The issues driving a developing economy

China is Going Grey

Maya Alexandri has written a superb review of a recent government study on China’s grey economy. The study claims that urban residents in China generate and earn an estimated RMB 4.4 trillion in grey income. Putting that number into perspective, that’s about the size of the current defense budget of the United States.

Let’s analyze those numbers for a moment. Figuring that China has approximately 300 million urban residents, that’s RMB 14,667 in underground spending/earnings PER urban resident each year. While US$ 1920 per year may not sound like a lot, it represents a figure that is 25% larger than what the National Bureau of Statistics reported for per-capita urban income in 2006.

This means that urban income is at least understated by 25% in government statistics, and if the NBS is not taking into account the grey economy (which it doesn’t look like they have,) urban incomes in China could well be underestimated by 50% or more.

In a day when there is a significant battle among economists as to exactly how much purchasing power China’s urban residents have, this discrepancy could be pivotal in the debate.

We love the towns, the towns that go “boom”

Superb article by Peter Hessler, with photos by Mark Leong, in the June National Geographic (viewable online here) that does the best job describing China’s industrial entrepreneurs through a close-up of the heart of China’s Horatio Algerism, Wenzhou.

I’ve been hearing and reading bits and pieces of apocrypha about Wenzhou for years. This article really pulled it all together.

Bang! You’re Dead

In the Hutong
Trying to get the cordite smell out of the air
1113 hrs.

Xinhua is reporting that fireworks in Beijing have killed one person and injured 270 over the Chinese New Year.

You see, this is where I start to have a serious problem with moral relativism. You say it is part of China’s culture to set off fireworks and has been for a thousand years. I say it’s wrong.

I say look at the pollution and litter caused by fireworks.

At the factory explosions that level entire city blocks.

At the fires that destroy homes and lives.

And, of course, the toll of dead and injured.

Fireworks are made of gunpowder. Gunpowder was created to kill people and break things. Fireworks are an accidental, incidental application of the material.

For a little perspective on what we’re talking about, police in Beijing confiscated 560 million illegal fireworks this year. At an average of, say, one gram of high explosive per, that’s about 1.3 million pounds of TNT. To put this into perspective, a fully-loaded B-52 Stratofortress bomber carries 51 500-lb Mk-82 Snake Eye bombs. That means that just the illegal fireworks confiscated in Beijing would fill 50 B-52 bombers. And that’s not even taking into consideration the 380,000 crates of fireworks sold legally, which at (I’m guessing) 10 lbs per crate, would fill another 150 heavy bombers.

Allowing millions of pounds of high explosives into the hands of people who have neither training nor the understanding of pyrotechnics to handle them safely seems to me a pretty straightforward example of a really bad idea.

In any culture.

The Coming Global War on Chinese Farmers

Table #113, The Hard Rock Cafe, Tokyo
Nachos on earth, Grilled Salmon to all good men
Embarrassingly light-headed after two Kirin Ichibans
1334 hrs local

Eastern European fruit farmers are the most recently aggrieved parties in China’s rise. Seems Polish farmers have filed a complaint with the EU claiming they are being undercut in the European market for strawberries and other cash crops by Chinese food producers who are getting tax subsidies and benefit from cheap land and labor.

Regardless of the merits of this particular case (which the Wall Street Journal article implies is not supported by the commercial realities), this is simply na early skirmish in a global war on China’s rise as an agricultural exporter – not of rice even cotton, but of cash crops. Many farmers in Eastern Europe and other developing regions retreated to cash crops when they were chased out of commodities by more efficient competition from places like the Ukraine, Argentina, Australia, Canada, and the US. Now China has realized that the landholding structure in China – and the surfeit of farmhands – makes the production and export of cash crops ranging from roses to berries to broccoli the perfect strategy.

High Tech + High Touch = Hasta La Vista Polish Berry Farmers?

China already has more folks on the farm than any of these other countries, and a government determined to keep as many people in the agricultural sector as possible. More people at less cost to take care of crops for whom tender loving care adds value seems to be the best use of this vast labor resource.

Now, let’s add to this mix growing investments by food producers in innovations like climate-controlled hothouses, drip irrigation, and other technical innovations coming from the U.S. and Israel, and China becomes the only agricultural products exporter that can combine the power of BOTH high tech and high touch in agriculture.

