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China: The New Critical Patient
Board: Macro Economic Trends and Risks

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By WatchingTheHerd
June 19, 2007

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(Also posted at: http://watchingtheherd.blogspot.com/2007/06/china-new-critical-patient.html )

China's economic growth and its interconnections to the world economy have attracted the concern of Americans across a wide spectrum. Stock watchers are interested in the impact of manufacturing outsourcing on margins and profits. Bond watchers are concerned about future Chinese demand for United States treasuries and the impacts of any possible reduction on interest rates. American workers nervously watch to see if the exodus in hands-on manufacturing jobs will extend upward and outward to other product development jobs. Politicians around the world are watching to see how the Chinese government attempts to integrate an unpredictable capitalist economy with the controls of a communist social system like a dessert topping and floor wax.

It used to be said that when the United States economy sneezed, the rest of the world caught a cold. The scale and alignment of the forces at work in China have made China the new critical patient of interest, in the economic, social and political senses.


China's Impact on Energy

If the Iraq quagmire wasn't uncertainty enough, additional violence in Afghanistan with suspected Iranian ties, the collapse of the Palestinian government and attacks in Lebanon have increased uncertainty over oil supplies and prices. Some investors view this uncertainty as a positive indicator to invest in energy stocks. The theory being higher absolute prices provide room for ever-so-slightly higher margins and higher profits.

I think it helps to really go back and think about the calculus behind a bet on energy. Energy is highly profitable for investors when energy prices are chasing demand that's chasing a growing economy. The problem is that an overly-energy dependent worldwide economy can drop energy demands precipitously when that worldwide economy slumps. The US recession in 1981-82 produced a sharp drop in oil prices, both directly by a drop in demand and as a second order effect as the initial price drops led OPEC members to scramble undercutting each other selling their output in a shrinking market. Those oil producing countries are no less dependent today than they were in 1981 to keep collecting oil revenues to fund their otherwise inefficient economies and placate their citizens.

For a bet on energy to pay off over the next 5-10 years, I think you have to bet on the following:

1) lack of a world-wide economic slowdown or outright recession

OR

2) continued economic growth in China, even if the US market slumps and demand for Chinese imports drops.

Option #1 seems doubtful for two key reasons. First, the political issues just mentioned have the potential to spike oil prices so high so quickly that the entire world economy would be put on ice in the event of a supply disruption or just drastically higher prices. Second, even in the absence of an actual disruption, the uncertainty over supply could raise prices high enough to hike inflation, hike interest rates, and slow the world and, in particular, the United States economy.

Option #2 could happen if enough Chinese see enough of an improvement in income / living standards to sustain more of their development internally rather than depending on exports to the US. Because the Chinese economy isn't very energy efficient, any growth in China will help minimize if not eliminate any net reduction in energy demand. So is this likely? This takes us to the next areas of interest.

China's Economic Balance

One YES argument for China continuing to sustain its rapid growth is that in one key aspect, the Chinese economy is evolving and growing differently than the last worldwide experiment in overnight capitalization - post communist Russia. Probably because Russia was already industrialized and had some experience with the economies of scale possible with highly centralized industry, the Russian economy quickly concentrated economic power in key industries in the hands of a well-connected and corrupt few - the oligarchs. The Chinese economy, in contrast, has left its economic power and manufacturing expertise spread across literally thousands of companies. The communist government is still involved at some layer with some regulation and corruption but the tactical decision makers interfacing with customers across the globe are still spread across thousands of firms. The longer this remains true, the better the chance that "invisible hand" effects might become obvious and provide the Chinese economy some better decentralized decision making that can mitigate some of the problems already taking root.

The NO argument is that the Chinese economy is going through the same social and environmental growing pains other industrialized nations went through in the early 1900s: shoddy environmental protections and resulting problems with bad air and polluted land and water, as well as working conditions that are appalling by Western standards. Without an Internet and instant telecommunications, it might be possible to get maybe an entire 20 to 30-year generation of Chinese to leave the collectives in the hinterlands and come to Shenzhing and assemble Dell computers or Cisco routers for 12 hours a day and $155/month. With an Internet, I'm not sure how long that can be sustained when those workers realize where all the profit is going. More importantly, how long will productivity continue improving in an environment of pollution likely to produce MAJOR, EXPENSIVE medical problems in the near future?

China's Political / Social Balancing Act

The July/August 2007 edition of The Atlantic has a cover story by James Fallows entitled Why China's Rise is Good for Us which is HIGHLY recommended. (#1) One of the most interesting points of the story is an insight gained from one entrepreneur operating as a "matchmaker" between Chinese suppliers and manufacturers and firms overseas wanting to outsource work to China. The insight? China is winning the manufacturing war not only because doing business is cheap but because doing business in China is FAST.

If you need to make a last minute design change in a new computer that requires a new specification on a part, you can find dozens of suppliers in a 20 mile radius who can supply the part in DAYS rather than weeks or months. There's an obvious chicken and egg aspect to this, of course. Since so much component manufacturing HAS been outsourced to China, there's bound to be a supplier in China versus Anywhere, USA that makes a suitable part. However, the value of speed versus pure labor savings alone should raise questions in American firms about the true cause of the competitive threat -- labor that's too expensive or management that's too slow in adapter to changing customer needs?

Fallows also makes a horrific point about the working conditions in China:

In the same week that 32 people were murdered at Virginia Tech, 32 Chinese workers at a steel plant in the north were scalded to death when a ladleful of molten steel was accidentally dumped on them. Even in Chinese papers, that story got less play than the U.S. shooting -- and fatal coal mine disasters are so common that they are reported as if they were traffic deaths.

It took American labor about 40-50 years to create a force to counterbalance the robber barons who developed America's industries in the late 1800s and early 1900s. Many of the practices that tipped the scales had to be invented on the fly. Now those methods (minimum wage laws, work hour limits, safety regulations, unionization) are certainly understood. China is about 15 years into the boom that has catapulted it into the manufacturing lead. How accelerated will their learning curve be in a Internet age? Will it take Chinese workers 50 years of 12 hour days to demand change?

Chinese entrepreneurs and managers are also learning many lessons about the benefits of capitalism which will make it increasingly difficult for the Chinese government to continue to push centralized planning and limited individual rights in a world where thousands (millions?) of citizens are exposed daily to the benefits of the alternatives. As a result, workers and managers are operating in a mode where their individual interests are being aligned together but in ways 180 degrees out of phase with the government. How long can the government keep the lid on that pressure cooker?

China's fast growth rate and sheer size are producing enormous tensions between the forces enabling the economic growth and the forces that can tear it apart if it grows without correcting some major problems. Whether you look at things through an economic (or investment), social or political lens and whether you focus on domestic impacts or worldwide impacts, China has to play a major part in your decisions.


WTH

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#1) http://www.theatlantic.com/doc/prem/200707/shenzhen


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