China Myopia

China isn't our bogeyman and it isn't our savior. We need to stop seeing China through a distorting rear view mirror. It informs bad policy and feeds into the fashionable, but false, narrative of American decline.
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The way politicians and pundits see China today reminds me of that little warning etched in the rear view mirror, "Objects may appear closer than they are." Peering through our rear view, China looms like it's tailgating us -- strengths magnified, weaknesses minimized, and economic fundamentals distorted.

So whether it's Mitt Romney telling us the China-Bogeyman story or Steven Rattner telling us the China-Savior story, they're looking through a distorted rear view mirror by using standard economic statistics to support their arguments. But these economic statistics fall apart in China.

China's Gross Domestic Product, for example, is a meaningless statistic. In China's informal economy, keeping separate accounting books is standard operating procedure for local companies. The books they show the taxman are different from the ones they show their investors, for example. So growth numbers from individual companies are often deflated. While growth numbers at the provincial level are often inflated. Provincial governors want to show the feds how sizzling hot their economy is to attract more domestic and foreign capital. In other words, when China looks like it's about to ram us "as the world's second largest economy," that supposition is mostly based on GDP numbers that are utterly unreliable.

Chinese trade volumes are meaningless numbers, too. According to The Economist, for every iPad we import, China contributes just $10 worth of value. Yet we value it according to its total production cost of $275, hopelessly distorting the picture of China's true participation in our balance of trade. It is estimated that if China's actual value-add in trade were calculated, our bilateral trade deficit would be cut in half.

So the whole "Rising China" schtick is based on misleading statistics. To calibrate a truer perspective on the strength of China's economy, we need to fix our gaze onto the continuing Made in China safety scandals, most of which are reported in the Chinese media but not here. These safety scandals are more than just isolated incidents. There are literally thousands of food safety scandals a year now. These safety issues are symptoms of grave problems at the heart of China's manufacturing capability.

The truth is that the foundation of China's economic might -- its manufacturing sector -- is riddled with risk. But in order to see this, you've got to do more than visit a couple factories and talk to some Chinese businesspeople (what passes for special knowledge these days.) You must walk the line where raw materials are formed into products. You must see for yourself how food and drugs are processed, step-by-step, from inputs to outputs. And ideally, you must try to wring safe products out of this system yourself.

What you'd see would surprise you. You'd realize that everything made in China is relatively risky. And that the great manufacturing juggernaut looks that way only if you are gazing through a distorted rear view mirror.

To understand why, let's consider how products in China are actually produced. First, the chains of companies that must collaborate to make things are abnormally long. So what might take three firms to produce something in America -- from raw materials to goods fabrication to distribution -- often will require three times as many companies in China or even more.

These gangly value chains imbue risk into products because the companies in the chain often focus on a single operation, like painting toys or scraping pig intestines for blood thinner enzyme. Because each firm tends to lack the ability to police its own product safety, and because the chain is so opaque that other companies along the line can't discern whether the inputs they receive are safe, each company in the long chain adds considerable safety risk.

In addition, the fact that companies in China's value chain are often state-owned compounds the problem. We tend to see Chinese state-owned firms as having enhanced competitive advantages over American firms because of the special treatment they receive from the Chinese government, such as subsidies, loan forgiveness, and bargain pricing on raw materials. However, Chinese state-owned firms tend to be the riskiest of all because they are shielded from the market forces that would normally force them to improve or perish.

So, the heavyweights of Chinese manufacturing -- the large infrastructure makers, the shipbuilders, the high-speed rail producers -- are often nothing more than Potemkin villages. They may flaunt their state-of-the-art equipment, but good hardware means nothing without good software. These companies lack the corporate DNA to make safe products. Their management is a scrum, with no overriding corporate governance or clear lines of reporting -- both of which are essential to making safe, reliable products -- and they lack basic quality control and procurement systems. Unsurprisingly, they usually fail simple quality and process audits by international customers. It's no wonder leading engineering and construction firms often prohibit Chinese-made infrastructure on major projects.

If shopping for Asian-made infrastructure, they'd rather turn to Japan or Korea. Remember in the 80's when America obsessed over a "Rising Japan"? We assiduously copied Japanese management style, from scientific quality control systems to the habit of standing in meetings to make them briefer. I have yet to encounter an American company that wants to copy Chinese management style.

Yet a long, opaque chain of sub-par companies is only part of the problem. Zooming up, we see a dysfunctional regulatory regime. Policing China's civilian nuclear power industry, for example, are 27 ministries and 14 public sector institutions. Because regulatory functions are spread across so many regulating bodies, the system itself undermines safety and accountability. And executing ministers obviously won't solve the problem.

So turning our attention back to today's China rhetoric, we come to understand that the noises from the China-Bogeyman crowd and the China-Savior crowd miss the point. China will do just fine in the near term. Its urban household and government coffers are flush with savings. Fortress China will hold, no matter if its economy slows. But its population will continue to need food, energy, transportation, housing, and medicine. Given China's ongoing struggle to produce these items safely, Chinese consumers will keep turning to the U.S. to supply them. That's why our exports to China keep rising year after year, in nearly every congressional district -- often by triple or even quadruple digits.

Looking beyond the balance sheet, though, we need to realize that the fundamentals of China's economy are weak. That in the longer term, China will need to address the systemic risks that riddle its manufacturing capability. And that these problems won't go away quickly or easily. After all, it took America nearly a century to undergo an Industrial Revolution, when our gangly, risky supply chains had to be integrated and rationalized. It could take the Chinese even longer, given the degree of complexity they face -- not the least of which is a system corrupt to its putrefied core.

In the meantime, we need to stop seeing China through a distorting rear view mirror. It informs bad policy and feeds into the fashionable, but false, narrative of American decline. China isn't our bogeyman and it isn't our savior. It's a giant, underserved market that desperately needs safe goods and efficient services -- both of which America is perfectly poised to provide.

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