At that point, China stops cranking out strawberries that are simply cheaper, it also cranks out better fresh strawberries, regardless of season, that can be grown organically.

Don’t think that’s a big deal? Ask the guys at Unilever, Group Danone, and other major European food processors desperate to find suppliers to help them service the exploding organic food market. Don’t think for a minute they aren’t watching this with extreme interest.

In other words, adding a little tech to cash crop agriculture will turn China from a low-cost producer of cash crops to a high-value producer of said exports in the matter of a very few years.

This does not necessarily mean the end of Polish berry farmers – or of farmers who compete against the Chinese. What it does mean is that, like their comrades in industry, they’re going to have to rethink how they do business, what they grow, and how they market it.

It’s Not Just the Berries, Guys

The EU, for it’s part, is still dangerously in denial about what the future holds. Per John Miller’s excellent Journal article:

“The Eu thinks it has much to gain by striking the right trade balance. ‘Agriculture will be an area of tremendous growth’ says EU trade commissioner Peter Mandelson. China can sell bulk products in the EU, serving EU consumers money, he says, while the EU can cash in on China’s growing middle classes by selling niche products such as wine and cheese.”

I hate to burst Commissioner Mandelson’s bubble, especially since his messages appear so expertly crafted to mollify agitated EU members without pissing off European food companies who increasingly depend on China. Unfortunately, his view of the world is unrealistic, and he is doing his producers of bordeaux, champagne, brie, and Parma ham a serious injustice.

There are Chinese producers in all of these sectors who are making incredibly rapid advances in production quality and marketing prowess. A small number of Chinese wineries have reached quality levels not too different than where Australia was two decades ago, and there are producers of gourmet cheese and other foods that are at least keeping up with the increasingly sophisticated Chinese palates, if not surpassing them.

If Mr. Mandelson really cares about the producers of these products in Europe, he’ll be telling them right bloody now that they need to haul themselves to China to begin building a taste not just for their products, but for their brands as well, and finding ways to beat the Chinese producers to the punch. After all, if the Chinese can produce high quality wines in the hills of Shaanxi and Gansu, one would think there are a few divisions of LVMH who could start doing the same thing under their own labels.

This won’t happen if the Nabobs of Brussels continue to purvey their palliative phrases designed to calm concerned cultivators.

European agriculture has a future if it rises to the Chinese challenge in their boardrooms and fields, not in the courts and legislative floors of the EU.

Oh, and by the way – to my friends in the U.S. and Australia – this applies to you guys, too.

And to all a good night.

Shanghai, the International City (Until 10:59pm)

In the Hutong
Watching the workers fit my old desk partitions into a Daihatsu microvan
0851 hrs

The Village Grouch (Hutong resident, author, raconteur, and Scuba pooh-bah) was in a foul mood when we spoke this morning. Seems The Grouch was on the 8:00 PM rocket from Beijing to Hongqiao airport in Shanghai, a miserable commute under most circumstances, but miraculously on-time last night.

Grouch lands on time at 10:05 PM, does that long slog from the gate to the street, gets to the taxi queue at 10:30 PM, and discovers that due to a “shift change,” there are no taxis to be had.

Now, let’s consider this for a moment. A major airport. China’s largest city. Before midnight. And NO taxis. Not because so many people are riding cabs, not because of awful weather. A shift change.

And Shanghai is an “International City?” Right.

Fly into JFK any time of the day or night, and there are plenty of cabs. Same for Heathrow, Narita, Chep Lap Kok, and Changi.

I know it sounds like picking nits, but it is indicative of the fact that China Hype has reached such a level that many of us wouldn’t even question the validity of Shanghai’s claim to be an International City a la New York, London, Tokyo, Hong Kong, and Singapore. But a municipality where the freeways are sinking, getting a business license takes MONTHS, and you have to time your arrivals for the taxi drivers is NOT an international city. It’s a cow-town with skyscrapers.

The skyline may be beautiful, and you may even be able to buy a decent meal on The Bund and buy a Starbucks. But Shanghai has a ways to go before it catches up with its own self-image.

And it’s an example of how many of us – myself included – need to fine-tune our B.S. detectors.

