This year, China has overtaken Japan as the second largest economy in the world. By 2025 or 2026, it is likely to supplant the U.S. as the world’s largest economy. Such estimates make Americans anxious. What is happening in this rapidly growing Asian country, what are the implications for us, and how should we treat our relationship with China going forward?
Here to share their perspectives are Dr. Lynn Reaser, chief economist for PLNU, and Jose Munoz, MBA, CPA, director of the MBA program at the Fermanian School of Business.
VIEWPOINT: Jose, in your 30 years of travel to Asia, what example can you give to demonstrate the amazing changes taking place in China?
MUNOZ: I remember the first time I flew into Hong Kong’s old airport, Kai Tak International Airport. No one prepared me for the white-knuckle approach to the landing, which makes San Diego’s airport approach look like a stroll in the park. You literally flew in between buildings before making a sharp 90-degree turn just before touching down on the runway. I was scared to death. The airport was old, over-crowded and with gates to handle less than half the planes on the ground, so most times you walked down a portable ramp like in the old movies and boarded a bus to the terminal, which was also old and over-crowded. Remember, this was when Hong Kong still belonged to the British, so you would expect something more than this.
The new airport, Chek Lap Kok International Airport, was opened in 1998, one year after Britain ceded rule of Hong Kong to China, and it is truly a marvel. It has to be one of the 5 finest airports in the world, with more space, fine dining, shopping, and entertainment – the locals actually go to the airport as a night out. Try saying that about any airport in the U.S. Keep in mind that Hong Kong never sleeps and there is always something going on. Ticket counter, customs, and security checkpoint lines are almost non-existent. As good as it was, it even got better with a massive pre-Olympics expansion. I think this one snapshot is an easy-to-understand item that illustrates the rapid and massive changes taking place in China. The scene in Hong Kong has been replicated in just about every other major Chinese city.
VIEWPOINT: Dr. Reaser, please tell us a little about your recent visit to China and some of your impressions.
REASER: The candor of the Chinese in many of our meetings was striking. Leaders are proud of the progress their country has made but are also acutely aware of its shortcomings. For example, while Chinese GDP (gross domestic product) is now exceeded only by that of the U.S., China’s per capita GDP is around 100th in the world.
Both the newest and the oldest technologies exist side by side in China. Airport security agents scan arriving passengers with fever-detecting infrared sensors. In restaurants, waiters are equipped with headsets and hand-held order devices to communicate with the kitchen. At the same time, China’s surplus of labor is evident. Where one worker might be adequate, three, four, or five might be engaged. We attended a banquet, where there must have been about a dozen servers attending to a table of 15. We also encountered an occasional horse-drawn cart from the countryside.
China’s focus on green industries and economic sustainability was unmistakable everywhere we went. Signs in the airport advised people to not use more paper towels than necessary, and discussions of electric cars were prevalent in our talks with government and industry officials.
VIEWPOINT: So how was this visit different from your previous encounters with China?
REASER: The change was dramatic. Twenty years ago, the sea of bicycles on the streets of Beijing was striking. My entrepreneurial idea at that time was to supply bicycle lights to the millions of bikes roaming the night streets in the dark. (I never executed on this brilliant concept.) Today, there are still some bicycles on the streets, but cars are dominant. Last year, China surpassed the U.S. as the largest car market in the world, with sales of 13.5 million passenger vehicles, in contrast to the 10.4 million sold in America.
Another difference is a new value of leisure time to the Chinese. This was not the case 20 years back; I remember a conversation with a young woman raising her first and only child. She spoke of her commitment to work six or more days a week to make for a better life for her child and of the willingness of the entire Chinese population to sacrifice for the future of the nation.
Now, most people work a five-day week. You see young people congregating in the parks in the evenings to practice swing dancing, followed by an energetic session of aerobic dancing. Wealthier Chinese have second or vacation homes in the countryside that they visit on weekends or holidays.
VIEWPOINT: As you met with CPIFA, what kinds of economic goals or priorities came out of those discussions?
REASER: Three themes emerged as dominant priorities: boosting consumption, maintaining external accounts, and moving toward greener, more sustainable practices.
VIEWPOINT: How was this increase in consumption evident during your visit?
