Current Events,  Mile High View,  Trade War

Predictions 2019: The Truth About China

Recently, China has been causing no end of concern for the American investor. The Trade War that sprung up between the United States and China has caused fluctuations in the market as the talks have gone well or poorly, and, as of this writing, nothing has been resolved. Investors are wary of what could come next. I believe there is a historical model that we can use to understand China’s end goals and the means they may use to get there.

At the same time, we have a window into China’s longer-term approach by looking at what China has done in steel production and the impact it has had on the worldwide industry. That may well be the analogy for medical, computer, mobile devices, agricultural machinery, telecommunications, robotics, and other industries.

But I am getting ahead of myself. First it is important to understand how China became the 2nd largest economy in the world, second only to the United States.

In 1970, China’s GDP was $92 Billion, less than 1% of the world’s GDP of $12.1 trillion. The United States, by comparison, had a GDP of $1 trillion. That was less than 50 years ago. Today, China’s GDP is $13.4 trillion – 145 times larger than it was in 1970. The United States grew just 20-fold to $20.5 trillion while the world GDP grew 7-fold to $84.8 trillion.

In 1661, Louis XIV ascended to the French throne. France was essentially bankrupt, having fought three major- and two minor wars. In those times, there was no paper money; money was “specie” – gold and silver – but France had no gold or silver mines. So, in 1665, Louis XIV picked Jean Baptiste Colbert as his Treasury Secretary and put him in charge of growing France’s economy.

French industry consisted mainly of small craft shops which could not compete internationally. What Colbert realized was that France needed industries. He set about making that happen. First came the Royal Privileges: foreign businessmen who set up in France had their factories financed by the government, were not charged taxes, and were guaranteed the purchase of all output by the French government. Glass and textile factories were built, and some of those companies still exist today. They were to be the best in the world in quality. The products were both sold in France and exported to bring in needed gold and silver. Competing products from other countries were not allowed into France, so there was no competition.

Colbert sent spies to England and other countries to steal production secrets and technology.  He recruited craftsmen and entrepreneurs, and once in France they were forbidden from leaving. Over 15,000 people were executed when they tried to return to their home countries or imported materials from other countries.

Factories employed over 1,000 workers, something new in France. The workers were paid minimum wage and worked 14-16 hour days. They only had religious holidays off, and Colbert lobbied the Catholic Church to reduce the number of religious holidays. Colbert encouraged women to marry before the age of 20 so that they would add more laborers to the workforce. Workers were housed in dormitories to be close to work.

Colbert formed a corps of state funded industrial inspectors who were charged with making sure products were of the highest quality. Failure to meet the standard would result in forced labor rowing on the King’s galleon.

The Dutch dominated international trade in the late 1600s. Colbert constructed a commercial navy to compete with the Dutch. Ships from other countries calling at French ports paid excessively high duties on the goods they delivered.

France became renowned for producing goods of the highest quality, luxury goods in particular. Companies that were born in those days like St. Gobain and Gobelin Tapestries maintain that tradition today.

And Jean-Baptist Colbert? He was hated both by the French and by foreign governments, but he launched France onto the path of large-scale industrialization. He made them an economic power. This model was given the name mercantilism by economic historians.

China has followed a very similar path. The Chinese government chose industries they felt would be key to growth and has been relentless in pursuing Chinese dominance in those areas: medical technology, computers, telecommunications, electric vehicles, mobile devices, agricultural machinery, and robotics, among others. The government owns the banks and thereby provides the financing. The government controls the building permits and determines what and where factories will be built.

An excellent example is TAECO, a joint venture between Chinese companies and several airplane manufacturers, including Boeing. TAECO was set up to convert Boeing 747s from a passenger configuration to freighter configuration. That is a common evolution for older aircraft. TAECO hangers and facilities were built on what was once a large duck pond. The government owned the property and streamlined the process to build the factory. The technology was furnished by Boeing. I believe at one point there were over 15,000 workers and all were housed in dormitories. Similar factories have been springing up across China for years.

It all sounds like France under Colbert doesn’t it? The government owns the land. The government controls the banks. The government decides on infrastructure. The government forces joint venture partners to share or give away their technology. The government limits competition and guarantees purchase on the products produced. They control construction and prioritize what is built and where.

