What Is China?

The following post is a reprint of last week’s January 4 issue of the Strategic News Service Technology Letter.   At the request of our members, we are hereby authorizing distribution of that issue to the general public.  If you find this blog useful, please point to it in your own blogs and writings.

This issue is retroactively dedicated to my friend Sergey Brin of Google, for having the courage to say No to Chinese censorship.

» What Is China?

 Most people probably assume that the reason for China’s enormous economic growth rates is simply size: anything powered by 1.2B people is bound to make a big splash. But India, with the self-proclaimed “oldest democracy in the world,” is about to exceed China’s population.

 What makes China so different?

 Westerners remember China’s turn toward “socialist market economics” under Deng Xiaoping (Teng Hsiao-ping). Deng was a political adept who outmaneuvered Mao’s hand-picked successor, Hua Guofeng, and often ruled without a specific single title of power. (See our “Takeout Window” for more biographical data.)

 Deng once said: [chinese characters]

 Translation: “It does not matter whether the cat is black or white; as long as it catches the mouse, it is a good cat” (commenting on the whether China should turn to capitalism or remain strictly in adherence with the economic ideologies of communism). Westerners assumed this meant that Deng, the pragmatist, was turning China toward free markets.

 Deng did not turn China into a market economy; far from it. Here is a quick description of early Deng achievements, from The Hutchinson Encyclopedia:

 “By December 1978, although nominally a CCP vice chair, state vice premier, and Chief of Staff to the PLA, Deng was the controlling force in China. His policy of ‘socialism with Chinese characteristics,’ misinterpreted in the West as a drift to capitalism, had success in rural areas.

 “His reputation, both at home and in the West, was tarnished by his sanctioning of the army’s massacre of more than 2,000 pro-democracy demonstrators in Tiananmen Square, Beijing, in June 1989.”

 In summary: the fellow who brought market economics to China, really didn’t. Instead, he helped install an economic model designed to gut its trading partners, described in detail below.

 Too often, today, sloppy thinkers and Western optimists assume that China is just a Big America, or a Big Vietnam, or a Fast India – or their Next Big Business Partner.

 Wrong. At a time when the world thinks the communist model has been proved obsolete, China remains a communist country. In fact, under the current leader, Hu Jintao, human rights in China have recently suffered and are now in serious decline, according to Amnesty International-USA, the Committee to Protect Journalists, Human Rights Watch, and others.

 China has tens of thousands, perhaps hundreds of thousands, of human censors monitoring citizen clicks and comments on the China government–controlled Internet. When my friend’s teenage daughter (a U.S. citizen) taught English there last year, police came to her apartment and grilled her about specific computer entries she had made. When one of Australia’s top mining firms, Rio Tinto, refused to allow China’s Chinalco to double its ownership interest last year (to 18%), China arrested local CEO (and Australian citizen) Stern Hu and three managers, who remain in jail today, under espionage charges. China denies any connection. In politics, thought, and business, China remains a police state.

 We all refer to China as “China” now, as though it’s just One of the Gang, like “Ohio” or “Denmark”; after all, it’s a member of the G7, right? Just another market economy finding its way in the global river of events —

 No, it’s not. And it isn’t in the G7. In fact, it isn’t even part of the G8, which includes Russia.

 So now ask yourself: When is the last time you called Communist China, Communist China?

 You’d better get used to it. There is no indication that the Chinese Communist Party has any intention of giving up any power at all, or of changing its power structure. In fact, discussion of anything political is basically off limits inside China; it is not done. Ah, you heard that there were some small moves toward shadow property rights in China? Sorry, that move has recently been reversed.

 Wait, you say – what about the spread of democracy, at least in town and provincial elections? Didn’t Hu Jintao just give a speech praising democracy? Well, that turns out to have been another false start: today, democracy seems to be declining rather than growing, and it never reached the national stage. In fact, these days Hu is insisting on a new policy of “no debate” on government decisions, even (and especially) at the highest levels.

 It is time to look at China, not for what it says, but for what it does, and to judge it accordingly. It is time to tell the truth about what Nobelist Paul Krugman calls “a misbehaving superpower,” rather than letting misplaced greed dictate the conversation. China is not what we hope it could be. China is what it is.

 Those who take this new tack will have a differing view, in general, from the global media – and a much more accurate one.

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What Is China?