Debunking the White Tornado

When I was a kid, a large consumer products company ran a TV ad campaign for it’s line of detergents, likening the effect of the product to a white tornado, a great whirlwind that would sweep in and clean anything, erasing even the most embedded filth. Perhaps it is this kind of marketing that contributes to an apparent belief among foreigners, particularly Americans, that adding something clean to something filthy makes everything clean.

I call this belief The Great White Tornado Theory.

The Great White Tornado Theory is used most often in China by advocates of foreign participation in China’s financial industry. Listening to the tales of embezzlement, corruption, and malfeasance among China’s banks, securities brokerages, and other sectors, executives of international firms shake their heads, tut-tut sadly, and remind media, policymakers, and each other that if ethically managed (read “foreign”) companies were allowed to fully participate in the market, by competitive force and dint of example they would help eliminate unsavory practices.

It’s an attractive theory, and as an advocate of greater competitiveness in China, I want to agree. A lot of my friends do, as do many people whom I respect deeply.

But both the theory and those who expound it have some credibility problems with Chinese audiences and impartial observers.

What’re We Doing Here?

Let’s say for a moment China were to allow open foreign participation in, say, the securities brokerage sector. Once we get past the rhetoric and the high-minded ideals, foreign firms are not coming to China to clean the place up – they’re coming to make money. After making investments in staff, high-priced offices, and years of lobbying, headquarters in New York, London, or Tokyo are not going to be telling their China teams “okay, guys, go out there and help build an ethical market.” No, the word from HQ is going to be “get out there and start making us a mint, or we’ll fire you and find somebody who will.”

The pressure to perform will be intense, and the competition – intensified by the arrival of foreigners – will make performing extremely difficult. The pressure to engage in common but unsavory practices to get business and drive results will be intense. In such a cauldron, the question of making the ethical choice and the profitable one will not come down to the name on the door or the pedigree of the firm – it will come down to the character of the individuals making those choices, and to how willing firms will be to sacrifice profits for ethics.

If the situation in other industries and places is anything to go by, the prognosis is not good.

Doing Like the Romans

The experience of other industries in China suggests the path that foreign securities firms might take.

There are those who believe that only a very limited number of foreign firms engage in unethical practices in China, and there are others who have confided with me that they believe it impossible to make a profit in China without bending your morality a bit – the system is simply rigged against that. In reality, China can be extremely hard on ethical corporate practices. As Peter Goodman wrote in The Washington Post last August:

“American business leaders often describe their China operations idealistically, suggesting that their presence here will compel Chinese competitors to adopt more ethical business practices. But in one key regard, the dynamic operates in reverse, with U.S. companies adopting Chinese-style tactics to secure sales, as they compete in a market in which Communist Party officials routinely control businesses, and purchasing agents consider kickbacks part of their salary.

Managers of U.S. companies say they are caught in a dilemna: They are answerable to shareholders on Wall Street and home offices that demand a piece of an increasingly lucrative Chinese market. Yet they are also held to account at home by the Department of Justice and the SEC.”

In short, when in Rome, companies are not acting like the Greeks. Foreign firms in the telecommunications, medical equipment, airport security, software, and computer hardware industries have all been accused of, have admitted, and/or have been fined for practices that are not only unethical but are indeed illegal in the U.S.

For the finance industry, is there anything to suggest that the record would be different?

The Record Elsewhere

A scan over the checkered history of the financial industries in the U.S. over the past two decades does nothing to suggest that there is something about an international institution that inhibits impropriety. The savings-and-loan scandal from the late 1980s, the insider-trading convictions of people like Ivan Boesky, the tainting of research by investment bankers, the growing options pricing scandal, boiler rooms, pump-and-dump schemes…all evidence drawn from the front pages of America’s largest newspapers, all representing ethical lapses in finance, and all taking place under the aegis of the toughest regulatory system in the world.

Taking the show on the road hasn’t helped. Failures in ethics and systemic controls at places like Morgan Stanley Japan Securities and Goldman Sachs Japan make clear that financial firms are not above rolling around in the mud with the locals like Mitsubishi Securities and the Murakami Fund in the name of profits. Indeed, if Japan is any model, one could argue that it is not foreigners who will clean up a market, but local regulators with sufficient political air cover to do the right thing.

So again, I ask – if foreign financial firms can find themselves in hot water at home for not doing the right thing, what evidence is there that they will have a cleansing effect on China.

