The Cover Story of the July 31st issue of Barron’s featured a story titled “What Could Go Wrong With China?” The article’s argument is that despite the massive economic growth China has undergone in recent years―an annualized 9% rise in GDP since 1978―there are many possible stumbling blocks ahead as the Asian giant trudges forward on its frenetic trajectory. From an aging population which will eventually drive labor shortages to growing corruption in the government and private sectors, the article provides significant evidence that the “China Miracle” will be difficult to sustain throughout the twenty first century.
Earlier in the year, we saw first hand some of the challenges China will face, especially in a world with increasing global—and regional―competition. Perhaps the most universal observable issue throughout China is the lack of English language skills, especially compared with other developing countries like India where English has been taught as a primary and secondary language for over a century. But language issues are relatively easy to resolve—intensive training classes can teach the basics in a matter of months. What will be far more challenging over the long-term for China are underlying flaws in its business and legal infrastructure.
We would probably argue that the highest hoop that China will need to jump through centers on its near complete disregard for intellectual property protection. Perhaps China’s most blatant IP violation came when Cherry Automotive, a GM partner, produced and sold a near identical copy to a car its joint venture partner build independently. But more common examples of IP theft center on everything from software―it is estimated that over 90% of government installs of Microsoft Office within China are pirated—to transportation technology such as the now famous Shanghai Maglev, which was built with Siemens IP initially. Now, China has announced plans to extend the current line, using “its own” Maglev technology. In other words China plans to reverse engineer what it learned from its German partner on the existing line, blatantly stealing IP in the process. Long-term, this type of behavior will catch up with China, as global leaders such as Siemens begin to more aggressively weigh the risks of sharing technology with the Chinese, even when billions of dollars of revenue are at stake.
But it’s not just China’s legal infrastructure which is a potential stumbling block for the Asian tiger. When we walked around the floors of various plants, we saw many cases where companies were attempting to compensate for lack of capital, equipment and machinery, and in the process, created inefficiencies which can add to the total landed cost of a part or item, making China less competitive compared with other markets. Consider one example where an otherwise advanced textile facility with slate of the art machinery was unable to palletize shipments because of a lack of forklifts. Instead they relied on back-breaking labor to lift shipments onto trucks. At another metals plant that we have done business with, capital constraints hindered the ability of the owners to buy raw materials at the most advantageous terms and prices. And by forcing customers to pay with letters of credit or via prepayment―which essentially serves as a financing instrument at loan-shark rates―they hurt their ability to compete with other global suppliers offering better payment terms and financing options to long-term customers.
There’s no question that China is growing faster than almost any other region on earth, at any time in history. The energy and excitement one feels walking through the center of Shanghai or an industrial park on the East Coast is incomparable to almost any other region in the world. But as we saw first hand, it’s highly uncertain whether China will be able to continue on its current trajectory, despite the awe-inspiring growth it has seen in recent years. In the end, inexpensive labor and centralized planning will only get the country so far.