China dreams

The sleeping giant has awoken at last and is doing brisk business. And Heathrow-Beijing club class is perennially full. Howard Davies, director of the London School of Economics, and his colleague Linda Yueh investigate the possibilities.

Last Updated: 31 Aug 2010

The China Dream has captured the imagination of Western traders for centuries. Christopher Columbus annotated the margin of his copy of Marco Polo's travels with the words mercacciones innumeras (incalculable trade). A more practical English writer in the 1840s noted: 'If we could only persuade every person in China to lengthen his shirt-tail by a foot, we could keep the mills of Lancashire working round the clock.'

More recently, the Chinese leadership's decision to open up its markets has attracted western companies in great numbers. The thought of selling a cappuccino, or a Big Mac, to 1.3 billion Chinese is irresistible. Normally hard-bitten chief executives have cheerfully approved costly 'fact-finding missions' by the marketing department. They have maintained expensive offices in Shanghai and Beijing, and financed speculative joint-ventures with Chinese partners - some real, some imaginary.

By no means all these newcomers to the Chinese market have made money.

Very few have made serious money; even fewer have made serious money in hard currency repatriated to the West. Yet the rush to the East continues. The number of beds in business hotels in China doubles every couple of years. Business-class cabins on flights to Beijing are full, and evidence of western optimism about the Chinese market is everywhere. The Rolls Royce dealership in Beijing has newer, shinier models than you'll find in London's Berkeley Square.

A recent report by economists at Goldman Sachs has added fuel to the fire. They argue that the four major developing economies of Brazil, Russia, India and China - acronymically dubbed the BRICs - will muscle their way into the global big league over the next few decades. Not just in terms of their growth rates, but also of their absolute size. And China is, of course, the biggest BRIC in the wall.

It is now highly likely that the Chinese economy will be larger than the UK's by the end of next year. It has already overtaken three members of the G7: Canada, Italy and France. On current trends, the Chinese economy will be bigger than Germany's by 2007 and, more speculatively, will overtake the US by 2041.

Of course, there are questionable assumptions behind this startling projection.

Goldman Sachs assumes that population growth will remain modest or negative in most of the developed countries, and also that the very high savings and investment rates currently observed in the big developing countries will be sustained. The first assumption looks reasonable; the second could be questionable if China increases its domestic consumption rapidly. But the general direction of change is pretty clear: if current trends continue, there's little doubt that developments in the Chinese economy will be absolutely central to any assessment of the progress of world GDP in future, and any company with global ambitions will need a significant position in that market.

But will current trends continue? What are the threats to continued expansion in China at the rate we have seen over the past decade or so since Deng Xiaoping told his people that 'it is glorious to be rich'?

The record is remarkable. Since 1989, the Chinese growth rate has averaged 9% a year. Exports, in dollar terms, have risen more than five times, and China runs a large surplus with the rest of the world, particularly with the US. In domestic currency terms, GDP per head is 10 times as high as it was in the mid 1980s and, although prices have risen perhaps 3.5 times, that still means a sizeable real increase in prosperity.

Much of this growth has been stimulated by investment financed by domestic saving. The investment rate has been around 35% of GDP (twice as high as the UK's). But China has also received huge volumes of foreign direct investment, having overtaken the US as the largest recipient of FDI a couple of years ago. In 2002, China received more than $46 billion of FDI, up from just $1 billion in 1985.

This is, on the face of it, a stunning record. Yet not all commentators are impressed. Once such is Joe Studwell, author of The China Dream - The elusive quest for the greatest untapped market on earth. He pours cold water on the 'straight line' growth theories of the optimists and points to the problems that have accompanied over-rapid growth in a country only hesitantly coming to terms with markets and free trade. He talks of fiscal meltdown and a banking system running out of control. How seriously should we take these criticisms?

It's true that it is rare to find a country that continues to grow at almost double-digit rates for a protracted period without some hiccups along the way. Yet China could maintain the growth record of the past decade well into the future. The scope for catch-up is immense. When China's economy equals the UK's in size, GDP per head will still be less than 5% of what it is here, since the Chinese population is around 23 times our own. As long as a sensible policy framework is maintained, and China continues to open up its markets to international competition, it is more likely than not that the economy will grow quickly.

But the 'if' is significant. The new leaders, President Hu Jintao and Premier Wen Jiabao, have inherited serious problems. Perhaps the most intractable are to be found in the state-owned enterprises (SOEs).

Many of these companies, of doubtful value in the first place, have been left stranded by the opening up of markets. Many face new competition from joint ventures with foreign partners and are essentially worthless.