Right Impulse. Wrong Reason.

Foreign participation in China’s financial sectors will be a good thing for a lot of reasons – it will increase competition, diversify services, and force everyone to work harder for the customer’s business. The institutional capital and investment mentality the foreigners bring with them should do much to stabilize the punter-driven technically-based markets, and possibly even bring some accountability to bear on listed companies.

Creating a cleaner market, however, is not one of those reasons.

The government knows all of this – there is a growing understanding among regulators that a well managed market requires an independent third-party overseer with prosecutorial powers in addition to whatever self-regulation can be put into place. (That’s not radical, anti-free market thinking, by the way – that’s theSecurities Exchange Act of 1934.)

For that reason, anyone who suggests to a government official in China that foreign participation will have a cleansing effect on China’s financial industry is merely flushing his own credibility down the toilet. Drop the argument already – it weakens a case that is strong enough on its own merits.

Nota Bene

The fact that The Great White Tornado Theory is specious and a lousy argument for open financial markets does not release financial institutions from the implicit obligation to do well and do good. Do not come to Rome and do as the Romans – come to Beijing with the full cognizance that the ability to know right from wrong – and to act on that knowledge – is a long-term competitive advantage.

Chinese companies and individuals are not going to be comfortable with placing their financial futures in the hands of institutions who engage in nefarious practices. All a foreign firm can offer today that a Chinese firm cannot is trust, the comfort that a customer is putting his faith in a professional whose ethics are above question. Lose that, and the Chinese financial industry will be a rat race and the foreign firms will be the first targets when the regulators grow new teeth.

Not Norma Rae

In the Hutong
Talking with the local Party boss
1655 hrs.

Our Party Chief here in the Hutong was talking with me about the unionization of Wal-Mart and Foxconn, and she brought up an interesting possibility that I had (stupidly, I now think) not considered before.

She noted that since, in fact, the unions in China are part of the government, they should be seen as an extension of the government’s regulatory infrastructure. She said that the WMT unionization process will be watched with great interest. It should not come as a surprise if the government began to see unionization as a disciplinary tool against foreign-invested enterprises (and private local firms) who are seen publicly as being unfair to their workers.

“Be good to your people, or we’ll unionize you.”

Not that any smart boss should need that threat these days. Even in a place like China, the costs of constant labor turnover are far higher than most leaders calculate, whereas the value of building a stable workforce in terms of both efficiency and the potential for process innovation could be substantial. But we digress.

The implications of the use of forced unionization as a disciplinary tool are huge. This would compel a lot of companies to re-evaluate their human resource policies, their costs, and indeed whether or not to build a facility in China. It would also significantly alter the tactics of international labor activists in their “workers’ rights in China” campaigns.

Not to mention create a gigantic opportunity for regulatory malfeasance….

Dreams Built on Sand: Investing in Chinese Real Estate from a Distance

Catching up on Podcast Backlog
In the Hutong
0916 hours

I just received an interesting e-mail from my brother Jeremy, who is a professional property manager in Los Angeles. He was forwarding me a newsletter from a Beverly Hills-based entity that is touting international investors on the “exciting, unaddressed opportunities” in real estate in China. They’re holding an investor forum, meeting with local developers, and they’ve apparently made several trips here.

Caveat: technology and media are my core areas, so I would not profess to be an expert (or even a specialist) in real estate in China. But I am a property owner in China, spend a lot of time researching the market, and speak and work with professional investors frequently. And, like my brother, I learned the fundamentals of real estate from my parents (who were – and my mom still is – successful real estate investors) at the dinner table and from nights and weekends helping tenants or cleaning up after them.

The fundamentals of China’s market would appear to make real estate investment a no-brainer.

  • The amount of real estate available is limited, both absolutely and by government regulation;
  • There are a lot of Chinese who need places to live, work and shop;
  • There is a population shift underway, with tens of millions of people moving into the cities;
  • Chinese lifestyles are improving, compelling locals to look to upgrade their current digs;Business investment is growing, driving a jump in demand for A & B class office buildings nationwide; and
  • There is a jump in demand for retail space driven by increasingly prosperous consumers.
All of this is true. Spot on. And all of that is exciting to investors who look worriedly at the softening U.S. market.

But to approach China as if it were a “normal” real estate market would be foolish. There are some critical differences between investing in Chinese property of any kind that U.S. investors need to take into account before being swept up in the China real estate bubble.