REASER: A considerable consumer culture has developed in the country. Even two decades ago, the Chinese demand for the newest and best was evident. I recall visiting a local television manufacturing factory that was suffering from falling sales and bloated inventories. The problem was clear. Chinese consumers were shunning the locally produced black and white TVs in favor of color sets imported from Japan.
The attraction of high-end stores and fashion is apparent. The side streets of Beijing and Shanghai still have the collection of small, dingy shops and stalls selling only a handful of food items and goods. Retailing is rapidly transitioning, however, to modern, brightly-lit stores in shopping complexes with a wide variety of merchandise.
A generation of Chinese “yuppies,” known as Xiaozi, has emerged. These are generally members of single-child families, with parents and two sets of grandparents who have bestowed generously on them. They drink Starbucks coffee and wear the latest style of jeans.
VIEWPOINT: How are people able to afford their new habits of consumption?
MUNOZ: Recently allowed strikes by Chinese leaders, particularly at foreign-owned plants, have resulted in better wages at some facilities. Workers are demanding a larger share of the profits. Labor costs have risen in China by 15% annually since a new labor law was enacted in 2008. Additionally, tax preferences for foreign companies ended in 2007, and costs for land, water, energy, and shipping are rapidly rising.
REASER: Chinese households save an average of 50% of their incomes today – about ten times the personal saving rate in the U.S. The public pension system currently covers only a fraction of the population, which has prompted people to save more as insurance against costs that might be incurred later in life. To reduce the saving rate and spur consumption, Chinese leaders are moving to create a better “safety net” by improving retirement programs.
The drive to raise the incomes of rural families and close the large gap with urban households continues. Last year, per capita disposable income averaged about $2,500 per urban household, which was about three times the amount earned by inhabitants of rural areas. China is now directing more investment and capital to its rural areas, including large public works projects. In addition, Chinese policymakers are also pressing for more technology and services-oriented sectors that will create more higher-paying jobs.
VIEWPOINT: What has contributed to this great income gap between urban and rural workers?
MUNOZ: The inequality in income is due primarily to the 50-year-old hukou system, which is a household registration system devised in the 1950s to support population control efforts and economic development plans of the then new Chinese Communist government. Those from rural areas were required to stay there and produce the vast quantities of food needed for the growing populations. They were required to stay away from the cities.
Over time, the rules were relaxed or ignored, and rural hukou holders became a part of the growing urban workforce, but at a severe penalty. These so-called ‘floating people’ (liudong renkou) were required to work 25% more hours per week while earning 40% less than their urban counterparts. They are clearly second-class citizens, with no schooling or health care provided for their families, and it is estimated that they number 150 million. Those lucky enough to find living space pay six times as much for half as much space as do their urban counterparts. The system has been likened to South Africa’s apartheid. These workers make up 70 – 80% of China’s textile, apparel, and construction industries, which gives their employers a tremendous cost advantage.
Due to growing discontent, China announced in March 2010 that it was going to reform the hukou system. The shape and size of these reforms has yet to be presented or explained.
VIEWPOINT: Twenty years ago, Chinese leaders spoke of their vision to create a system of capitalism with “Chinese characteristics.” How is that vision materializing today? Or is it?
REASER: The vision is still cloudy. Opinions and practices differ significantly, running the gamut from tight government control to avid endorsement of free markets. Many corporate leaders are members of the Communist Party.
Because of this, foreign investors interested in entering the Chinese market must typically form a joint venture with a Chinese firm and are generally limited to a 49% stake. In contrast to the U.S. Federal Reserve, China’s central bank is not primarily politically independent. The Bank does make recommendations on monetary policy, but the political leadership is responsible for the final call. Credit is allocated to favored sectors including, at the present time, “green” technology and the rural economy. There is also a fear of failure and turbulence. Local governments subsidize companies at risk of bankruptcy. Firms experiencing sharp declines in their stock values are instructed to buy back their shares. The foreign exchange rate is managed carefully.
At the same time, China is making major strides to become a more open, market-oriented economy. Many of the economists and leaders we met have studied at universities in the U.S. In fact, some of the individuals we met were greater advocates of the capitalist model than many of our own citizens. New businesses continue to sprout rapidly in the country, supported by venture capital. Small investors participate aggressively in the stock market, with day-trading a popular pastime. Most firms in China are profitable.
VIEWPOINT: Does the growth of Christianity in China have an impact on its economy?