70% of Chinese exports are from factories that were relocated from overseas. For example, several years ago FOXXCOM, a Chinese company, employed 300,000 low paid laborers housed in dormatories.100,000 of those workers were dedicated to producing Apple products like the iPhone and iPad that would be exported back to the United States alone. The other 200,000 were working on Hewlett Packard and other high tech company products.

This is how China has evolved from an agricultural country to the second largest economy in the world. What’s more, China has not played fair. In 2001, they joined the World Trade Organization (WTO) as a developing nation[1] and gained access to many of the provisions designed to help developing nations grow. For example, tariffs on cars are 25% for cars shipped into China compared to Chinese cars imported into the US at 2.5%. China is now the 2nd largest economy in the world but has still not changed their status with the WTO.

However good China’s methodology sounds, it also seems like the economy is built on a foundation of sand. From what I’ve read, many of the big industries are not efficient; they are funded and supported by the government, so there is little incentive for them to be efficient. TAECO, for example, was operating at a significantly reduced rate a few years ago. How much of that was due to a slower economy and how much to inefficiency, I don’t know. But I can say inefficiency certainly contributed.

We know in this country there are certain functions the government should do, but when the government becomes involved in the private sector it seems to be inefficient and ineffective. When I presented in Las Vegas, I stated the US Post Office had been privatized. I was corrected. It is a separate agency of the US government. (Thank you, John! I do make mistakes, and when I do, I try to correct myself. Please forgive me.)

While I was wrong in my presentation about the US Post Office, I wasn’t about Pechiney or Credit Lyonnais. Pechiney, a metals company, and Credit Lyonnais, a bank, were nationalized in 1982 as France faced a government deficit. By 1993, Credit Lyonnais was bankrupt. At the same time, parts of Pechiney were sold off and then the government raised money by privatizing Pechiney once again.

For a long time, I have searched for a quote from a leader of China when he was visiting the George W Bush in Texas in 2003. Jiang Zemen was the leader of China. (I have to apologize again; I said it was Deng Xiaoping.) I did not write down the quote or information and only tried to recall from memory and searches online. But the essence is important to understand. Miffed when President Bush was describing US planning, Zemen responded that the United States is 200 years old and plans in years. China is 4,000 years old and plans in centuries.

China has grown from a backward rural economy to the second largest economy in the world. And they have done that in a very short period of time, just as France did during the time of Louis XIV and Jean Baptiste Colbert. Both became world economic powers.

Remember what happened in France: In 1789 a lot of people lost their heads – literally – in the French Revolution. But that was not the end, and after the kings came the emperors. Napoleon came to power in France as an industrial world powerhouse and with such an economy behind him, he was able to build the French Empire. He conquered Spain, Italy, Germany, and reached as far as Russia.

In 2017, at the 5-year summit, Xi Jinping, the supreme Chinese ruler, announced the “Made in China 2025” plan. The goal of the plan is to make China the leader of the industries of the future. The plan calls for Chinese companies to produce for Chinese consumption. The target is to produce 80% of electric cars, 70% of industrial robotics, 70% of medical devices, 60% of targeted tractors, and 10% of aircraft in China by 2025.[2] They want to dominate as well in robotics, telecommunications, and computers. If China is successful, they would displace most of what the United States exports to China. Instead of reducing the trade balance, it would reduce US exports to China by some 85% to 90% while maintaining or growing Chinese exports to the US. Their goal is to replace the United States as the world leader in technology.

My guess is that trade talks with China will not persuade them to back away from “Made in China 2025”. They feel they can outlast the United States in a trade war. I would also guess China will make great strides in those targeted industries. They will be strong competitors in the short-term with government financial support, whether efficient or inefficient. The US will have no leverage since they will be producing for China, and I do not believe they will play fairly and honestly.

