlling the internet, when I attempted to purchase a book about China for my Kindle from Amazon while in staying in Beijing. The internet connection timed out for 2 minutes. The exact rules of China's firewall are constantly changing and opaque. Basically, it slows down all internet access of sites outside China and prevents access to "distasteful" materials like pornography and any news or commentary critical of the CCP. It can be easily and legally circumvented with a proxy or virtual private network (VPN). So why does China bother if it's so easy to ignore? While anyone can easily circumvent the firewall, it plays a powerful role in controlling the media that most Chinese consume. A Chinese woman can do a search on Baidu with servers located within China and get lightning quick responses, or she can access a slow and censored google, or buy a VPN to access uncensored google. For most Chinese, they simply don't bother using anything but Baidu, because they have no reason to. It never occurs to them to do an internet search for "CCP official embezzlement" because they're never confronted with those kinds of stories in the first place. As Americans, we're frequently confronted with stories that are distasteful to the government, like say Abu Ghraib torture, without having to do a specific search for it. The Great Firewall lets the elites access whatever they want, while the vast majority of the country is content to consume the media approved by the CCP. Another effect of the slowing of external sites is that all media companies that want to produce for the Chinese market must locate their servers in China, which places them under the power of the CCP. The result is primarily self-censorship with the occasional arrest of a dissident blogger or raiding of an internet server center. A random aside, Baidu not only censors on behalf of the CCP, it sells Chinese companies the right to hide negative search results.
Party Rule and the People's Liberation Army China is a blend of a benevolent Singaporean style autocracy, a capitalist development state like Japan, and robber-baron socialism like Russia. For national matters the Party enjoys complete central control. China is run by 9 people, the Party's "Standing Committee." These are selected from the 25 person politburo who are selected from the roughly 370 person "central committee." The People's Congress (about 2200 people) periodically rubber stamp these rulers. The Chinese state firmly retains a Leninist structure - mirroring the state at every level is the parallel but superior Party. Hu Jintao is the state president, but more powerfully he is the party secretary. The key to the CCP's control is the power to appoint and remove personnel. The CEO of every large company, the president of every major university, the chief of every police bureau, and every provincial governor serve at the pleasure of the CCP and are appointed by the completely secretive "Organization Department." The result is that all the major commercial and political organs serve state interests when so ordered. In 2009 while western governments were imploring big banks to lend, the CCP ordered Chinese banks to do so. In the west, bank lending shrunk; in China it surged 50%. “As an organization, the Party sits outside, and above the law. It should have a legal identity, in other words a person to sue, but it is not even registered as an organization.” – He Weifang, law professor.
It's critical for investors to understand that the western style boards of large Chinese companies are a facade. A party committee oversees all major strategic decisions of these companies and has final say. One striking example was in 2004 when the CEOs of China's largest 3 telecom companies were "shuffled" with no prior warning. One of the CEOs was on a roadtrip in the UK to pitch investors on an upcoming share sale when he was abruptly informed by the CCP that he was to immediately resign his current post and take control of his primary competition. It was as though the CEOs of ATT and Sprint suddenly announced they were switching places. In 2009 the exercise was repeated with 3 major airlines. Similarly, western investors need to understand that there is no independent judicial system. Judges are completely under the thumb of the CCP.
It's worth noting that the centralization of power is complete only for national matters. Provincial governments and townships enjoy tremendous freedom, largely because Beijing lacks the power to enforce their authority far beyond the city limits. In my readings, I found numerous examples of local leaders ignoring Beijing edicts from the Cultural Revolution to the present day. In general, the recalcitrant officials are not openly rebellious, rather they pay lip service to Beijing and just substantively ignore the CCP orders. On rare occasion CCP leadership will make a show of jailing or executing these leaders, usually under unrelated corruption charges. While the most egregious cases of corruption are prosecuted (e.g. Li Gang and Ma De), for the most part local officials are allowed to be corrupt as long as they stay under the radar and support the Party. Additionally, on very rare occasions there are obvious rifts within the power structure of the CCP, as when Jiang battled Hu over Shanghai corruption in 2006.