 Most of our readers are more interested in the economic aspects of this question than in issues of human rights, media control and censorship, military buildup, or the country’s increasingly interesting international political alliances. All of these areas are worth study, and, in general, all veer from the view generally portrayed in Western media. The story of an increasingly aggressive Chinese navy, about to become a Blue Sea (open water) force with its own carrier fleet, buttressed by continued additions of attack nuclear-armed submarines, is not much told, although I can’t see why not.

 The successful Chinese shoot-down of a satellite by a land-based missile got media attention, for a week. But it should be taken on a much more serious level, as a direct threat expression against any nation intending to use satellites in war.

 The now-documented cyber attacks by Chinese-sourced computers against Western economic and military targets, suddenly ramping up on a straight line for the last two to three years, deserve more public conversation. Recent estimates are that 80% of such global attacks on U.S. economic, infrastructure, and military targets come directly or indirectly from the Chinese government and military.

 And China’s continued shipping of weapons and parts to Iran, and general violation of U.N. sanctions against North Korea and other dangerous nuclear wannabe states, is disconcerting at best.

 But in this discussion we will focus on economics, both because it is in SNS members’ near-term interests and because the successful implementation of Chinese economic policy enables all of these other programs.

 What Is the Chinese Economic Model?

 Although the politics of China remains communist, the economics might be called Advanced Mercantilist. China has taken the lessons of Japan and South Korea in dealing with the West and modified them with “Chinese characteristics.”

 Here are the basic tenets of the Chinese Model:

 1. Steal Intellectual Property. IP represents the crown jewels of the global economy; they are the peak achievement of Western civilization, and of all of China’s competitors. China steals IP daily, in every possible way: through force, through simple copying, through reverse engineering, through industrial and government espionage, through common theft. China also has a national policy which prevents non-Chinese firms from selling in China unless companies transfer their most valuable IP to China as the price of market access. The clueless ones obey; just ask Boeing.

2. Use Slave Labor Rates to Become the Low-Cost Producer of All Goods and Services. If you are building a downtown tower in Shanghai (and there are a lot of them, many empty), you may not have to pay some of your workers for six months to a year. Or you fire them just before that: free labor! It doesn’t work that way in Chicago or Paris, does it? With 800MM country folk in line for coastal jobs, there is perhaps a 30-year supply of poverty-level wage earners happy to make export goods at below global cost. The rest of the world’s workers are paying, with their own jobs, for this unhappy result of near-term Chinese economic history, and of the past actions of the Communist Party.

3.Sell Stolen IP Back As Global Exports. Japan opened this model, but China has perfected it. In addition to the usual pirating of IP, for domestic markets and for export, there is a new twist that further harms the global marketplace. It isn’t enough to find Windows – or a foreign film on DVD – for sale for $1 in Hong Kong these days. How about in Nebraska, California, or Texas? No global market is secure from pirated IP.

4. Industrial Policy: Subsidize Key Industries. Japan also started this idea, but China takes it much further. Originally, the government (or the People’s Liberation Army) owned virtually all large enterprises, but even today, it retains  strong interests in most key export companies, which makes government assistance less transparent. Many outsiders assume they are dealing with “real” companies, when they are actually dealing indirectly with the Chinese government. Examples of subsidization and export dumping would include tires and, more recently, steel exports (sound like Japanese history?), now being tariffed by the E.U. and the U.S.

Look at the big sales of wireless 4G LTE gear in Europe for the last six months, and ask the local competitors (Nokia Siemens, Alcatel) why they can’t match price, and have been losing out to Huawei and no-brand upstarts from China? Or why the final (China) bid price is sometimes as little as 10% of the European group bid price average? Does this sound a bit like Japan in the U.S. TV market back in the ’60s and ’70s?

Here is a rather fascinating question: Given China’s model, is it possible that ALL exports in government-selected industries represent poverty labor and subsidies, and therefore the practice of dumping?

5. Prevent (or Restrict) Unwanted Imports. Use structural rules to prevent any real competition in your domestic market in any areas targeted by industrial policy. (Example: wind power equipment sold today into China must be made using Chinese manufacturing tools, and must fit a non-standard Chinese watt figure.) China has chosen the original path of allowing two kinds of imports: food and raw materials – the latter for making things to be value-added and exported back to the seller – and industries such as cars and planes, in which IP needs to be stolen domestically before the local industry can be created.

Members will note that both the auto and aerospace industries are just making this turning point during 2010, and China will soon be an exporter in both markets.

