Special Reports
 
 


THE CHINESE CHALLENGE

by

Bryan Gould

________________
  

   
An Economic Triumph
I first went to China in 1978 as a member of a British Parliamentary delegation. We were the first Western politicians to be invited into China following the fall of the Gang of Four.

The trip was like visiting the moon. The country was unlike anything I had ever seen. Literally everyone wore drab-coloured Mao tunics. The only cars were heavy black Soviet-made limousines that ferried senior Party officials around Beijing; otherwise, everyone rode bicycles.

There were no shops, apart from the handful of Friendship Stores that were open exclusively to foreign dignitaries and diplomats. Otherwise, the only signs of commerce were the mounds of cabbages and pumpkins piled up on street corners and brought to makeshift markets by peasants from the countryside.

There was no colour anywhere, apart from huge red banners proclaiming the Five Modernisations. It was impossible to escape the blare of loudspeakers, broadcasting party propaganda, on trains, in streets and from poles in the fields. When we ventured out of our state-run hotel (also restricted to foreign visitors) in the evening, we would attract large crowds who had never before seen a white face.

I returned to China in 1995 as the Vice-Chancellor of Waikato University in New Zealand and thereafter visited it once or twice a year for a period of eight or nine years. The transformation from 1978 was astonishing. Vast new infrastructure projects were being undertaken. Popular wisdom had it that 20% of the world’s cranes could be found in Shanghai over this period. Huge areas of traditional housing were swept away to make way for motorways and new industrial and commercial development. I recall travelling in to Wuhan from the airport along a newly opened, multi-lane motorway and my taxi having to avoid peasants walking towards us with donkey carts, so unfamiliar were they with what a motorway was.

That transformation has continued apace. The rest of the world has been astonished by the speed with which China has taken its place as a major economic power.

China has, at a time of recession for the rest of the world economy, maintained an annual growth rate over recent years averaging 10%.

Just this year, with nominal GDP of US$5.8786 trillion, China has replaced Japan as the world’s second largest economy, having overtaken Germany for third place four years ago; it is on track to overtake the United States by 2030. China will become the world’s largest producer of manufactured goods, surpassing the United States, this year. It is already by far the world’s largest car manufacturer, with a total production nearly twice that of Japan, and two and a half times that of the United States.

China’s trade surplus in 2010 was US$185 billion but was as high as US$295 billion in 2008. In a decade, China’s share of world trade has grown from 4% to 10%. China became the world’s largest exporter, overtaking Germany, in 2009. Exports constitute 39.7% of GDP. China’s foreign exchange reserves now total US$2.454 trillion, nearly 50% of GDP, even after huge overseas investment over recent years.

It is not just on the production side that the Chinese economy has achieved a new dominance. China is now the world's largest car market and the biggest energy consumer. Inward foreign direct investment totalled US$105 billion in 2010 and Chinese outward foreign direct investment now totals US$261.5 billion; both totals are growing fast.


All this is impressive enough. But the fact that China, with a fifth of the world’s population, but GDP per capita at present of only about one fifth that of Japan, gives some indication of the potential for future growth that Chinese leaders will now have in their sights.

A New Solution to a Political Conundrum
While the economic development is the most eye-catching aspect of the transformation, the student of politics will also find much to marvel at. China has succeeded where the Soviet Union failed, by finding a way to combine a centrally directed economy and a monolithic political structure with the innovation and enterprise that only a market economy can provide.

Mao Tse Tung had recognised the Soviet failure – the extent to which the Soviet economy had succumbed to sclerosis, and Soviet society had become stultified. Mao’s solution to the problem of maintaining a rigid central political control while stimulating renewal and innovation was the Cultural Revolution – an attempt to ensure that the party organisation was never allowed to become a dead weight - but the cure proved to be worse than the disease.

Following Mao’s death and the fall of the Gang of Four, however, Deng Xiaoping initiated a new approach, in which the Chinese Communist Party maintained its central political control, and set the broad framework of macro-economic policy, but – within that framework – allowed private enterprise to flourish. The consequence has been that a large element in China’s economic growth has been the prospect for many entrepreneurs of becoming very rich. China is now home to more billionaires than anywhere else. There are perhaps 120 million Chinese, living largely on the eastern seaboard, who enjoy living standards comparable to those of the prosperous Western middle class.

It is, though, a version of private enterprise that we are unfamiliar with in the West. It is a private enterprise that is self-consciously an arm of government policy, but which – in return for complying faithfully with that policy – is free to pursue its own interests. The key is that the Chinese seem to have recognised that government and private enterprise can interact to their mutual advantage, each doing what it is best equipped to do, each contributing to the achievement of the goals of the other.