The People's Liberation Army (PLA) has one purpose - to keep the CCP in power. Another way of phrasing the same proposition is that the CCP relies on the PLA to maintain its power. The recent state and Party leaders Jiang and Hu spent an inordinate amount of time visiting military installations to maintain this support. While details are unclear, it appears that in the Tienanmen square uprising in 1989 a significant percentage of soldiers and commanders were reluctant to attack their fellow citizens (aka the treasonous protesters). The party responded by strengthening its oversight and integration with the military. The PLA has always been involved in the economy. Sometimes recruited to work on industrial projects, they have also invested in companies and stated businesses to boost their meager budget. In the 90s, the CCP ordered the PLA to divest most of its economic interests, but PLA leadership remain among the wealthiest Chinese with tendrils that reach into every industry. One American businessman who spent years working with Chinese factories told me that many of the factories he dealt with were secretly run by a single PLA gang; he learned this when investigating why factories that should have been competing with one another were instead acting as a cartel.
Contrary to this picture of a reactionary and unchanging leadership, both the Party and PLA are rapidly modernizing in their own way. The Party has started eagerly recruiting the brightest students from college and inviting star entrepreneurs to join their ranks. The PLA has become much more merit based and is working to become a modern military. In this way, the leadership has created a social safety valve by offering the ambitious but unconnected a way up the ladder, while simultaneously improving the skills of the ruling class.
History It's worth taking a slight historical detour here. There are some themes that recur throughout China's 3000 year past that I believe are still in play. First, modern China sees itself as the descendant of Imperial dynasties that ruled the Han people (representing 92% of modern Chinese). While China actually spent about half of its history in more of a federalist system and much of its time under foreign (i.e. non-Han) rule, it's the imperial dynasties that consistently wrote China's history books and today form its political lineage. From around 50 BC, these dynasties employed a complex meritocratic system of staffing the bureaucracy. The theme of centralized power rippling outward through talented bureaucrats remains in vogue today. Second, China has never been particularly interested in international trade. In the BC era, China routinely turned away foreign trading missions, asking for only pledges of sovereignty and tribute in the form of silver. Even when it briefly ruled in the oceans around 1350 AD, China's fleets made a few trips to other countries to demand allegiance and then abandoned the routes out of a lack of interest in the resulting trade. In 1793, a British trading mission was famously told by Emperor Qianlong that China had no interest in British manufactured goods. The opium wars 50 years later were partly an attempt by Britain to eliminate the massive trade surplus China enjoyed as they exported tea and silk and imported mostly silver. I think today's economic policy reflects a similar sentiment but with a twist - whatever foreigners make that the Chinese want, they are determined to learn to produce themselves. This is of particular importance for western companies that hope to sell in China, a topic I'll delve into further in the next section.
Another theme from Chinese history is historical revisionism necessitated by the power of ideas. Most imperial dynasties burned older histories, executed the authors of non-favorable histories for treason, and ritually revised the past to make their own authority look like an obvious extension of the past. In the past century, China underwent several such revisions. For example, Mao disdained Confucius and cited the early Qin dynasty as exemplary. Today's communist party is reemphasizing Confucianism and disdains the Qin period as too authoritarian. In the mid 1800s, a group of nationalist Christians led the Taiping rebellion that resulted in a staggering 20 million dead. Mao's Great Leap forward led to a similar number of lives lost from famine. Ideas in China are powerful and the government correctly views ideas as weapons. This explains their aggressive censorship of seemingly benign intellectuals and religious leaders.
International Trade and Materialism Arun and I paid special attention to China's brands. So far, China has produced few brands that can compete internationally (Lenovo is a rare exception). Chinese companies have excelled at cheap manufacturing, but can they move up the value creation chain and produce a Nestle or General Motors? While we saw many examples of weak Chinese branding and amateurish advertising, we also saw some examples that should make western brands concerned. China has knockoffs of Starbucks, KFC, Nike, and just about every other major international brand that appeared well executed to my untrained eye. Ultimately though, I think it matters little. Chinese demand is likely to rise so quickly that China doesn't need to find a foreign market for its brands, at least not in the next decade. It has 1/4 of the world at home. That's a lot of feet to wear Li-Ning (the local brand equivalent of Nike).