Yet closing them down could bring a sharp and destabilising increase in urban unemployment, with unpredictable social and political consequences. So while privatisation or bankruptcy look the most sensible options, it will be painful.

And the SOE problem is at the heart of the critical situation facing Chinese banks. The four major banks in China, the so-called policy banks (Industrial & Commercial Bank of China, Agricultural Bank of China, Bank of Communications and Bank of Construction) were not, in the past, simple commercial ventures. In essence, they were funding channels, used to promote economic development. They advanced loans in their chosen sector, often without close attention to the creditworthiness of the borrower. Indeed, the banks in some cases had little choice but to lend to firms well connected with the local political hierarchy.

As a result, their balance sheets are weighed down by non-performing loans. The published figures show that, taken as a whole, some 30% of the four banks' outstanding loans were not being serviced by borrowers, even though some bad loans had already been transferred to special asset management companies designed to recover the banking system's bad debts through work-outs and negotiation.

This is a tough problem. But the Chinese are addressing it in a forthright way. They have set up a new banking regulator, chaired by the former chairman of the Bank of China, and seem determined to clean up the banking system's balance sheet as quickly as possible. The example of Japan, where banks burdened with bad debts have been a drag-anchor on the economy for the past decade, gives them a powerful incentive to succeed. In January, the Government announced an injection of more than $40 billion into two banks - and most observers think more will follow.

Another linked problem is the fraught question of corporate governance, and indeed of the legal basis for property ownership and contract negotiation in China. Much of the underpinning of a successful capitalist economy is lacking in the People's Republic. Accounting standards are poorly enforced and the concept of independent directors is a relatively new one in China. Disclosure rules on the stock exchange do not match up to those in operation in developed countries, and those foreign companies that have thought it necessary to go to court to establish their ownership of assets have not always found that to be a happy experience.

Again, the leadership seems clear about what needs to be done. A powerful new securities regulator has been set up and new securities laws put in place, with the help of experts from Hong Kong in particular. But reforms will take time to have a real impact on behaviour.

All of this change must now be implemented against a tight timetable imposed by Chinese membership of the World Trade Organisation, and the commitments and obligations that this brings. The decision to join the WTO has forced the Chinese to be more open about the position of their corporate sector, and particularly of their banks, and this has exposed problems that were latent but not well understood by outsiders.

Optimists about China regard this as an entirely positive step. The pessimists point to the immense transitional problems that have been exposed, and the difficulty of resolving them in short order. Which leads to the biggest question, and the hardest: does China have the human capital needed to manage an astonishing transition from a backward planned economy to the front rank of the world's developed economies?

At the very top of the Chinese political tree, the answer looks promising.

Deng Xiaoping may or may not have had a detailed understanding of the workings of Western markets, but he pointed decisively forward. Zhu Rongji had a very clear view of what was necessary to manage the transition, and the new leadership, although only in place for just over a year, has shown solid judgment so far, and has impressed those who have met them.

Their willingness to look outside China for advice, and to acknowledge frankly the scale of the difficulties they face, is impressive in any political leaders, and especially in China. For instance, the Fourth Generation leaders have demonstrated a plethora of xinsiwei - 'fresh approaches to doing things'. Their 'balanced and co-ordinated development' approach is recognition of the need to pursue economic growth while devoting more resources to social development, particularly health and education in poor regions. But however promising the top looks, the cadres and managers further down the hierarchy will be essential in this process. A deeper cultural change is needed.

How well is the UK positioned to take advantage of the opportunities that will certainly arise in the coming decades, whether or not they are precisely on the scale forecast by the optimists at Goldman Sachs?

Up to now, the signs are mixed. We run, proportionally, one of the largest trade deficits with China. Our exports of £1.5 billion are dwarfed by imports from China of nearly £7 billion. We are no longer, perhaps, seeking to lengthen 1.3 billion Chinese shirt-tails, but nor have we succeeded in attracting the Chinese to our newer exports, whether gin or genetics. And our share of Chinese foreign direct investment is similarly modest. By 2002, British FDI in China had reached only £3 billion, a mere 1% of the estimated total.

But there are optimistic signs. British insurance companies are beginning to penetrate the Chinese market: two British banks, HSBC and Standard Chartered, are well positioned in the marketplace, perhaps better than almost any other western competitor.

And now that the political acrimony relating to the transition of Hong Kong has been removed from the equation, the former colony is acting as a bridge between the UK and China rather than an obstacle. The Chinese themselves seem keen to develop a counterweight to their US relationship in western Europe and particularly in the UK.

One striking sign of that development is the fact that this year, for the first time, more Chinese students came to study in the UK than went to the US. In the long run, educating the future elite of the People's Republic could be as good an investment as any other we could make in the China Dream.

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