Does The West Have All The Answers?
In the West, of course, dominated as we are by an Anglo-American model of capitalism, a close and symbiotic relationship between government and the private sector such as the Chinese have achieved is regarded as anathema. The Western view has been that the best thing government can do for industry is to “get off our backs”. Government intervention is almost invariably seen as unhelpful, “second guessing” an infallible market will always produce worse results, it is said, than if it had been left to itself.

Regulation of the market place is seen as unnecessary and sure to be self-defeating. And even those traditional spheres of governmental responsibility and activity – like infrastructure investment, or the provision of public services like education or prisons – are increasingly being colonised by private investors and providers. The role of government in providing and guaranteeing the essential building blocks of economic success – essential physical and technological infrastructure, a safe environment in which to do business, an educated and motivated workforce, a proper level of advanced research – is discounted.


In the United Kingdom, for example, the proudly proclaimed goal of the newly elected coalition government is to “shrink the state”. In the United States, the Obama administration struggles to identify, let alone apply, the lessons from the global financial crisis. In a small economy like New Zealand, which has experimented for nearly three decades with an extreme free-market policy, there is no disposition to recognise its failures. Blind faith is still reposed in the magical ability of the “free market” to deliver salvation.

The Role of Government – China Style
There can hardly be a starker contrast than with the approach followed by the Chinese government. To explore that contrast, and to ask the obvious questions, is not to endorse or commend all or even any of what the Chinese have done and are doing. But it is surely prudent to recognise that the Chinese economic performance has been achieved while pursuing a very different political and ideological approach from our own. No dispassionate observer could possibly say that we can have nothing to learn from the Chinese.

So, how have the Chinese done it? In many respects, there is no mystery. A government that has virtually guaranteed stability and continuity is able to take a long strategic view. A government that sees little need to curry favour with voters or with particular interest groups has been free to pursue a single-minded objective – the economic development of the country. A government that can take decisions, irrespective of the civil or property rights of individual citizens, has been able to plan and decide solely in accordance with those economic goals.

They have used that freedom of decision and action to be quite ruthless and have accordingly attracted severe criticism from trade partners. A case in point has been their policy on the foreign exchange value of their currency. The Chinese renminbi is still not fully convertible and its value is accordingly established by the direction of the Chinese government. By pegging its value to the US dollar, they have been able to take advantage, in terms of the competitive pricing of their exports, of the fall in the dollar’s value.

There can be little doubt that the renminbi is substantially undervalued and that that is a deliberate element in Chinese trade policy. The size and persistence of the Chinese trade surplus is incontrovertible evidence of that undervaluation. The situation is reminiscent of the German and Japanese trade surpluses before the Second World War which Keynes and others correctly characterised as a powerful and aggressive assault on the economic power of the United States and Great Britain. Keynes was clear that the creditor countries were as much to blame as debtor countries for the trade imbalances that threatened world peace.

Manipulating the currency is just one example of government intervention in economic policy and in wider strategic matters. It is safe to say that, in marked contrast to the attitude of Western governments that the national interest can safely be left to market forces, the Chinese government has a well-developed strategic view as to where the national economy can and should develop and literally every economic actor in China is required to comply with that strategy.

So, the domestic programme of infrastructure development is highly planned. Transport, physical and electronic communications, energy supplies, scientific research, education across the board, are all integrated parts of a wider strategy. They are all publicly funded as part of a coherent programme of economic development. That programme is given practical effect as a matter of national priority; individual interests that might conflict with that priority are simply swept aside in a way that would be unacceptable in a Western democracy.

The Chinese government takes full responsibility for macro-economic policy. It determines monetary policy (principally interest rates) and controls exchange rates and capital flows in and out of the country. It relies greatly on fiscal policy – principally public spending levels and taxation – to control inflation and to target sustainable growth rates. It exercises close control over the Chinese banking system. It pays particular attention to the competitiveness of Chinese production – the key to their export success and growth rates – which is, of course, where controlling the international value of the currency assumes great importance.

This is all of course quite different from the attitude of Western countries where macro-economic policy is almost totally ignored. What passes for macro-economic policy (and the term itself is almost regarded as a dirty word) is limited to delegating to unelected and therefore unaccountable bankers the responsibility for fixing interest rates as part of a narrowly focused emphasis on controlling inflation; everything else is left to the market.

International trade is a further example of a quite different approach. The Chinese take a strictly strategic view in deciding what goods can be imported and on what terms. The export effort is carefully directed. It is no accident that the first Western country with which China concluded a free trade deal was New Zealand – a country which was too small to pose any threat and was seen as a useful test-bed on which to sort out the possible wrinkles that free trade might bring with it.