  1. The lending market for second-hand properties is so small as to almost be non-existent. Banks simply aren’t set up to lend on real estate except when it’s being developed, or when the developer is selling newly built offices, stores, and homes to buyers. This means that if you have cash you can make some good buys on pre-owned properties, but it also means that if you ever want to sell, you’re going to be looking at a limited market. Read “depressed value.” That’s fine if you’re relying solely on rental income to get your return, but if you care about capital appreciation at all, you’re going to be challenged a bit.
  2. Multiple listing services don’t exist – and thus there are no statistics on comparable sales. The only thing you will ever know on any property is the asking price. This means that you are never sure what your property is worth. Nice, huh?
  3. In China, you don’t own property. You own usage rights for a fixed term. That also changes the dynamics of resale price, and of property value.
  4. Chinese real estate law is still evolving. Unlike in the U.S., where you have a solid body of law on which to base your investments, in China the actual rights that you own are subject to change as real estate law evolves. And if you want to evict a tenant? Landlord-tenant law is extremely nebulous here. Zoning is starting to happen, but you shouldn’t be surprised to see new apartment blocks going up next door to factories – or vice-versa. Right next door to our upscale residential neighborhood out in the suburbs, they’re building a giant international exhibition center. So much for our quiet neighborhood.
  5. There is no way to check the credit of a tenant, and your options for compelling payment of rents are few.
  6. Good management is hard to find. By good, I mean professional, consistent, service-oriented, un-corrupt, and businesslike, managers (or management companies) who will keep tenants happy and make sure you still make money. That’s tough anywhere, but it’s even harder in China, where tenants and residents think the management company is ripping them off no matter how well the place is run. Frankly, I think it’s a bad idea to own a piece of income property that you are too far away from to actually oversee yourself, but if you can put an honest manager in place, you can get away with it. Marriott made a recent move into the property manage.
  7. Inventory is pouring into the market. Beijing, to give a single example, has been described as “a construction site with a parking lot” and it’s little different in any of China’s tier one or tier two cities. Some of the largest advertisers in China are real estate developers, and with good reason – they need to pull them in quick. The construction shows little sign of abating, and, given the way they do things here, probably won’t until the market collapses under the sheer overhang of inventory.
  8. This is still a market where strange things happen, even to very large, savvy investors:
  • A residential development not far from where I live lies 2/3 empty after nearly a decade in part because the government officials who granted land use rights to the developer had not actually cleared those rights, and the peasants who formerly worked the land are fighting.
  • Another development lies abandoned next to a major freeway offramp because the developers simply skipped town with the investors’ money.
  • And let’s not forget the case wherein McDonalds signed a 20-year lease on their massive flagship restaurant, only to find that another government agency had granted the rights for land use to a well-connected Hong Kong developer. The restaurant was gone a mere 5 years after it was built.

None of this is to suggest that you should NOT invest in real estate in China. I have no doubt there are opportunities for the adventurous, speculative investor here. But before you invest, whether it’s in a piece of property or a China real estate fund, do your homework first. Talking to a bunch of developers during a trip here, or reading the fund prospects doesn’t count. Ask hard questions, and ask a lot of people. Then make your own call.

As for me, I own Chinese real estate because I bought when the cost of renting my house over the last six years would have nearly paid for it, interest and all. Would I buy today? I’m not sure.

Friedman Gets So Close, and yet Misses the Real Story

In the Hutong
Contemplating sleep
0104 hrs.

Richard, The Peking Duck, has posted Thomas Friedman’s NYT Op-Ed highlighting some of the critical issues facing rural China.

Say what you want about Friedman, he hits on a critical point most of us lifelong urbanites tend to miss: China is destroying farmland not only through urbanization and water pollution, but by outmoded agricultural practices driven by outdated policies. Rural economic reform, the place where Reforming and Opening began, has stalled. In many respects, policymakers have forsaken farmers to build cities and industries.

The issues Friedman touches circle but do not hit on the real story. I don’t think it would be an exaggeration to suggest that we are seeing the early danger signs of a hollowing-out of large chunks of China’s agricultural economy.