6. Use Currency Manipulation to provide artificial aid to your export companies. Why play fair? The Japanese perfected this through currency market (forex) intervention, but the Chinese did them a step better, by locking into the (U.S.) market they wanted to parasitize. This “dollar peg” recently has had the added benefit of devaluing the yuan vs. virtually all other Asian and emerging-nation currencies as the dollar dropped, giving China a further global competitive edge and enraging past trading partners, from Brazil to Indonesia.

7. Price for Export, Suppress Domestic Consumption, and use domestic savings to drive the above policies. While everyone is talking about how wealthy the new Chinese coastal middle class has become, they forget that there are another 800MM+ Chinese still waiting inland on the farm for anything good to happen to them. Despite the latest boom, the Chinese people are still among the top global savers. China seems to be allowing faster wage growth, and is encouraging domestic consumption, more than Japan has.

China has further modified this Japanese model by building domestic investment pools through imbalance of trade accounts, the direct result of the policies described here. China is no longer a poor country; it now holds the largest currency reserves in the world. This leads to a big public relations issue for the country, as the rest of the world asks anew: What is China?

8. Create the Appearance of Free and Fair Trade, Without the Fact. By making certain promises for the future, and by pointing to talk vs. the action inherent in the  above policies, the global community somehow allowed China to join the World Trade Organization, although, in fact, China  has not signed off on all of the WTO requirements, which might surprise less-informed members, and it regularly loses cases before the WTO. Even so, China achieved its primary goal: market access around the world, which is key to its own mercantilist model working properly. The results have been spectacular: on Wednesday morning, the Wall Street Journal declared China the new leader in global exports, beating out Germany and the U.S.

9. Encourage Foreign Direct Investment – But Don’t Allow Controlling Ownership. We’ll take your cash, the message is, but you don’t get anything for it. Sure, outsiders can invest; but we’ll hold all the poker chips. This is China’s improvement over the Japanese and SK models, and it is a meaningful one. Japan has since become the largest source of FDI in China. But the Japanese are smart: they build assembly plants, not design and production plants, and leave their IP at home.

Does this combined policy set sound anything like free markets, or free trade? Not at all. China has made use of markets only on the most limited basis. If you doubt it, take a close look at Chinese banks.

I have found myself increasingly frustrated by the gap between what the media seem to think about the Chinese model vs. what it appears to me to be. At our recent SNS Annual Predictions Dinner in New York, I mentioned the uneasy relationship between reality and the public Chinese GDP figures. When they were publishing 11%, I was figuring 11%-15%. Then publicly announced rates dropped to 6.5%, at which point the government spent about 3X more than the U.S. on stimulus (on a GDP basis, but there you go again) and brought it right back up to its pre-announced, politically required sweet spot: 7.5%-8%.

This is not a market, it’s a lever. Want a different number? No worries.

 Earlier, while speaking to the Orange Wireless CIO Forum in Hampshire, England, I read the audience a quote from the Financial Times which perfectly described the problem, and which I will paraphrase here:

 “The top two Chinese banks announced record profits this quarter, although note must be made that, in this case, the definition of costs and revenues, and therefore profits, are dictated by the government. Their stocks subsequently rose in Hong Kong.”

This is not a joke; it’s the FT. Revenues and costs are decided by the Party, so profits are decided by the Party, then “free market” equity trades occur on the Hong Kong stock exchange as a result. Are you kidding?

Chinese banks are not banks; they are cash distribution pipelines, generally controlled or heavily influenced by the government. Selective industries are fed loans, based on the flavor of the week, on terms dictated from above. When the pipelines are empty (as they are now), the government just inserts more money into the other end.

(Yes, in the days of the TARP, one is forced to make the comparison to recent U.S. and U.K. behaviors; but these are a “bailout,” and the Chinese banks have operated like this for years. Unlike their Western cousins, they are supposed to operate like this.)

What can one say about an economy in which numbers are not numbers and banks are not banks?

So, before the world continues on in its near-breathless wonder at the Chinese Miracle, let’s reassess:

It pays to steal IP, to use slave labor wages, to lie about trade practices, to ship pirated goods into foreign markets, to force IP disclosure in return for limited market access, to subsidize exports, and to manipulate currencies. Is there any part of this that is legal in international terms, or that should be applauded by the world community?

Not that I can determine.

Remember how China dealt with 3G – at the time, the most important (patented) technology in wireless communications in the world? Instead of letting out contracts to foreign firms, as all other countries did, China stole the IP from Qualcomm, with some help from Siemens and perhaps local firm Datang. It took years to reverse-engineer and then differentiate the tech into TD-SCDMA, now coming to China’s consumers about five to seven years late.

