Saturday, June 13, 2009

Making Sense of the Tremendous Growth in China

Towards the end of last year, my team wrote a paper about the tremendous growth in the UAE, analyzing the region as a potential location for Foreign Direct Investment. With oil above $120/barrel and tremendous growth in both India and China, it was fairly easy to see that the UAE was well positioned to become a new powerful economic center between Europe and Asia.

Then the econalypse of 2008/2009 happened and the sands that all that growth was built upon quickly shifted, leaving many of those towering buildings in Dubai empty or partially completed. The center of the world for crane rentals suddenly faced the realization that comes with $40/barrel oil and the interconnectedness of our global economy.

Throughout our visit to China, we were constantly stunned by the pace and scope of growth throughout the country. Every city we visited was filled with cranes and construction crews, often working until well into the night (3am in Shanghai). New freeways, subway systems, waterway tunnels. 50, 100 and 150 story office buildings. High-rise apartments packed densely into every corner of the city. And this wasn't just a building here or a building there, this was the equivalent of 10-12 Winston-Salem's being added in all directions of almost every major city.

During our visit with the CITIC Group, their Chief Economist told us that the State Government had set the mandatory GDP growth rate at 8% in order to sustain the level of employment required to meet their goals and sustain a harmonious society. As I've mentioned before, the Chinese economy is still much smaller than the US, but 8% growth is an enormous number for a country of 1.3B people. Over the past decade, the Chinese economy has averaged between 10-11% growth per year. But given the resetting of the global economy, it's worth examining if this rate of growth is realistically sustainable over the next 5, 10 or 20 years.

So where will all of this growth come from? Let's take a look at a few potential areas of growth, as well as some factors that could limit the growth if not addressed and corrected.

Growth Areas

Demand for Goods, Worldwide - While consumer's bank accounts, 401(k)s and home values have all fallen over the last 12 months, it hard to believe that regions with traditionally strong consumer demand (US, Europe) will stop buying goods. If anything, they will continue to move towards low-cost goods, which can only favor Asian manufacturers and sourcers. When visiting one of the Garmet manufacturers during our trip in Hong Kong, someone asked if they expected many factories to be reopened in the US (or North America) given the stimulus from the US Gov't. The response was that they pay their workers in Mexican plants $13/hr, but pay their workers in Singapore/Taiwan/Malaysia $0.21/hr, so it's hard to make the math of the stimulus work unless people in the US wanted to start paying $200 for a pair of blue jeans. At another factory visit in Xi'an, the Operations Manager told us that more and more factories are moving to the western part of China because the costs in the eastern plants are growing too fast. He said that for every 500 miles they move west (with Xi'an being the western gateway today), their labor costs drop by 50%. And China still has 25% of their population (450M people) living in western providences and areas. Many of those people make less than $5/day, with over 100M making less than $1/day. Those types of numbers say that it will be very difficult for the US to get back any of the jobs that have gone overseas in the last 1-2 decades.

Demand for Goods, Domestically (in China) - The GDP of China has risen from $2/person to $2,300/person over the last 20 years, and is expected to rise to $5-6,000/person in the next 3-5 years. After the economic collapse in 2008, the Chinese government quickly realized that it was too dependent on exports, with only 30-35% of GDP going towards internal consumption. With all the growth and opportunities within China, there is quickly developing a growing middle-class that is seeking additional goods, services and comforts in their lives. Many of the changes in the middle class are trending towards Western ways of consumerism. Just as the middle class became the backbone of growth in the US since WWII, there is an excellent chance that this same growth will happen within China over the next 10-20 years. Ironically, one of the things that many people have identified as coming out of the Tiananmen Square incidents in 1989 is the liberalization of China, which is creating greater economic freedoms from small and medium sized businesses.