Since the 5-year summit in Beijing, China launched the “Belt and Road Initiative” to rebuild the Silk road. Xi Jinping has called it “The Project of the Century”. The original silk road was not just one road but multiple routes that connected all of southern Asia. The Belt and Road Initiative is the same, with all roads leading to Beijing. The “Road” portion relates mostly to the seas, such as the “Road on Ice” which refers to controlling the Arctic Ocean. The Pacific Silk Road refers to controlling the Pacific Ocean. The Digital Road refers to controlling cyber space.

The “Belt” refers to controlling land leading from Beijing through southern Asia to Eastern Europe and Africa. China is pouring trillions of dollars into building new- or updating and modernizing existing roads, railroads, ports, and power stations. The money is not given out like US’s aid: it is loaned through Chinese companies. Countries like Azerbaijan and Georgia will benefit immensely by cooperating with China; these small countries will gain access to the larger world economy. China plans to economically strengthen Tajikistan, Kyrgyzstan, and Kazakhstan to help them defend China’s western border.

What this means, in part, is that other countries will be unable to question China about human rights, corruption, or intellectual property theft. It will give China a strategic leverage over countries in Asia, Eastern Europe, Africa, and even countries like Greece and Italy.

Hambantota seems to be an example of how China will exercise their power. This example shows how the Belt and Road Initiative “… amounts to a debt trap for vulnerable countries around the world, fueling corruption and autocratic behavior in struggling democracies.”[3]

Hambantota is a port in Sri Lanka, and the president of Sri Lanka wanted a vast new development of the port. China provided loans (not direct aid as the United States tends to do). When the loans came due, the Chinese renegotiated terms that became more and more onerous. Eventually, the Chinese repossessed the port and Sri Lanka still owes a significant part of the debt. The Chinese now anchor a good portion of the Chinese navy in the port.

Under Mao’s “Great Leap Forward” in 1958, the plan was to make more steel than Britain. China, prior to that time, had very little steel production. Steelmaking was an industry of focus for decades. By 2015, China was responsible for over half of the world’s steel production: 803 million tons of the world capacity of 1,620 million tons. The United States was producing 86 million tons in 2015. That same year, there was an excess supply of 600 million tons over the demand. China was dumping steel at prices that were below cost to produce. China’s production would cause a number of steel companies to close their doors. Chinese companies could dump steel because they were government supported.

That gives insight into Made in China 2025. They intend to dominate industries in the medical, electric vehicle, computer, telecommunications, robotics, advanced materials, and agricultural machinery industries. That will impact investments in American and other countries in those industries. In assessing which companies to invest in, it will be, in my opinion, critical to evaluate not only other American competitors but Chinese companies as well.

Remember how the French mercantilism ended? A number of people lost their heads to the guillotine. But the kings were succeeded by emperors like Napoleon. With French economic power behind him, Napoleon set out to build the French empire. He conquered Spain, Italy, Belgium, Holland, Austria, Poland, and much of Germany. Napoleon raised an army to build the French empire. He was able to finance that due to France’s industrial power. It seems like the Chinese have realized that they do not need to raise an army to conquer the world. They can buy their way there by owning the railways, the highways, the ports, the internet, and the power stations.

As for investments, we know that the Chinese government-owned or controlled companies generally have little incentive for efficiency. That is the positive for American companies. It is also a reason to question investments in China.

Abraham Lincoln asked this question: “if you call a dog’s tail a ‘leg’” does the dog have five legs? No, the dog has only four legs. Calling the tail a ‘leg” does not make it a leg.”

It will be important to follow and understand what is happening in China. There will be pundits who will bemoan their entry into those key industries and will shudder when they make some breakthroughs. But I believe just their entry and a few break throughs will not put them on a path to long-term dominance of those industries. Just because they say they are going to dominate does not mean they will, no more than calling the tail of a dog a “leg” makes it one. But it will impact some US companies, and, in my opinion, it is prudent to be very cautious in investing in those companies.

As a side note we have added a number of new readers from those who were at the Las Vegas Money Show. We hope you will find these letters informative and useful.

[1] “Some Things Are True Even If Trump Believes Them.” Thomas Friedman, The New York Times, March 13, 2018.

[2] “The People’s Republic of Protectionism.” Barrons, May 4, 2018

[3] “How China Got Sri Lanka to Cough Up a Port.” The New York Times, June 25, 2018.

One Comment

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