China to Enter Three Year Decline as Problems Mount

October 4, 2010 Posted by Chris Devonshire-Ellis Reading Time: 7 minutes

Op-Ed Commentary: Chris Devonshire-Ellis

Oct. 4 – In the job I have, I am fortunate enough to be able to compare over 20 years’ experience of actually living in China with the past five years of travel across emerging Asia – India especially – and, in that time I have witnessed firsthand the development of China’s relationship with the United States and Europe. It gives me, I like to think, a unique perspective on how China is doing. When my business began in Shenzhen for example, Deng Xiaoping was still the leader of China. As Jiang Zemin and Zhu Rongji spearheaded China into global trade with the ultimate objective of WTO membership, they were replaced with Hu Jintao and Wen Jiabao who delivered the Olympics yet have had to deal with the aftermath of their predecessors occasionally cavalier efforts to make China a global player.

Perspectives on China always need a base to judge them from, and I have four – a first hand knowledge of China’s growth over the past two decades, the ability to compare China with another massive emerging economy in India, frequent travel to the United States and the intellectual and international trade capabilities that provides, plus I have to run, manage and develop a business in the country as a foreign investor. While pro-China (after all I run a successful business with 10 offices there), it is also in my interest to try and work out what is happening, as much for my own businesses benefit quite aside from the consultancy aspect I am paid for. If I judge China incorrectly, my own business suffers. That’s a little more motivating to get it right than the average China commentator paid to produce just words.

I do believe that in comparison with previous occasions, China is going to enter into a period of some uncertainty over the next three years and that the process of doing so has already begun. There are a number of reasons for this, but all are to do with failings of government. Propping up the uncertainty is the issue surrounding the current party leadership. With two years to go prior to the curtain being drawn on Hu and Wen’s leadership, the Communist Party has to find successors. With a hard core of about 300 decision makers at the National People’s Congress, and even that concentrated further within the Communist Party Politburo, jostling for power is now taking place in bids to secure the most coveted positions. While Western-style democracy puts the decision making power in the hands of the people to decide and political campaigning begins a few months before election-day, in China the process of power broking lasts considerably longer. In terms of political decision making and forming a government, it’s actually a far less efficient system. It is also having the effect of stymieing China’s development as we speak.

While politicians wrangle and jostle for position, much of the actual power then rests with the military in securing China’s borders while the politicos wrangle over individual favorable positioning. This, I suspect, is behind the unseemly and quite heavy handed approach China is currently taking with its border disputes. The recent Japanese issue was blown up rather more than it should have been, and China demonstrated a somewhat unsavory approach to what should be a diplomatic issue by allowing it to enter commerce and cultural exchanges. That’s a pretty hard line, but then again which general would want to be the fall guy for conceding an inch of disputed territory while the party is occupied debating its future leadership. No one would, and until we have a new Chinese leadership in place, I expect the hard-line attitude over border disputes to continue.

I also expect the same for the RMB position. There are arguments for both sides, that the Chinese are playing it right, and that the Americans are also correct in labeling China a currency manipulator. The latter is probably true, but does that mean China will shift its position? It hasn’t so far, aside from a few, tiny moves when Washington starts to get overheated. So what will happen? America can’t afford a trade war, and China won’t budge. Expect more of the same for the foreseeable future.

Another aspect of China now is the desire to involve politics in trade. That’s a worrying development, and is again caused by hard line factions within the government. No quarter is being given while leadership issues have to be resolved. It’s also a form of bullying; China poking sticks at nations that don’t follow its diplomatic desires. Want to meet with the Dalai Lama? Trade meetings get canceled. Want to send patrol ships to monitor disputed islands? We’ll cancel shipments of supplies to you. Want to award a Nobel Peace Prize to someone we don’t like? We’ll threaten diplomatic sanctions. All this is happening now, and it doesn’t bode well for the next three years until a new leadership can assert itself and restore a more diplomatic approach.

There’s also the issue over the economy. I’m not an expert, but I do know how to read a balance sheet and I’ve been in China a long time. I can’t quote the numbers, and even if I did someone else would come up with an opposite theory. All I can say is that is just doesn’t feel right. Traveling around China I have come across acres and acres of empty, prestigious property developments. I’ve seen entire cities built for a population of millions but with actual residence of 100,000. “Build and they’ll come” seems to be the mantra. But they won’t. China’s population is actually shrinking, and unlike India, another 100 million people are not coming into the labor pool. China needs more people to sustain its previous growth, but they aren’t being born.