When will the world catch up to this kind of charade? The answer just might be: now.

I think there have been two turning points, and we have just recently passed both. First, China’s “friends” suddenly find themselves equally the victims of China’s model, their currencies undercut by 30%+ per year, and their trade balances going deeply into the red. Surprise! Suddenly they, too, can see how the model works, and the U.S. doesn’t look quite so stupid anymore.

And second: Copenhagen.

China appears to have gone to the December Copenhagen meeting on climate change with the intention of blocking a major agreement while scoring political points against the U.S. In practice, perhaps thanks to some quick moves by President Obama, the opposite seems to have happened. (See “Quotes of the Week.”) By sending a lackey in Wen Jiabao’s place to leadership meetings, and then blocking agreements, while Obama came up with a global financial solution to the rich/poor debate, the tables were turned on China.

There is even some talk that Obama and Secretary of State Hillary Clinton were tipped to a secret “blocker’s meeting” being held between China, Venezuela, Brazil, and a few other countries, which they literally “crashed” (walked in on, uninvited) and turned to their advantage, bringing Brazil back to the table.

China came out of Copenhagen appearing to have played a saboteur’s role, and no one in the world (except Venezuela’s Hugo Chavez) is happy about it.

 Who’s Counting?

Without accurate or standardized accounting, even China’s equity markets are intrinsically dangerous, insofar as there, too, the numbers are essentially made up, or are arbitrary at best. And without the rule of law, specifically as regards theft of intellectual property, there is literally no way of the nation getting from where it is now to where the civilized world is now, without decades of work on judicial and legal infrastructure.

And then there is the issue of a command economy in the modern world. One recent study on Chinese pricing found the equity market vs. real estate market pricing with a 7X larger gap than was found in Japan, just before its own real-estate bubble collapse decades ago. Clearly, there are asset bubbles inside China: real estate is overpriced while apartments and offices lie vacant in huge numbers in the cities. China-made steel has gone from under- to over-supply, and is now going begging on the global markets.

Indeed, the global outcome of a fast-growing command economy has been the government-determined explosion of asset bubbles all over the world – not because China is growing, the cause assumed by most economists, but because the government is buying resources (and their future options) on the global market, forward for 5-20 years. The result: instant commodity asset bubbles, worldwide, and further destabilization for non-Chinese consumers of these commodities. Of course, if the Chinese play the bubbles wrong, they will lose even more as prices collapse.

Could the Chinese create a global catastrophe by commanding all of this leverage into the wrong assets at the wrong time, by deflating the value of high-IP goods, by forcing global competition against unsustainable cost bases, and destroying non-Chinese business infrastructure? Sure. In fact, this is almost a “when,” and not an “if,” question. What could possibly be more dangerous to the world than a command economic system run on a global scale?

(One good answer: five evil traders on the 7th floor at Goldman Sachs.)

In summary, China should not be treated as though it were just another fast-growing free-market nation, with inevitable road bumps making things a bit uncomfortable; it isn’t. China is a top-down, completely controlled system, running on a zero-sum economic model made to produce one winner, and many losers.

 So What Is China?

There is nothing like it. It is a communist country that has fooled the West out of its money, and the West has been only too willing to go along for the ride. Now, as China’s other trading partners come in for the same rough treatment, it is becoming a global pariah, and its excuses and delays are increasingly falling on deaf ears.

What can its trading partners do to help bring China into compliance with global economic practice? Insist on actions, not words. Use tariffs when dumping, subsidies, or internal structural market blocs are the issues. Insist on justice where IP is involved. Do not disclose IP to China, under any circumstances. Stand up for your own rights and property; refuse to be bullied. If you can’t trade there, trade elsewhere. Make sure that goods made in China do not use slave labor, in one form or another. Make your goods somewhere else.

Instead of rewarding outrageous behavior, condemn it, in public.

Ask politicians and leaders espousing free-trade bills whether they have thought through the result of free trade in a rigged game, in which all of the cheapest goods and services are made by China? Stop shopping at Wal-Mart, a wholly-supplied Chinese distribution system.

Do not be shy about tariffs: it is the one thing that can go wrong for the Chinese economic model described here. If China stops buying our goods, what happens? Boeing takes a hit. (This was coming anyway.) If we stop buying Chinese goods, what happens? It would be the end of the Chinese model, and the Communist Party knows it.

Require fair trade; refuse extortion. Tell the truth about China’s tactics. Become an economic locovore, not just eating local food, but buying local goods and services.

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