Some may suggest this is an inevitable step in modernization, and that’s fair. But I’d look at it another way. If there is a way to keep those farmers who aren’t interested in an urban life on the farm and offer them a way to participate in the kind of growth that China’s secondary and tertiary industries are enjoying, wouldn’t that be a good thing?

Let’s look at it another way. China’s cities are supposed to absorb 10 million rural migrants a year for decades to come. With the end of the Hukou system, that number might well grow. An outright rush to urbanization will bring problems China is unprepared to handle. Why not moderate that rush by creating more opportunities on the farm? Who knows? Apply a little microfinancing and some appropriate technology, and we may wind up with a bit of a green revolution in cash crops.

I’ve been having long talks with Hanya Kim and her beau Sagi over at Netafim about this stuff. Stay tuned for more on agriculture and technology.

Egg Flu Dung

In the Hutong
Contemplating Kosher Veganism
2125 hrs.

Richard at The Peking Duck says almost everything that needs to be said about China and the Bird flu, except possibly this Reuters piece that suggests that there is a danger in eggs!

Apart from the fact that this has the potential of taking all of the fun out of an omelet or a breakfast buffet, it turns out that the greatest danger to egg eaters is not what’s inside the egg, but the feces and excreta on the shell.

Sure, we can wash our eggs. But why do people outside the poultry processing industry have to come into contact with chicken poop?

If nothing else, this situation is a guttural scream for restructuring of the food processing and retailing sector. I don’t mind my books or my clothes being “disintermediated,” but I’d just as soon put somebody who is going to take care to make sure that the food products don’t bring death and disease in a concentrated form into 400 million homes around the country between my breakfast table and the farmer.

China, India, and Technology

In the Hutong

The India vs. China thing has become something of a fetish among global executives, business analysts, government officials, and think tankers, and now The Economist.

As a strategic issue, the India/China issue is totally irrelevant. Any senior executive anywhere in the world who is still saying “hmm, should we go with China or India” is out of touch and a danger to his company and its shareholders.

India is given far too much credit for its IT industry, which is a good thing for the country, no doubt, but is not the answer to the country’s ills. It makes up a mere 4% of GDP, and is going to find its long term upside as a mass employer sorely limited as the country runs out of trained graduates. Worse, as we are discovering worldwide, the IT revolution has two distinct phases. In the first, a company creates an industry, first in assembling machines, then designing them, then providing services, then writing software, then designing the whole deal.

In the second, traditional industries in agriculture, manufacturing, and services begin to absorb increasingly sophisticated doses of IT, radically transforming the industry and raising its productivity and profitability. This is where the big payoff comes – when the entire industry is fundamentally changed.

With its English-speaking masses, its technical universities, and a global community of Indian engineers, the company will certainly do well with the first.

But India’s challenge is education beyond this elite, because that is where the nation struggles, and its lack of inward foreign direct investment. Without the inward FDI, traditional industries find making the major investments to transform and modernize their businesses a major, often insurmountable challenge. And without a large pool of labor with an elementary and secondary education, where is the workforce trainable to operate in those modern transformed enterprises? Literacy runs at 57% (vs. China’s 91%), and an appalling 45% of adult women are functionally illiterate in India.

So India is set to hit a wall in this second phase unless it begins redressing some fundamental problems. Building hardware, writing software, and even creating services will only absorb part of the population and make a few sectors globally competitive. China, on the other hand, is already starting to transform its industries.

That can all change in a heartbeat. All India needs to do is begin taking a chainsaw to the license raj, and it will suddenly look like a great bet – even if companies have to provide their own workers with basic instruction. I expect it will happen, but not soon.

BTW – check out Silicon Hutong’s India soulmate – The Sepia Mutiny.

Salespeople in Short Supply in China

In the Hutong
Watching the Sun Set

This article on Xinhuanet notes that salespersons are the most wanted professionals in China. Extending that logic, clearly companies are recognizing the value of an effective sales force.

No brainer of the week:

CRM and sales-force automation (SFA) companies take note: they’re this )( close to getting it in the boardrooms of China, Inc. I would guess 2005 would be a good time to redouble efforts in the Middle Kingdom. Hmm?

More Capital: Just What China’s Securities Markets Don’t Need

The Garage in the Hutong

China’s insurance companies, loaded with capital that needs to be invested someplace that offers either some security, relatively decent returns, or both, have now been authorized by the government to start pouring their capital into China’s A-share market.

