Why Rattner's Wrong on China

In an emotionalop-ed last week, Steven Rattner defends the strength of China's economy. But he's wrong.
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In an emotional NYT op-ed on Wednesday, Steven Rattner defends the strength of China's economy. But he's wrong. And not for the reasons set forward by the "pessimists-lite" crowd he rebuts. He's wrong because he's using macro-economic indicators to make his point. China's "extraordinary" investment rate of 48% of gross domestic product. Its 2.2% decline in housing prices over the past nine months. Its interest rate cuts, bank lending, currency. These measures are all beside the point.

If we swoop down from Rattner's bird's eye view to the realities on the ground, we see a very different version of China's economy. Let's consider infrastructure. Sure, the Chinese may be investing a lot in this sector. But the domestic steel they're using has been banned on most international infrastructure projects. For example, in the recent construction of a tank farm for a Saudi Arabian refinery, Halliburton invited several Chinese companies to bid but banned Chinese made steel.

China's iron ore tends to be structurally inferior -- that's why China must import most of the ore it needs to make steel. And Chinese steel derives from China's fragmented chain of primitive mills, smelters, foundries, and fabricators, imbuing every steel application made in China with risk.

But structural deficiencies are not the only reason big, multinational customers typically avoid Chinese made infrastructure. The state-owned companies that sit on top of China's supply chain usually lack the most basic attributes of a well-run business. A few short years ago, a major oil and gas exploration company invited China's most technologically advanced shipyard to build an offshore drilling platform. But a routine audit revealed the shipyard to lack the very DNA a company needs to create products reliably.

There were no clear lines of reporting. Job functions were vague. Basic quality control systems were not in place. Uniform procurement standards were not in place, either. So the shipyard failed the audit. And when the international customer offered to help the yard improve its standards, it refused. A billion dollar order was not enough of an incentive to change. After all, the yard could keep serving its domestic customers and still thrive.

Steel is not unique. Risk is baked into everything 'Made in China.' Food, drugs, consumer products, you name it. Food safety presents such a vexing problem for Chinese families that you can now track the hundreds of yearly Chinese food safety scandals on a Chinese website which translates to mean 'Throw It Out the Window,' as well as on an iPhone app called the 'China Survival Guide.'

The relative risk baked into everything Made in China derives from systemic weaknesses in China's economy that could take many generations to fix. These include China's long, opaque, and fragmented supply and distribution chains, in which every player adds risk, time, and cost; its overlapping and corrupt regulatory regimes; and its continued dominance of the state-owned sector, impervious to market forces which would normally pressure companies to improve or perish.

Mr. Rattner and the naysayer crowd he rebuts can argue about the meaning of macro-economic data coming out of China (all of which is suspect, anyway, because of the lack of China's data integrity). But this approach misses the point. Until it can manage the systemic risk that permeates its economy, China's economic output -- the goods China makes -- will never be reliable.

Indeed, Rattner, on his recent visit to China, may have had "a feeling of [China's] lunging further and further into the 21st century." But the opposite is true. From a manufacturing perspective, China is stuck in the 19th century, when the Western nations rationalized their industries. Terrifyingly enough -- especially when it comes to our own vulnerable food and drug supply -- China seems content to stay there.

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