China: Paper Tiger?

From: Rakesh Bhandari (rakeshb@STANFORD.EDU)
Date: Thu Aug 21 2003 - 01:18:40 EDT


FROM THE ARCHIVES: August 1, 2003

Why China Is a Paper Tiger

Americans seem to be fixating these days on the idea of China
stealing away American jobs. That's interesting because fear of China
among its developing-country neighbors, who had much more plausible
reasons to worry about the impact of this rising competitor in the
same economic niches, has peaked and started to fade. Instead, Asians
seem to have realized that not only is the China threat overrated,
but the country is an engine of growth that benefits them.

It's perhaps understandable that Americans are very aware of their
country's trade deficit at a time when the economy, while growing,
isn't producing many new jobs. And China is the natural scapegoat,
since bilateral trade was $103 billion out of kilter last year in
favor of Chinese exporters, the biggest deficit America has with any
single country.

In the world of public perception, it doesn't matter that the goods
the U.S. is buying from China are largely low-tech commodities that
it was already buying from other countries at higher prices. Or that
the goods the U.S. is selling to China are on the whole more
sophisticated products, and the American companies which make them
need to capture a significant share of this new and growing market in
order to maintain an edge over global competitors.

In fact, U.S. and Chinese economic interests are quite closely
aligned, because the two economies are so complementary. You might
even say that China is an economic colony of the U.S., with its
currency so tightly pegged to the dollar and American companies using
it as a base for their low-cost manufacturing.

That might seem like a strange idea given how nationalistic the
Beijing regime is. But consider the government's actual behavior, and
it's not hard to imagine that if Paul Bremer were running China
instead of Hu Jintao, he'd be accused of exploiting the country's
economy to benefit the U.S. and other Western countries.

First of all, the most productive sector of the economy is largely
run by foreigners, for the benefit of foreigners. China may boast of
being the largest recipient of foreign direct investment in the
world, but it got that way in part by offering preferential tax
treatment and other incentives to multinational companies. Those
ventures in turn export not only their products, but also their
profits, often hidden by manipulating the prices used for
transactions within the companies.

The Chinese government, meanwhile, has been burning through its
people's savings like an Internet company, to provide employment to
hundreds of millions of workers. While a few state-owned companies
are well run, they are the exception to the rule. Officially, the
state sector is profitable, racking up $31.8 billion in net profits
last year. But much, if not all of that is an illusion, the result of
government investment and bank loans being booked as profit.

This happens because the true cost of capital to a state-owned
company in China is effectively zero. Officially, the state-owned
banks charge interest, but it's understood that they will continue to
lend increasing amounts of money to the companies for the foreseeable
future. Since Chinese continue to save at a high rate and put their
money into savings accounts, this is sustainable for now, but not

The financial open vein is particularly debilitating because private
entrepreneurs have trouble staying in business. In almost every
industry there is overcapacity because the state companies pile into
product categories where there are profits to be made until there are
no more profits. Then they continue producing, even at a loss. As a
result, private companies which are concerned with making a return on
their investment are driven out. Some are nimble enough to keep
finding new niches, but by and large the only reliable way to recoup
one's cost of capital is to be in an industry with high barriers to
entry, natural or regulatory.

This is reminiscent of South Korea right before the Asian Crisis. The
chaebols had the same "if we build it, the demand will come"
mentality about continuously expanding capacity. By 1996, the top 50
business groups in South Korea, whose sales accounted for over 97% of
GDP, were making a net loss. At least South Korea had already
achieved developed country status, with companies that had proven
records of entrepreneurial success and global brands, not to mention
reserves of human capital to draw on. China has to face the challenge
at a much earlier stage, albeit with one big advantage: Officially
the government hasn't amassed much of a debt burden.

Here's one illustration of how poorly China's companies have
performed: In 1993, nine of the country's best firms were allowed to
list their stocks overseas, initially in Hong Kong. Five of them are
today trading below their IPO price, with the average return for the
last decade just 30%, or less than 3% per year. The companies listed
on China's domestic stock markets are even more pathetic.

So China is using the hard-earned savings of its people, which could
have been devoted to building globally competitive companies, and is
instead throwing them down 100,000 state-owned ratholes so that
Chinese workers can produce artificially cheap products for American
consumers to enjoy. The government is even taking away the dollars
earned by selling these products and loaning them back to the U.S. at
low rates so that those American consumers can keep on buying.

There's still time for China to get wise. But the point here is that
Americans should be sanguine about China's development model. Thanks
to Beijing's own policies, China is giving them cheap capital, cheap
manufactured goods sold below their true cost and a market for
sophisticated, high value-added goods. At the end of the day, China
will be left with uncompetitive companies, depleted savings and a
balance-sheet recession. It will have to sell off the distressed
assets of its failed banking system, at which point Western companies
can buy up even more of the economy at fire-sale prices.

As a recent article by Yasheng Huang and Tarun Khanna in Foreign
Policy suggested, the true competitive threat to Western
multinationals comes from India. Entrepreneurial companies are
growing up in truly competitive conditions and are starting to
challenge on the world stage in sectors where the U.S. has enjoyed a
very profitable edge, such as software.

One more thought about China: Since the two economies are
complementary, it's ultimately not in the U.S. interest for Beijing
to continue with its self-defeating policies. A sudden collapse would
hurt the U.S. because the market for U.S. Treasurys might be
disrupted, social unrest could damage American-owned factories and
the market for U.S. goods could dry up. In short, Americans should be
somewhat concerned about China, but not for the reason they think.
The good deal they're getting now can't last forever.

Mr. Restall is editorial page editor of The Asian Wall Street Journal.

Updated August 1, 2003

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