Certainly, adding institutional investors into a market of largely unsophisticated punters could bring some much-needed stability into the markets, and would also create a class of investor theoretically able to compel better governance and transparence among listed PRC firms.

Apart from the macro-economic benefits, however, one has to wonder whether Chinese insurers as businesses are likely to benefit from the new regulation. Remember, these firms make the investments in order to secure their premiums and make a healthy profit from their investment. The abnormally high P/E valuations of Chinese issues, combined with a low level of transparency and governance, tends to argue that – in the short term at least – putting a significant portion of their capital into the A-share market will put that capital at risk. And putting too little capital in would fail to stabilize the market sufficiently to raise A-shares to investment grade.

Additionally, the government looks likely to retain controlling ownership of nearly all of the issues in the near- to medium-term, thus reducing whatever leverage the insurers would have over the companies and their governance. The government could essentially vote its shares and overrule the insurers.

What makes much more sense is to take steps to compel local securities markets to be more competitive, and give them the wherewithal to do so. Increasing the percentage of state-owned enterprises traded on the bourses, raising the limits for equity investment by insurers, and implementing (and enforcing) the highest international standards of governance (to be phased-in over a 3 year period) would do much to address the fundamental issues in the market. In the meantime, pouring institutional capital into an overpriced market with shareholders restricted to trading 30% the outstanding shares of 1,500 questionably-governed companies on a bourse that behaves more like The Las Vegas Strip than Wall Street is simply throwing good capital after bad.

The Coming China AgTech Boom

The Silicon Hutong Suite, Intercontinental Hotel, Singapore

Whenever someone gets enough of an adult beverage into my system and starts talking about the fundamental challenges China faces, he discussion eventually turns to the plight of China’s peasantry. All of the development in industry and services will be for naught unless some way can be found to bring prosperity to the 900-million or so peasant farmers that make up China’s rural population.

That millions – perhaps hundreds of millions – of those farmers will migrate to China’s cities is considered a given among “informed observers” of Chinese population trends – people like the Asian Development Bank, the World Bank, and similar government-organized super-national organizations (GOSNOs for short). The question that nobody can seem to agree on is how many of those farmers will be surplus to needs in Chinese agriculture (and thus will need to be absorbed in the urban workforce), and how quickly they will make that shift from rural subsistence farmer to urban migrant worker.

This question is no trifling matter. Setting aside completely the peasantry, there is a huge mass of urban industrial workers in state-owned enterprises that need to be shifted out of the inefficient state sector and into more efficient, globally competitive companies. Once they’ve made that shift, an entire system to provide for their social welfare has to be created, because the government and the SOE’s have been carrying that up until now. Nobody expects this change to be fast – it will take years.

NOW, add onto this the challenge of absorbing a rural population in cities already crowded with unemployed or underemployed workers.

It’s daunting. The clear answer is to drive rural prosperity. Quickly. Keep em down on the farm.

My soapbox, now as before, has always been to create an agricultural economy that is high value-added, labor-intensive, and resource (i.e, land, water, capital) efficient. Provide those high-value crops to the increasingly prosperous urban population in China, and leverage government investments in infrastructure and the growing foreign role in transportation and logistics to create a global export market for those crops.

Now it looks like China is starting to figure it out. In a recent article in the Far Eastern Economic Review, Andrew Browne and Lai Yang have demonstrated that despite policymakers preferences for agricultural self-sufficiency, local workarounds on land use and China’s entry into the WTO is allowing local farmers to tap the demand for cash crops, and move up into the nations’ middle class. They give stunning numbers. China now produces half of the world’s vegetables and melons. China produces four times as many apples as the U.S., and the quality is improving rapidly.

And American producers of apples, broccoli, and similar crops are hurting…while producers of maize, wheat, soybeans, sugar, and cotton will likely celebrate. There’s good reason for that: the U.S., with around 5-10% of its population engaged in agriculture, has consolidated farms and it excels at the mass production of grain, beef, and oilseeds. But even with migrant farm labor, American fruit is premium priced in Asia.

In the end, China’s policymakers will undoubtedly see the wisdom of horticulture and comparative advantage over seed security. But that brings up another problem.

