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The Wheels Fall Off China's Boom   (April 1, 2008)

Please note I am saying "the wheels fall off China's boom" not "off China." That distinction is important. If the Chinese government mishandles the economic/ financial bust which has just started, then the wheels could indeed fall off China, Inc.

I have posted here for years that factories have been moving from China to Vietnam, Thailand and elsewhere. Now BusinessWeek confirms the trend: China's Factory Blues
The days of ultra-cheap labor and little regulation are gone. As manufacturers' costs climb, export prices will follow

The bigger multinationals may be having second thoughts, too. A report by the American Chamber of Commerce in Shanghai found that more than half of foreign manufacturers in China believe the mainland is losing its competitive advantage over countries like Vietnam and India. Almost a fifth of the companies surveyed are considering relocating out of China. "The big story here is that globalization is for real—and China is no longer what it was," says Ronald Haddock, a vice-president at consultant Booz Allen Hamilton, which wrote the report.

The rise of the yuan may be the biggest single factor driving companies to relocate. But other government policies are contributing to the crisis. Last year, Beijing decided to cut or cancel tax rebates on more than 2,000 items used to make exported goods. The impact has been huge. "The end of rebates has raised the cost of manufacturing many goods by 14% to 17% at the factory level," says Harley Seyedin, president of the Guangzhou-based American Chamber of Commerce in South China

The process of abandoning factories in China is not terribly orderly: Rising costs forcing some South Korean factory owners to flee China

In Qingdao, Sung Jeung Han, manager of the Korean Society and Enterprise Association said 20 percent to 30 percent of the 6,000 South Korean firms in that eastern port city were losing money.

"The wage rise, yuan appreciation and higher input prices are the main reasons," he said by telephone.

The minimum wage in Qingdao has risen 43 percent in the past three years to 760 yuan, or $107, per month.

Other government initiatives to share China's growing wealth more widely and to minimize social tension are also deterring employers who are required to provide more mandated benefits for their workers and are paying higher pollution fees.

Employers are grumbling in particular about a new labor contract law, which went into effect at the beginning of this year, that makes it harder to lay off staff members.

It may seem anachronistic to place Chairman Mao in the cart with the shaky wheels, but I did so to illustrate that China's government retains the flawed structure of Mao's era on which new layers have been poorly grafted.

When the need arose to suppress protesting Tibetan monks, China's rulers quickly mobilized hundreds of thousands of regular Red Army troops and deployed them domestically. This centralized command-and-control reveals that the fundamental layer of China's government remains a Communist dictatorship ruled by a small oligarchy.

When SARS threatened to disrupt trade and the people's trust in their government, the central command-and-control structure quickly asserted itself on a national scale: no public spitting, etc. etc.

The structural problem is this: the economy is essentially controlled by local government, not the central government. When the economic reforms began in 1978, several key structural changes were made, the consequences of which are still playing out.

One was that regional and local governments were given control over economic development. Thus if a city government wants to build a huge sports arena/shopping complex, they can approve the construction without central Party or government approval.

This is the structural root of many of China's unsolvable problems such as corruption and industrial pollution. If a factory is spewing airborne lead into the air, the central government has the authority on paper to do whatever it wants, but in practice the enforcement of regulations is largely in the hands of local government: the very same government tasked with providing new jobs and enticing capitalists to build new facilities in their city/area.

Even stickier, the local officials wined and dined that factory owner to build there for the jobs, and the owners provide some level of "support" for the local Party officials. Perhaps not outright cash, but benefits nonetheless: influence, contracts, gifts, etc.

So now you the local official must go the factory owner, who you just sat next to the previous night at a banquet, sharing jokes and liquor, and you're supposed to tell him to buy a horrendously costly scrubber for his smokestack or you'll have to shut him down?

Structurally, that is simply untenable. This is the root of story after story in which the factory shuts down for a few days and then starts releasing the airborbe lead at night, when nobody can see it. That's the "solution" which works for the owner and for the local Party officials who are in some sense "co-owners," for if the factory shuts down or moves away, they lose.

Another structural reform was made which is now haunting China in a fundamental and pervasive way: who provides pensions and health insurance. Unfortunately, China's central government chose the same unstable formula the U.S. did way back when: make the employer responsible for employees' pensions and healthcare insurance.

This worked fine when the government owned 100% of the entire country; every factory and commune was essentially owned by the central government. But as the economic reforms took hold and the government began closing down or selling government-owned factories, then the workers began falling through the shredding safety net.

In other words: China does not have a centrally operated pension or healthcare system. Those workers whose employers survived the transition have pensions, those whose employers are gone do not.

Among our Chinese friends' parents, there is a great divide. Those who spent their lives working for a Party newspaper or bureaucracy or the Army receive a pension, and life is really pretty good. But those who worked for a factory which has closed have nothing.

This structural divide is precisely what is destroying the social contract and fabric in the U.S., where government workers and those who labored for surviving multinationals have pensions, while those who worked for firms which ultimately failed have nothing until they qualify for Social Security and Medicare.

