Thursday, January 23, 2014

Bay Area Economic Ties To Greater China May Not Be So Great

Today the Bay Area Council Economic Institute released its 2014 edition of "Ties That Bind: The Bay Area's Economic Ties with Greater China."  I attended the primary authors' discussion of this report tonight at the Commonwealth Club.  I recognized some of the subject matter from last year's conference at USF's conference on China's financial reform.  I read the executive summary and I'll make time later on to read the full report, so here's my initial impression.

It's obvious that China's miracle economic growth is slowing down.  The authors cited urbanization and an aging workforce as structural problems but glossed over the enormous cost of environmental devastation.  Replacing coal in energy use will drive investment, but China is already running into opposition from its neighbors as hydroelectric projects on the Mekong River threaten water supplies to Southeast Asian nations.  China's rush into sustainability is thus becoming a force for destabilizing regional relations.  The panel did mention how Bay Area companies with expertise in sustainability are in demand in China but I suspect playing environmental catch-up will be more expensive than anyone thinks.  Contrast this with the US's experience with environmental regulation starting in the 1960s.  Environmentalism coincided with US urbanization and one force did not hinder the other's contribution to economic growth.  China's central planners have a bad habit of tackling one economic theme in full force and leaving others to languish.  The environmental sustainability push now may leave little planning flexibility for addressing the country's aging work force or inadequate health care system.  This is the fundamental flaw in centrally planned economies that even bullish Wall Street cheerleaders ignore when they sell more Western investors on Chinese joint ventures.

Speaking of joint ventures, Silicon Valley Bank has one in China.  SVB lends to most of the VC-backed startups in the US, so it must think it can replicate this success with Chinese small and medium size enterprises (SMEs).  They see opportunity in the Chinese bank sector's focus on SOEs, real estate, and municipal governments at the expense of SMEs that want to expand.  I see risk in SVB's approach.  Asians traditionally present a different face to Westerners than they do to their own familiars.  It's a cultural trait that is still particularly pronounced in China.  I am not the only financial analyst who has noted that China's economic statistics are largely fabrications intended for a foreign audience.  The Heritage Foundation deconstructed China's imprecise financial picture in 2013.  Western banks penetrating China's interior in search of growth will learn hard cultural lessons for the next few decades as Chinese partners present them with deceptive results.  American bankers need to read the history of foreign hongs that penetrated China's interior during the colonial Hong Kong era for a glimpse of what they can expect.

One of the panelists noted that foreign banks still can't use renminbi within China.  No kidding.  China invented that currency as the foreign version of the yuan because it did not want its domestic currency to be fully convertible.  Check out the Shanghai Free Trade Zone, where the Chinese government is specifically chartering branches of non-Chinese banks that can freely exchange currency.  The CFR gave a good run-down of the Shanghai FTZ last year.  The opening of FTZ footholds for foreign merchants and bankers to penetrate the interior follows the precedents set through centuries of trade concessions.  Like I said above, Western businesses need to read up on the histories of hongs and national trade legations before they start smacking their foreheads in frustration.  Closed Asian societies open on their own timetables, in their own ways.

China has allowed a huge banking sector to grow in record time.  Much like the ghost cities and empty malls that litter China's interior, these banks are impressive but dysfunctional so long as they serve state planners' interests in presenting an image of success to the outside world.  The "shadow banking system" of weakly collateralized securities sold to the emerging middle class as wealth management products (WMPs) is a disaster waiting to happen.  Next week will reveal whether a default on a half-billion dollar WMP will affect ICBC.  The inevitable detonation of a significant portion of WMPs tied to non-performing real estate may trigger a collapse in confidence in the Chinese banking system that forces the PBOC to intervene.  I have no idea where the PBOC will obtain the liquid resources it can use to backstop WMPs.  It has been injecting enormous amounts of liquidity into China's overnight lending markets to stabilize repo rates, and another huge bailout will stress it in unforseeable ways.  Imagine the black swan implications of PBOC selling off some its US dollar reserves to raise yuan it can use to backstop a run on its own banks by Chinese middle class savers.  Even if China can contain a WMP implosion, the evaporation of middle class savings intended for health care expenses and childrens' education will dash whatever hopes the country had for adding a strong consumer spending component to its GDP.

The panel's speculation that Chinese SMEs are capable of untold innovation strikes me as a cultural mirroring effect.  We see what we want to see in Chinese entrepreneurs while we are ignorant of Chinese culture.  Innovators think differently partly because they're genetically hard-wired to break molds.  Western cultures that elevate individualism over tribal identification attract misfit immigrants and celebrate idiosyncratic underdogs.  Where is the cultural evidence that this is tolerated in China?  Confucian societies value filial piety, ancestor worship, and hierarchy for the sake of hierarchy.  Those are not cultural conditions conducive to innovation.  I would like to see evidence that major Chinese technology companies are capable of incentivizing the three types of innovation I heard US tech executives talk about earlier this week at the Commonwealth Club.  I will give the panel and their report credit for mentioning the Chinese Enterprise Association and the China Energy Group at LBNL.  Innovation and technology transfer are things the West does very well.  China does not yet do them well.  I expect many Chinese engineers and middle managers will experience cognitive dissonance when their corporate mandarins hand them "innovation goals" they must meet.  We will see the results of this cultural trait grafting experiment in China's GDP, assuming state economists don't falsify the figures.

The People's Republic of China ranks 80th out of 175 on Transparency International's Corruption Perceptions Index for 2013.  That's kind of bad.  The PRC also ranks 137th out of 178 on the Heritage Foundations' Index of Economic Freedom.  That's pretty bad too.  I am skeptical of American business executives who do not study history or speak other languages but charge off into foreign investments in search of ROI.  They remind me of American military strategists who assured us our adventures in Iraq and Afghanistan were affordable.  Nothing in foreign direct investment (FDI) is as simple as buying into a new market in search of uncorrelated assets that fit a gap in modern portfolio theory.  Just like military intervention, nothing substitutes for deep cultural immersion and local credibility.  Good luck to Bay Area firms that want to penetrate China in 2014, the year of the horse.  They can reduce their risk by hiring Western-educated ethnic Chinese whose family contacts in China will give them straight answers.