The Chinese government intervenes as a matter of course in other areas as well. It has a clear industrial strategy; unlike the West, where “picking winners” is widely dismissed as futile and counter-productive, the Chinese have no doubt as to where those winners are needed. Huge public resources are put into developing leading-edge technology – and if they cannot wait to develop it themselves, they buy it or acquire it by less scrupulous means.

The labour supply is also clearly recognised as a governing element in future economic development. Great attention is paid to the skills needed by the labour force in a modern economy – not only to the higher-level research and technological skills but also to the general level of education of the workforce as a whole, only a small percentage of which has become fully operational in the modern productive economy.

Rather like the Hong Kong economy of last century, where illegal immigration across the border with China provided a virtually inexhaustible source of cheap labour, the Chinese can maintain low wage rates and therefore price competitiveness at the bottom end of the labour market, even while growing development and competitiveness are raising living standards and wage rates at the higher end.

Planning for the Future
It is a fair bet, however, that Chinese leaders do not take it for granted that these advantages will produce the outcomes they want. If the Chinese are to achieve the living standards they want for a fifth of the world’s population – standards comparable to those in the West – they are going to need access to a much larger share of the world’s resources than they currently command. And a greater share of the world’s resources for China means a smaller share for others.

The resources they need now and will need even more in the future if they are to achieve their goals, are in most cases finite - minerals and agricultural land to name but two examples. The Chinese leaders will calculate that it is not enough to sign trade deals or conclude contracts to buy the products they need. They do not wish to risk taking their chances in a competitive bidding war. If their future development is to be guaranteed, they need to do more than acquire access just to the products themselves; what is needed is control over and ownership of the means of production themselves. And the best time to achieve that access and guarantee it into the future is to buy it now, when assets in most western economies are relatively cheap and when China itself is cash-rich.

To recognise this is not to criticise. China is entitled to compete and compete hard with western countries for what the Chinese will see as a fairer distribution of the world’s resources. But we should be under no illusion that that is the Chinese game plan.

It should come as no surprise, therefore, to see a huge Chinese effort around the world to buy up not just outputs but the means of production of key strategic assets. The phenomenon has even attracted the attention of fiction writers. The Man From Beijing, a recent book by the Swedish crime writer, Henning Mankell, takes as its theme a high-level Chinese attempt to buy, in effect, a poor African country.

Real life provides substance to underpin this fantasy. Chinese outward foreign direct investment is rising fast and will go on rising. Nearly 20% of the US$227 billion total Chinese outward foreign direct investment was made in 2009, all the more remarkable in view of the overall fall in global FDI in that year.

That investment is clearly targeted at particular areas. One focus is industrial capacity – particularly high-tech capacity – in the United States. The investment effort involves government-owned Sovereign Wealth Funds and State Owned Enterprises, as well as private companies with undeclared links to government.

It is even more obviously focused on mineral resources in Australia, where Chinese investment has increased dramatically. The Australians have become increasingly wary of such investment; a Chinese bid, for example, to gain control of the world’s largest deposit of rare earths was blocked in 2009 by the Australian Foreign Investment Review Board. China already controls 95% of the world’s rare earth reserves; rare earths are an essential element in much modern electronic communication technology.

New Zealand on the Shopping List?
The investment effort extends beyond Australia (where Chinese purchases of Australian farms have risen tenfold) even to a small economy like New Zealand, where Chinese interest in food production has risen significantly. Some Chinese efforts to buy up not just dairy products but dairy farms and production processes in New Zealand have attracted considerable attention. The high-profile bid for the Crafar farms (20 dairy farms that are now in receivership) by the Chinese company, Natural Dairy, is a case in point. Public anxiety, as well as the obvious deficiencies of the bidders in terms of simple business reliability, led to approval for this deal being refused by the Overseas Investment Office. Significantly, however, as soon as one Chinese bidder was sent packing, another immediately took its place; that second bid is now being considered.

The Crafar farms are not the only instance of increased Chinese interest in New Zealand agricultural production capacity. New Zealand’s leading farming services company, PGG Wrightson, is currently in the process of deciding whether or not to accept a Chinese takeover bid. And there are other instances that, by flying under the radar, have been brought to a conclusion without controversy or even public awareness.

Not many people registered, for example, that Synlait Ltd, a significant New Zealand company with a $237 million turnover, employing 195 staff and manufacturing specialist milk powders, was the target last year of a successful $82 million bid for a 51% controlling shareholding from Bright Dairy and Food Company, China’s third largest dairy company.

