Sunday, January 31, 2016

China's Shanzhai Economy Mocks Innovation

China has a long tradition of "shanzhai" knock-off goods. Companies shamelessly copying global brands without compensation or even attribution contribute to China's poor reputation for quality manufacturing and intellectual property (IP) protection. Shanzhai extends to more than just brand image. It permeates every aspect of China's allegedly miraculous growth, including real property and government statistics. Its persistence poses risks to Western investors who underestimate China's resistance to cultural change.

PwC republished Booz's 2009 report regarding shanzhai as an innovative phenomenon. It may have appeared innovative when China was trying to convince the West that its booming production would translate into what we would recognize as an advanced economy. Things never worked out that way. Breakneck production without the rule of law to protect innovation eventually turns off international investors.

China somehow managed to fool amateur observers into thinking that everything would be okay once it grew out of its wild frontier phase. The Atlantic in 2014 interpreted shanzhai as an evolutionary crowdsourced ecosystem for innovation. Silicon Valley would recognize innovation without IP protection or market share as an invitation to further piracy. The Wall Street Journal had a similar analytical lapse in 2009, more from a political and cultural standpoint. Astute observers integrate social and political trends into economic analysis if they understand those trends from a native perspective.

Native mainland Chinese have not developed the legal and political traditions the Anglo-West relies upon to protect property rights, including IP. Some Chinese innovator making shanzhai wearable tech is unconcerned with the product quality or global branding that leads to defensible market share. They're still in it for the fast buck because they cannot count on legal protection outside China or political protection within China. Western observers who cannot see shanzhai through Chinese eyes would find this inscrutable. Personal connections through "guanxi" matter more than rules and laws. The Chinese Commonwealth "bamboo network" diaspora matters more than sovereign trade agreements. The West continues to misinterpret these concepts by pretending to see in China what it wants to see in its own culture.

Shanzhai has metastasized beyond consumer goods into real property. Freakonomics noted in 2013 how shanzhai skyscrapers copy other popular building designs. Run a Google image search of China's property boom to see entire cities containing replicas of Paris' Eiffel Tower, quaint European town squares, and parts of Manhattan. China's government economic statistics have long been unreliable, according to descriptions of the Keqiang Index. Replacing that index with something the UNDP or WTO can audit would be a sound step. Instead, the WSJ reported in 2015 that China's State Council would replace the Keqiang Index with measures tracking quality of life. The state is acting in the spirit of shanzhai innovation, copying Western ideas wholesale without grokking how enforcing laws means breaking personal ties.

The shanzhai apotheosis is a huge red flag for US investors with exposure to China. Mainland China's economic growth is more mirage than reality, notwithstanding CSIS's "Broken Abacus" 2015 nonsense that China's economy is bigger than what it self-reports. Try reconciling national-level economic data with provincial-level data and see how China's national authorities guide subordinate governments into supporting its fabrications. Investors betting on US-traded instruments for Chinese stocks or ETFs are gambling that reality will eventually catch up to fantasy. Shanzhai's continued dominance of Chinese business culture makes that a poor gamble.

Full disclosure: No positions in any Chinese investments. BTW, I have corrected the spelling of "shanzhai" after publishing this article.