The problem facing western brands trying to access China is one of regulation and price. On one popular shopping street in Suzhou, I saw a Nike store, Li-Ning, and then a tout selling fake Nike. The real Nike shoes cost about $160, Li-Ning was $60, and the fake Nikes (of lower quality) were $20. Most western luxury brands actually cost much more in China than in the US and Europe, despite being manufactured in China. One common reason is that the companies have export-only licenses so the goods must be exported out of China and then re-imported back in and face tariffs. Alternatively, KFC is omnipresent in China and faces no premium since there's no export involved. As investors, we need to distinguish between western brands that effectively do business locally (like KFC), and western brands that must import some element of the business (like Coach). At best the latter group will face an uneven playing field and at worse they could be forbidden from selling in China at any time. Foreign companies need a license to sell within China and this license is viewed as a privilege and can be revoked on a whim.
China has adopted a policy of requiring foreign corporations to form local partnerships. I spoke to a senior executive at Ford who explained that lately the Chinese have been demanding not only partnership in the ownership structure, but also in the high-skilled labor; Ford is required to locate a major engineering office in China if they want to continue to do business there. Unabashedly (and I'd argue very intelligently), China is aggressively studying the technological and managerial expertise of the companies that do business there. The Chinese government understands the idea of "smiley curve." In a product's life cycle, there is a lot of value created in the design and engineering phase, only a little during manufacturing, and a lot during marketing and retail. For example, of a $30 pair of headphones sold in the US, only about $3 stays in China. China wants a bigger piece and has the policies in place to get it. What does that mean for Ford? While I think that Chinese demand will grow fast enough to provide plenty of sales to both Ford and local brands, it ultimately depends on what line the Chinese government chooses to pursue. If they decide it's in China's interest, the government will not hesitate to withdraw the permits that currently allow foreign brands to sell within China.
The Chinese clearly intend to exploit western companies for profit, expertise, and as corporate police. One example of the latter comes from Macau (also spelled Macao), a small island south of China that was originally a Portuguese colony and is now a special economic zone of China. Macau has been a crime ridden center of gambling, organized crime, prostitution, and money laundering for much of the last century. One man, Stanley Ho, had a legal monopoly on casinos. Recently, the Macau government (with Chinese encouragement) invited a half dozen US casinos to establish operations in Macau. These casinos, including Wynn resorts, have their global operations scrutinized by the Nevada gaming board. They have to play by the same rules in Macau as they do in the US. As a result, they have a clear incentive to report unfair and illegal activity of their local competitors to the authorities and to establish infrastructure that rewards a clean gaming economy.
A key question concerning China's future is if they can generate the domestic demand to reduce their reliance on exports. I find it impossible to understand how anyone who has visited China could doubt that the answer is a resounding Yes. The Chinese are arguably the most materialistic people in the world today. The middle class Chinese are incredibly aspirational and consumption driven. They desperately want to improve their quality of life and understand that education and hard work are the way to get there. Contrary to the communalism imposed by the government, individual Chinese are entrepreneurial spirited. Everyone I spoke to supported the idea that most people in China are looking to improve their economic status quickly, either from temporary factory worker to skilled labor, or from mid-level auditor to investment fund manager. In Shanghai, conspicuous consumption abounded from knockoff Rolexes to genuine European luxury cars. The religious practices in China support this materialism. In the words of one young Chinese professional, the Chinese Buddhists are not really religious but just come to temple on rare occasion to pray for wealth or good test scores. This was in line with my observations at the Buddhist temples; the "prayers" available for purchase (ribbons or wood carvings with text) were for wealth, good test scores, a job promotion, or having a male child. While some books suggest that as many as 80% of Chinese are a member of one religion or another, the Chinese people I spoke with thought the real number was a small fraction of that. In China's early history Confucianism may have been an obstacle to economic growth since Confucius disdained merchants and trade. The Confucianism of China today ignores these tenets and emphasizes the ideals of a harmonious society and respect for authority.