MUNOZ: The prevailing view is that Christianity and the market economy go hand in hand as they are both seen as modern and related to business and science, and because Christianity discourages idleness, dishonesty, and injury, encouraging instead community and good citizenship.
Independent estimates by the Pew Forum and by former party officials show that the number of Christians in China could number 130 million (in 2008), which would mean that there could be more active Christians in China than in any other country in the world. If this correlation actually exists, capitalism stands to continue growing.
VIEWPOINT: What is the financial relationship between the U.S. and China?
REASER: The U.S. and Chinese economies are now inextricably linked. China’s exports, many of which are produced by American firms operating in China, need the U.S. market. In turn, we need the investment of China’s large current account surplus to finance our large external deficit through purchase of our Treasury securities and other financial assets. It is China’s sizable holdings of U.S. Treasury securities that have allowed the U.S. government to run large budget deficits, our citizens to maintain low personal saving rates, and our lenders to maintain low interest rates.
If China were to liquidate its holdings of U.S. assets, interest rates could possibly soar and the dollar could plummet. Fortunately, China would be loath to take such a step. Such a move would inflict severe losses on its own portfolio. It also could be expected to push up the value of China’s currency sharply, which would hurt the competitiveness of its imports. Nevertheless, as China’s consumer society continues to grow, its trade surpluses are likely to shrink, implying smaller purchases of U.S. securities.
MUNOZ: China is also diversifying its investments in the U.S. by dramatically increasing its foreign direct investment (FDI) into the U.S. Chinese companies have found that land costs in parts of the U.S. are one-fourth of what they are around Shanghai. While labor costs are as much as 15 times higher in the U.S. than in China, Chinese companies receive local and state payroll tax credits and other benefits which help offset those costs, as do the reduced shipping costs and lead times for their American customers. Culturally, the “made in USA” label has some appeal to Chinese manufacturers.
VIEWPOINT: We know that China tightly controls the value of its currency, closely managing its appreciation. What is likely to occur if the yuan is allowed to float freely according to market forces?
REASER: Chinese officials are divided as to what would happen. Some believe it might initially rise only to eventually fall back close to its prior value. Others, including a number of American economists, believe that a sizable appreciation will be necessary to help achieve equilibrium in world financial markets.
Calls for China to allow its currency to appreciate have persisted for some time. Americans argue that by preventing a sizable appreciation of their currency, the Chinese are in effect subsidizing their exports and restricting imports. Most Chinese appear to believe that their currency should be allowed to move over time, but that the process should be carefully managed. Disagreement exists over the impact of a higher value of China’s currency on the U.S. trade imbalance. While a stronger yuan might slow the importation of Chinese goods into the U.S., imports might well just shift to other countries, such as Vietnam, India, or Indonesia.
MUNOZ: As Chinese wages have risen, some foreign companies have responded by relocating to the poorer, lower cost, western regions of the country, but in some cases, they are actually exiting China. For example, Wham-O (maker of the Frisbee and the Hula Hoop) has brought back half its production to the U.S., as China’s labor costs rose. Any appreciation in the yuan could rapidly erode China’s labor cost advantage. In fact, an outsourcing and re-structuring firm has estimated that China is now more expensive than Mexico, India, Vietnam, Russia, and Romania.
VIEWPOINT: In what ways is China changing to become more environmentally sustainable?
MUNOZ: For every new governmental policy or initiative, there are many glaring examples of environmental degradation that reflect the reality of China today.
The recent massive floods in Gansu, a poor, remote province of western China, killed more than 1,000 residents. Blame has been placed on the combined effects of uncontrolled logging, denuded hillsides, agriculture, and the building of many dams. In southeastern Fujian province, a massive toxic spill of copper-processing acidic wastewater into the Ting River essentially poisoned the river and killed thousands of fish.
China has almost 20-25% of the world’s population but only 7% of its available water resources. Worse yet, it is estimated that up to 80% of it is undrinkable. The standing joke among residents of south China’s apparel industry is that one can tell which colors are in fashion in the West by looking at the color of the river. One company, Fuan Textiles, was discovered to be dumping 22,000 tons per day of untreated dye and wastewater directly into the river.