China’s new found urban wealth also has largely been built on credit. The enormous numbers of cars that have come onto China’s roads the past 18 months has largely been the result of virtually interest free loans. Add to that the money that appears to have filtered away into unsustainable property projects and the entire picture seems wrong. Build a property for US$10 million, the speculators move in and prices rise, and the government can report a profit on the original project. Yet it’s useless without people actually living in them. When that bubble is pricked, China’s bad debt in its government and banking sectors is going to really hurt, along with the ordinary folk who bought into the dream.

That won’t necessarily affect foreign direct investment, but it will affect the mood of the nation. China’s new leaders need to fix it, and that is why so much attention is being paid to the next generation. Yet with two years to go before that is decided, the forthcoming period is going to be very uncertain, and along with that, strict adherence to rules, regulations over business and civil rights along with more stressed diplomatic and trade relations will occur.

The economy also has to be recalibrated away from export manufacturing and more towards boosting its own consumption. That’s a process that is currently underway, but it has proven patchy, and some of those empty property developments would have been far better money spent on developing infrastructure in China’s central and western regions, and Sichuan in particular. That is China’s most populous region (if you include Sichuan Province and the neighboring municipality of Chongqing), and the dynamics it has, if unleashed, could rejuvenate the region and its surrounding provinces. Yet it remains under-invested, with a lack of infrastructure, a distinct lack of interconnectivity with its neighbors, and totally inappropriate projects being put in their place. Local annual income is about US$4,000 per annum yet there are US$1 million apartments for sale on the road close to Chongqing to “the elites.” What elites? I get increasingly concerned when I see, on a regular basis, such promotion of prime real estate across the country. As I said, acres of such developments have been built. Over-inflated, over built and totally out of reach of the ordinary Chinese citizen. Its not real development, and the prices asked and profits shown are unattainable and false.

As wages have also increased, and costs across the country have risen, China’s path the next few years is going to be difficult. The bad debt I suspect is throughout the system will have to be dealt with at some point, although a lid will probably be kept on it until the next leadership can formulate a policy to deal with it. If the hammer does fall, and China enters into recession and housing goes into negative equity, the repercussions for the party are extremely serious. That is also being reflected in a harder line in policing and security issues. China is indeed becoming rather less friendly than it was. some sections of Chinese media are already placing blame on foreigners for China’s economic problems. They vary from the U.S. government for creating the global credit crunch, to foreign investors not paying workers enough, to accusations of rampant profiteering from low cost China production. It’s an old political sleight of hand, when the economy starts sliding, blame someone else. In a one-party state, the someone else is the foreign investor, their government, and the overly capitalistic ways. “Give us more money” cry the Chinese. “We’re being exploited.” Expect such rhetoric to increase. Managing a Chinese workforce is going to become more demanding.

Five years ago, when I started our India practice, there were many reasons for doing so, not least because the country was a similar size and I felt it was also opening up just as China had done in the 1980s, the signs and signals looked the same to me in India then as they did in China in 1987. However, another reason that I didn’t mention so much was also a pillar catalyst behind the decision to open in India, and that was to hedge against China if things turned for the worse. If profit levels begin to slip (fortunately that hasn’t happened to us in China at this point), then I’ll need to make those up from elsewhere. Increasingly, establishing a business to contribute profit levels in India looks like a shrewd decision. As China slows, India is growing, and providing an increasing amount of sales revenue into our own bottom line, becoming more important as time goes on. That may yet become vital as an additional income stream if China’s economy deteriorates. Hedging against China I would suggest, would be a wise strategy to consider.

Meanwhile, for the next three years in China, until the new government hierarchy is determined, expect a bumpy ride, a slowdown, and a decline in domestic business confidence. Foreign investors should be OK as China’s domestic market opens up, but be cautious over expansion plans. Buyers from China are likely to face an increase in quality problems, and an upsurge in China derived bad debt, so take steps to enforce contracts properly and ensure letters of credit are in place and drawn down only when the goods are clarified as appropriate. Meanwhile, occasional ultra nationalist fervor, a very strict adherence to rules and some erratic diplomacy is likely to become the norm until China’s next generation can take the helm and steer the ship back into calmer waters. It will take at least three years.

Chris Devonshire-Ellis is the principal and founding partner of Dezan Shira & Associates, establishing the firm’s China practice in 1992. The firm now has 10 offices in China. For advice over China strategy, trade, investment, legal and tax matters please contact the firm at info@dezshira.com. The firm’s brochure may be downloaded here. Chris also contributes to India Briefing , Vietnam Briefing , Asia Briefing and 2point6billion

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