The Environment and New Construction I was apprehensive about traveling to Beijing after reading stories of air so polluted that it made breathing difficult. In 2006, blue skies were a distant memory and on most days, you couldn't see more than a few hundred yards because of the thick smog. Remarkably, Beijing is less polluted today despite a doubling of cars on the road. In the government's 11th five year plan, released in 2007, the Chinese government fully acknowledged their environmental catastrophe. They publicly accepted that the pollution was reducing GDP by as much as 3% a year, killing tens of thousands of people a year, and reducing the expected lifespan of the general population. As a result, the government enacted some of the most vigorous environmental controls in the world. These included car emission regulations that are more restrictive than in the US and regulations and subsidies to put modern pollution scrubbing technology on factories and power plants. It's hard to overemphasize this point. The Chinese environment is still a mess, but they are devoting tremendous resources to cleaning up; China builds about 50% of the world's solar and wind plants and is investing $1 trillion over the next decade in renewable energy. The environment is a national priority at every level, from the top of the CCP to the average entrepreneur. Local officials are now judged on both environmental and economic metrics. While Beijing air remains significantly more polluted than Manhattan, the results were clear. On my last day in China, I was able to enjoy Beijing with clear blue skies. An obvious place to look for investment opportunities in China is in companies that produce "green technology."
My friend Arun and I debated whether China will face a hard landing in the next 4 years (I think so, Arun disagrees). I'd need another few pages to delve into the macroeconomics, but one turning point for China is clear. At least the current wave of real estate and construction spending is over. The Chinese government recognizes this and recently announced the construction of 30 million low income homes in the next five years. Critics argue that the "home" in question is sometimes as small as 150 square feet and little more than a berth for temporary laborers. Also, provinces are counting projects already underway as part of the new home construction figure, but it's still a massive undertaking. The goal is to support the construction and real estate markets while providing political cover for the CCP in case unemployment rises and GDP growth slows. Investors need to keep a close eye on such projects. The initial boom in infrastructure was largely productive; China needed highways and high speed rail. The next round may consist mostly of bad loans for "bridges to nowhere."
Conclusions Learning about China will be a lifelong endeavor as I chase a quickly evolving target. I don't pretend to understand China, but this trip and the associated conversations and readings have given me a rough sketch. First, China may claim to be the oldest surviving civilization, but it is a young and materialistic economy; it will continue the process of industrialization, urbanization, and especially, rapid growth in consumption. Second, China is authoritarian and savvy; the government is using their power to exploit western technology, expertise, and capital; success in China (or selling to China) requires dealing with the CCP. Third, the Chinese are incredibly aspirational and will work hard to advance in life; I believe they will likely reshape the nepotistic CCP structure around them (especially if the USA keeps stupidly denying visas to their best and brightest). China will continue its expansion as a global economic power. They will inevitably grow from the manufactures of the world to also challenge the west as engineers, designers, and marketers. The key question is: will they choose to isolate themselves or will they gradually integrate? Will the government focus on import replacement and continue to "protect" the population from foreign goods and media, or will they globalize?
The advantages of investing in a company like Ford that is based outside China, is that they have much stronger corporate governance and are subject to western laws. The string of recent Chinese accounting frauds is just the tip of the iceberg; investors in Chinese companies will be in for a bumpy ride for the next generation or longer as they find no legal system to protect them and few sympathetic ears in government. However, China may continue to block imports by restricting permits, employing tariffs, and giving home grown companies special advantages; if so, foreign companies that are attempting to sell to China may end up as poor investments. I haven't come to a satisfying conclusion yet, but I think the answer lies in carefully investing alongside mainland Chinese. For example, as the majority investor in the mezzanine debt in a state owned company, you are likely to find yourself defrauded. If you own 2% of the senior debt or equity of the same company, you are investing alongside the Chinese and the company's management will have a tough time singling out your investment for "special" treatment. If this analysis seems too paranoid, it's worth looking at other historical precedents. Large US companies routinely defrauded British investors in the 19th century through dilution of equity and subordination of debt among even less subtle methods.
China's booming economy and sheer size will offer tremendous opportunities for investment over the next generation. With some smart decisions and a careful approach, we can profit from what may end up being the single most important secular trend of our lifetimes - the rise of China.
Cheers,
Ari
Aside from my own observations and discussions with Chinese locals and expert foreigners, I am indebted to three books. "The Party" by Richard MicGregor is a phenomenal look at the modern Chinese political structure. "China: A History" by John Keay is a great overview of ancient China. "Postcards From Tomorrow Square" by James Fallows is a short collection of essays with some revealing anecdotes about Chinese culture.
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