The steps being taken by the farmers that Andrew and Lai Yang talk about are basic and their scale is comparatively small. What happens when cash-crop combines like the Longda group mentioned in their article become the official model for Chinese farming? Demand grows for key inputs, and you face shortages in water, land, transportation, refrigeration, etc.

Some of the issues:

  • Water is in critically short supply in China. Even the most optimistic estimates (government statistics) place China’s per capita water reserves at the minimum level required for a healthy economy. Given that reserves are likely much below those numbers, water is clearly a critical limiting factor facing China’s agricultural modernization.
  • Farms are some of the worst creators of water pollution in China. Current farming practices must be changed if this is to stop.
  • While logistics are making progress, the situation in China is still horrible. There is no supply chain less tolerant of mistakes than a cash-crop supply chain, and the country is just not there yet. Coastal provinces are addressing these problems, but until cash crops can be brought from the interior as well, the radical inequalities between the west and the east in China – a festering sore point with the non-coastal populace – will grow, defeating much of the purpose of agricultural modernization.
  • The supply of land available for agriculture shrinking. Cities are growing to accommodate the influx of displaced rural peasants. City dwellers are demanding a growing amount of space per capita. Suburbs are sprouting. Everywhere you turn in China demand for land for non-agricultural use is growing so quickly that the government has to inflict draconian measures to stop it.

In short, the move to cash crops is a great trend. But the leap to making it sustainable is going to require significant changes to the way crops are grown in China, including:

<> Techniques for raising crops with a minimum of water need to be adopted, adapted, and developed further. First, crop selection needs to begin emphasizing varieties that can be grown (or are best grown) in arid conditions. Some fascinating work in this area is being done in India at ICRISAT, but China absolutely must add arid and semi-arid crop research to its significant studies in reforestation. Indeed, a powerful case could be made that the focus of reforestation in China should be on sustainable cash crops for semi-arid environmens. There are significant opportunities here for businesses in consulting, equipment, fertilizers, etc.

<> Second, techniques like aeroponics need to be developed further to allow their commercial utilization before it becomes economically essential to do so. More research, but a clear need for the world’s leading developers of this technology to be here and be involved.

<> Wastewater processing for agricultural will eventually become a necessity. Yes, it’s ugly, and as a longtime China resident I have a hard time dealing with the possibility that my fruit is being watered by something unmentionable, or indeed downright dangerous. But the realities are that China, like India and many other nations in the world, will have to turn to the use of wastewater in crops for part of the agricultural requirements. China could start by endorsing the Hyderabad Declaration on Wastewater Use in Agriculture and turning to reputable international firms to help. The problem here, of course, is that China has just destroyed any near-term opportunities in this area by publicly infuriating a major foreign investor in wastewater treatment and disallowing a 15% annual rate of return on a treatment project. With all respect to the Chinese government, it is unlikely that any facility solely operated by – or controlled by – a local utility will reliably deliver processed wastewater of the kind of quality that agriculture would demand. China needs foreign firms, their technology and their management in this field like nowhere else.

<> Logistics needs to be addressed in two ways. First, clearly there needs to be government-private partnership, including foreign firms, in the creation of an effective system for moving fresh fruits, vegatables, and the like from anywhere in China to anywhere on the planet in time to have them arrive fresh at supermarkets worldwide. That’s a huge task and will require a lifetime of effort to accomplish.

Second, as in interim measure, processing infrastructure needs to be moved close to the point of harvest in order to be able to process the crops sufficiently to withstand (in some usable form) transportation to distant markets.

<> Postharvest physiology is another part of the solution, developing ways in the modification of plant breeds to help the crops maintain quality and prevent spoilage.

A premature focus on a potential solution that ignores the obstacles can create much larger problems than it solves in the context of a place like China. Anticipating the challenges – and addressing them – is a process that not only makes the solution viable, it also determines what areas China needs to focus on in developing technology.

Spending the national treasure on duplicating technologies that already exist is at worst an unconscionable waste, and at best an unsure bet on future returns simply for the sake of keeping the money onshore. Import substitution as a policy, however, has been out of favor for decades, particularly among countries with significant advantages to leverage.

Spending the national treasure, on the other hand, in green-field (no pun intended) areas of research and development that can propel the country beyond its greatest challenge is, on the other hand, a wise choice. And if it means that a few foreign companies need to make a healthy profit to get China there a few years sooner, where is the harm?