Innovation - China graduates 600,000 engineers from university programs per year, while the US only graduates 60,000. Its elementary school children are in classes at least 6 days a week and are typically bilingual at an early school-age. While it's true that the US has been the center of 21st Century Innovation by some standards, others believe that the US stumbled or wasted the past decade and is failing behind in driving innovation in key technology areas. But once again, the massive numbers will drive the need for changes and innovation. Cleaner environmental conditions, renewal energy, greater food production, next-generation mobile communications - all of these challenges will spur innovation internally, and it will be subsidized by the State Government who has declared those all to be challenges that could impede China's sustainable future. Does this mean the US will stop innovating? No. But this should be a wake-up call to the US that our ways of looking at superiority or value-creation may need an overhaul. More and more major companies are locating R&D facilities in China, and it's only a matter of time before the innovation created in those labs spurs local entreprenuers and scientists to go out on their own and create the next Google or Genentech or Toyota or Airbus.

Government Influence - It my seem ironic to think that government influence could drive greater economic growth, but it's very possible that the isolationism and single-party system in China could provide the stability between market cycles to help guide China into areas that will allow it to continue to growth at such a rapid pace. Whether this growth is via tax incentives to critical Chinese industries, or through fiscal policy and stimulus, it's very possible that future growth will drive their political policies more so than in the US where party politics and re-election strategies often have more influence that long-term country growth.

Potential Stumbling Blocks

US Consumer Spending - Just as the Chinese are not going to be able to radically shift their culture to become greater consumers of goods overnight, neither will Americans be able to drastically reduce their addiction to consumption. But there is a possibility that the latest downturn, just like a bad result from a doctor's exam, will provide shock treatment to many Americans and begin a cycle of reduced consumption. The days of the House-as-an-ATM are gone (at least for a while) and many people are out of work, so the cash to spend is just not there. Whether this will change long-term is still to be determined. The possibility of a newfound "Buy American" sentiment could also arise and put a dent in Chinese exports to the US.

Rising Environmental Costs - As we experienced in Beijing, Xi'an, Shanghai and Hong Kong, the skylines of these major cities are badly polluted. With the growing presence of cranes driving new buildings and factories, this challenge will only get worse in the near term. The massive use of coal to power the country leads to polluted water, polluted air, and contributes to the loss of "green" space around the country. Finding alternative energy sources is one challenge facing the government, but also taking on the cost of cleaning their environment to sustain food and life will become an increasing burden. These costs will take away from GDP production.

Product Safety Costs - The recent problems with lead paint on toys shipped to the US highlighted another lack of control that could have a long-term impact on their ability to export. When safety issues directly effect children, the sentiment grows loud to associate "Made in China" with potential harm for children around the world. Trust is a commodity that is not easily replicated or imported, so the Chinese will have to increase their adherence to commonly used guidelines for safety and inspection, adding new costs to their products. These additional costs represent capital that will not be available for GDP production.

Growing Population Costs - Similar to the US, China has an aging challenge with it's population. The greying of their population will increase costs for healthcare, home-care, pharmaceuticals and all other aspects of extended life. How these added costs will be absorbed is still to be determined, since China does not provide a public safety-net similar to the US with Medicare, Medicaid and other programs.

The Laws of Big Numbers - 8% growth (or anything near that level) doesn't happen in developed countries. At some point in the near future, China will begin to face the challenge that all large organizations face, trying to navigate a giant ship in an ever-increase competitive world. Changes won't happen as fast. Competition from outside China will learn from their success and improve on their processes. Countries or businesses considered about the growing might of China may look to hedge their futures with goods and services from elsewhere in Asia, Eastern Europe, Africa or South America.

By no means does this short list of possibilities and challenges tell the whole story of what may happen with Chinese growth over the next couple of decades. The growth China is experiencing today is not only massive on a global scale, but its impact on the rest of the world will resonate for generations to come. Will they be able to sustain it in a way that ultimately creates more value than destruction? We'll have to wait and see. But if they can coordinate their economy in a manner that is anything like we saw at the 2008 Opening Ceremonies, the odds of success are a distinct possibility. It will take Olympic-like precision to get past some of their growth challenges, but whatever happens, the world will be deeply impacted.

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