There are other critical issues concerning product safety, workplace safety, and infrastructure. Chinese mining accidents always seem to be in the news with many deaths, often blamed on unsafe work conditions. The tainted powdered milk scandals of several years ago have just reared their ugly heads again, even with the conviction and execution of one of the corporate CEOs that was responsible. A massive traffic jam of unheard of proportions occurred on a highway from Beijing to Inner Mongolia, limiting traffic flow to one third of a mile per day, and stranding motorists for up to two weeks without relief.
REASER: The pollution threat to urban areas is palpable. A thick haze hanging over Beijing is also evident in Shanghai. In fact, 16 of the 20 cities worldwide with the highest levels of air pollution are in China. Prior to the 2008 Olympic Games, China moved its major industrial plants out of the central part of Beijing into outlying areas. That policy has been maintained. Driving is now rationed in Beijing, with car owners only able to travel on “odd-even” days according to their license plate numbers. Conservation is clearly a focus, although there are exceptions. For example, in Shanghai, one is struck by the vivid color display at night with skyscrapers throughout the city lit from head to toe. Some of these contrasts represent the Yin-Yang in a culture focused on balance. Others represent the clashes inherent in an economy and society undergoing rapid and far-reaching change.
The country does aim to have 15% of its energy consumption supplied by alternative fuels (including hydropower and nuclear) by 2020. It appears that this goal will be readily achieved, with some thinking that 18 to 20 percentage rates will be accomplished.
MUNOZ: Even China’s harshest critics will acknowledge that there has been progress in the country’s environmental awareness and desire to be environmentally friendly.
VIEWPOINT: What recent issues have arisen in relations between the U.S. and China?
REASER: The largest complaint continually voiced by the U.S. against China regards the country’s currency (as mentioned above). However, China is a
lso the target of criticism because of the counterfeiting of goods and violation of intellectual property rights. There appears to b
e some progress on these issues, but the critique remains. For example, counterfeit goods are no longer featured in stores on major shopping streets, but vendors are eager to guide you down side streets to sell them to you. Meanwhile, goods patented in the West are commonly “reversed engineered” and then sold as Chinese products. The largest motivation for a greater enforcement of intellectual property rights is likely to be the development of new products by Chinese firms, and the drive of those companies to protect their innovations.
Chinese criticism of the U.S. involves two primary issues: (1) technology and (2) visas. The Chinese would like to see much greater access to technology, and they oppose the many restrictions the U.S. imposes because of concerns over national security. There is also much concern over the limitations we impose on travel from China to the U.S. China’s officials argue that the allowance of freer travel could help offset some of the large trade deficit now existing between the Chinese and American economies.
VIEWPOINT: What should Westerners consider when engaging in future relations with China?
MUNOZ: A major concern for the West is the next long-term direction to be taken by the Chinese government. The era of President Hu Jintao and Wen Jiabao is coming to an end, under whose leadership China flourished and achieved its most dramatic growth. Vice President Xi Jinping is seen widely as the replacement for President Hu, and is due to take over in 2012. Of significance is that Hu and Xi are on opposite sides of the domestic policy issues in China, and this will have a direct bearing on China’s future directions. Xi is from the so-called Shanghai School of Development, which places priorities on urban centers and market-based reforms. Xi is also called a ‘princeling’ – a title given to descendants of China’s original communist leaders.
Hu wants to focus on more rural development and more central state control, which is ironic, because under Hu’s leadership, China has loosened state control and the rural-urban divide has become more severe. This divide in top leadership strikes at the heart of the future of China. Will China become more market-oriented or more state-controlled? Will the emphasis be on urban or rural areas?
REASER: Attitudes towards China in the U.S. cut sharply in two directions. Numerous companies of all sizes are currently doing business with this huge economic entity or at least exploring possibilities. American investors continue to look for ways to participate in the rapid growth spawned by China throughout Asia. At the same time, Americans despair over the possible loss of jobs and the potential erosion of our competitiveness relative to this emerging economic giant.
China’s commitment to grow their technology and services sectors, areas where the U.S. has so far enjoyed a comparative advantage, means that we must continue to innovate, improve productivity, and improve our educational system. It is important that we try to raise our standard of living rather than worry about or prevent China from raising its standard.
It is also vital that we strive to strengthen the Chinese-American liaison by encouraging more candid exchanges of ideas and thoughts. We should not lecture the Chinese; indeed, we do not always have the best answers. Still, China knows it has much to learn from us. We can do much to extend and deepen our relations.