China has plans to fund national pension and healthcare systems, but being horrendously expensive--recall China has 1.3 billion citizens, to the U.S.'s 300 million--those remain future plans.

Another structural problem (dare I call it a new form of dialectical materialism?) is inflation. The cost of food and rent is rising by leaps and bounds in China, and the central government's attempts to control prices by fiat have been largely counter-productive.

Trying to force prices lower in times of shortage is like trying to compress water: it doesn't work. Lower the price of electricity without lowering the input costs (coal) and you end up with electricity shortages.

Pave over thousands of hectares of prime rice land with high-rises and you get declining production. Divert water from agricultural producers to the Olympics and you get declining yields. Declining yields result in demand/supply imbalances and rising prices.

MSN commentator Jim Jubak foresees negative consequences of the upcoming Olympics--consequences which are to some degree reflections of the structural problems I outline above: China's looming Olympics disaster The Beijing games are supposed to showcase China's stature on the world stage. But they're producing protests at home and may shut down big hunks of the nation's economy. (Several readers recommended this link--thank you.)

Lastly, the idea that China could simply shift its manufacturing sales to Europe as the U.S. recession takes hold has been revealed as hope not reality. As BusinessWeek notes, Ireland--along with the rest of Europe--is suffering its own real estate bust and slowdown as factories close or move to cheaper climes: Ireland: The End of the Miracle The powerful euro has crushed the country's decade-long economic expansion—and its competitiveness

New correspondent J.S. offers an "on the ground" report from Shenzhen, China, on many of these issues. I asked J.S. to comment on rising prices, China's stock market decline and the reaction of average citizens to these unwelcome developments. Here is his report:

The real estate bubble in Shenzhen has started to deflate. Rents however seem to have only leveled off and not gone down noticeably. What I found troubling was how the rental increases seem to be squeezing the lower wage earners. My Chinese friends say their 1200 RMB per month apartment was 1000 before the last increase. Meanwhile the apartment I am renting went from 1900 to 2100 in a year. You can see how in percentage terms the increases are much greater for the cheaper and more affordable apartments.

There is much talk among the people I know about how the RMB appreciation is causing some factories to operate at a loss or very low profit. Contracts signed a year ago that were profitable are now losing them money with every shipment. Wages are increasing as well so that is causing them problems on the cost side. My friends report that prices are outpacing the wage increases. There is talk about the factories moving to lower cost centers where the wages have not increased so much as around Shenzhen. Some of the more forward thinkers are already predicting a move to Vietnam. Others disagree and say the language problems with Vietnam are too great and it is very difficult to source the items needed to complete a finished product.

I am always asking the business people whether it is as busy as normal or if it has slowed down. I would expect the credit crunch and consumers flocking AWAY from Walmart to be having an effect by now. The tendency is that if there is a slowdown to regard it as normal or seasonal, it seems like no one here really understands how bad it may get before it gets better.

Stock market investing by the ordinary people here is very widespread. When I mention that one of my friends does stock market investing for a living they pipe up and say, Me too. Surprising to me as a lot of these people shouldn't be gambling with what little money they have. Some say that they made a lot of money and now after the market drop they are near the break even point. This was before the last drop in the Market that took it below 4000.

If I was not familiar with it from prior trips to countries like Argentina and Thailand the price of electronics here would have been surprising. Lcd tv sets and laptop computers are all significantly more expensive than in Canada and the USA. I would say about 20% or more. Some small electric convenience items however (iron, rice cooker) are breathtakingly cheap.

Real estate appreciation has been such a driving force in Shenzhen that when the market starts dropping which it is now doing I expect there to be a lot of dislocations among the average people. The number of Realtors is mind boggling. It seems that every fifth or sixth storefront is another realtor office. This is what happens when real estate goes steadily in one direction for about 20 years.

They have carved themselves a comfortable niche by getting between the renters and the owners as well. There are many buildings where the security people will not let you look for apartments for rent unless you are with an agent. The agents typically charge 1/2 a months rent to the owner of the apartment and 1/2 a months rent to the tenant. Of course this drives all rents up about 8% over where they should be.

Air Quality is consistently poor in Shenzhen based on visibility between my apartment tower and the ones that are somewhat distant. I have one day in 10 where the haze in the air is quite bad only and not really bad. In the two months I have been here I have not noticed any improvement. The effect at street level is almost unnoticeable for me however unless standing right beside the flow of traffic which is quite noxious. No coughing hacking or wheezing from the pollution yet for me. Not like Manila!

The average person here has no tendency to blame the guv'ment for everything like we do back home. The people seem to be stoic and uncomplaining for the most part even when difficulties arise. I think it will have to get a lot worse before the average person starts to complain about government handling of the economy and pollution. If anything I think the pollution will be the first thing the public would fix on that they would find the government at fault for.

Thank you, J.S. for a deeply interesting report. For more background on China's challenges, please read China: An Interim Report (2005).

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