The Chinese Government’s Hidden Hand?
Anxiety about the activities of Chinese firms in such instances is of course increased by the close but murky connections between the strategic goals of the Chinese government on the one hand and the purely commercial objectives of Chinese companies on the other hand. Such connections between government and commerce are not unknown in the West, but most international trade deals attempt to establish “level playing fields” and therefore outlaw supposedly commercial proposals which are in reality subsidised means of achieving governmental objectives.

Yet, it is clear that much of what passes for commercial activity by Chinese firms is in fact part of a government-directed strategy. The huge increase for example, in the number of Chinese firms bidding successfully for major infrastructure projects around the world is certainly a function of the interest that the Chinese government takes in securing such contracts. The suspicion must be that some such firms are set up specifically to obtain overseas contracts as a means of extending Chinese influence, particularly in developing countries.

Chinese firms are often able to offer favourable prices and financing arrangements because their commercial operations are in effect guaranteed by cheap funding guaranteed by a virtually inexhaustible government purse. Chinese firms are already by far the biggest infrastructure contractors, with strongly entrenched dominant positions throughout Africa and in Eastern Europe in particular.

The Chinese government is able to combine these contractual arrangements with claiming a position as significant aid donors to poor countries. They see trade, aid and influence as complementary elements in a single integrated drive to ensure that China will have the access and control it needs to claim a much greater share of the world’s resources.

We should make the necessary adjustment in our thinking, in other words, so that we understand that a bid for a strategic asset by a Chinese firm may not be just a matter of a private firm taking advantage of a commercial opportunity. It may be part of a much wider picture in which the firm and its bid are to be seen as elements in a government-directed strategy to secure national goals.

Can the Dragon Be Domesticated?
None of this means that we should regard Chinese development as unalloyed bad news. Our concern should be to understand the Chinese situation and the nature of their policy objectives so that we can make sensible and prudent responses in our own interests. We should focus on protecting and advancing those interests, and on encouraging the Chinese to develop in a direction which creates mutual benefit rather than conflict.

The signs in this regard are not entirely discouraging. By contrast with the experience of the Great Depression, when US protectionism helped to drive the world economy into reverse, the Chinese economy has remained – through the current recession - dynamic, open and increasingly market-driven. That continued buoyancy has done much to avoid a repetition of the 1930s experience.

The trick for us is to encourage the development of the Chinese market for our goods, while at the same time being alert to the Chinese propensity to seek ownership and control of our productive capacity. The task for our policy-makers is to eschew the simple-minded notion that any business is good business, and to distinguish those arrangements that serve our interests from those that do not.

That task may not be as difficult as it seems. The Chinese will be the first to expect and accept a hard-headed approach, and they may have their own reasons for changing course, at least to some extent. The Chinese economy is at present seriously unbalanced. Odd though it may seem to Westerners accustomed to concerns about a damaging emphasis on consumption rather than exports, the Chinese have the opposite problem.

A Chinese refusal to allow an appreciation of their currency so that their extreme and unfair competitiveness is reduced is likely to present them with an inflationary problem which will do the job for them. One way or another, we are likely to see a re-balancing of the Chinese economy, towards domestic consumption and away from exporting, over the coming years.

A clue as to this kind of development in the future may be seen in the fact that China recorded a trade deficit of $7.3 billion in February, following an unexpectedly small surplus in January. This suggests that China, with rising living standards and an increased propensity to import, may be in the course of moving to a new phase, in which its hugely increased purchasing power is used to become an even more powerful magnet for key goods and services than it is at present.

Nor should we forget either the example of Japan. I recall spending time in Japan in 1980, at a time when the Japanese economy looked very much like today’s Chinese economy, albeit on a smaller scale. The air was thick with predictions that Japan would overtake the United States as the world’s largest economy by the turn of the century. We now know that those predictions came to nought – and it may be that China, as it emerges from the rapid growth of its initial development phase, will also find the going increasingly tough.

This suggests that we should concentrate on trying to ensure that China is increasingly drawn into global efforts to regulate the world economy. They have as much to gain in the long term as we do from reforming the international monetary system and dealing with imbalances in particular, and from achieving environmentally sustainable development.

Most importantly, we need to make sure that competition for the world’s scarce natural resources is conducted with as little conflict and misunderstanding as possible. The Chinese should be brought to see that launching a none-too-subtle direct grab for the natural and technological assets of other countries is likely to provoke a damaging backlash. The responsibility is ours, as well as China’s. It is for us to strike a proper balance between accepting China’s legitimate claim to a fair share, and our own right to continue to own our own assets and manage our own affairs. It is in everyone’s interests that we should be crystal clear on that fundamental issue.