The China Bubble

U.S. companies are banking their future success on tapping into the enormous Chinese market. They're in for a nasty surprise.

At the height of the dot-com bubble in 1999, the magic word for hyping a stock was "Internet.", one of many speculative dot-com companies, earned a gilded stock price of $11 per share in early 2000. Buoyed by an initial investment by, it ultimately raked in $300 million in early financing. Like many Internet companies in that era, however, it never earned a profit; when the bubble popped in late 2000, just months after went public, the company announced its liquidation, driving shares down to 19 cents, a 98 percent loss. Today, the magic word for hyping stock could be "China."

A China strategy remains the holy grail for global companies. While China's growth has slowed from over 10 percent just two years ago to 7.6 percent in the second quarter of this year, executives still make their China strategy prominent in pitches to analysts and investors. Thirty-seven percent of companies surveyed from a range of industries consider China "critical to global strategy," according to an Economist Intelligence Unit report from November that surveyed executives from 328 companies. Forty-six percent expect China to be their biggest market within 10 years.

The conventional wisdom is that multinationals that successfully build market share in the fast-growing Chinese market will deliver profits that reward investors handsomely. Indeed, the success stories can be astonishing: Yum! Brands, which operates over 3,800 KFC restaurants in China and claims a 40 percent share of the fast-food market, received roughly 40 percent of its 2011 revenue and $900 million of its $1.8 billion operating profit from China. Boeing, which cites China as its biggest customer outside the United States, has a 52 percent share of China's commercial aircraft market; its business there is worth $4.8 billion, 7 percent of revenue. Nike, with revenues of over $2 billion in China and 16 percent market share in the country, reported in 2011 a Greater China operating margin (percentage profit before interest and taxes) of 38 percent, the envy of the corporate world.

But China is a much more difficult market than most company's stock prices reflect. In a May study by the European Union Chamber of Commerce in China, a business advocacy group, half the 557 member companies surveyed said that market access and unspecified regulatory barriers limited business opportunities and hurt annual revenues by 10 to 50 percent. The American Chamber of Commerce in China found similar results in its 2012 survey.

Many firms in industries the Communist Party deems sensitive -- such as oil, telecoms, and information technology -- hit a ceiling once their company expands above a certain size. Because reaching economies of scale fuels long-term success, constricting market share damps U.S. company prospects in China. Although there are individual exceptions, U.S. companies' share of the Chinese market has been shrinking. Industrial output by foreign-invested firms in China as a share of the national total peaked around 36 percent in 2003 and has declined ever since to about 27 percent in 2010, the most recent year for which data is available. The theft of sensitive technology, which leads to reduced market share, is also a concern. The technology firm American Superconductor claimed 70 percent of its business disappeared in 2011 after a Chinese partner convinced one of its employees to steal some of its technology. The November Economist Intelligence Unit report found that half the executives surveyed in big companies were concerned or very concerned they would be forced to give up their intellectual property in exchange for market access.

But the most unappreciated problem with investing in China is the unexpected risks that arise. "The government can close us down suddenly, or it can help native Chinese firms to steal our technology and gradually replace us in the market," says one U.S. CEO of his firm's China operation who asked to remain anonymous. Foreign assets also face the threat of liquidation. Although they're safe from Latin American-style government takeovers, China can de facto nationalize assets by exercising such strict control over taxes, regulations, and costs that it effectively controls and drains foreign firms' profits. Nearly 40 foreign electricity producers rushed into China in the 1990s, lured by long-term contracts with guaranteed returns. Today, nearly all these firms have since exited, often selling their plants to the Chinese after being unable to make money as rising coal prices outstripped electricity-rate increases set by the state and as Chinese firms benefited from access to state credit and subsidized coal. And though unlikely, China could descend into political instability or an armed conflict with Japan, the Philippines, Taiwan, or Vietnam -- a scenario in which foreign businesses would find it very difficult to operate. Such risks don't receive enough attention from analysts and investment managers. In its biannual country risk survey, Euromoney magazine optimistically gives China a risk rating of 61.5 points (100 being least risky), compared to 75.7 for the United States and a 53.7 for India.

As with so many stock market fads, investors and analysts haven't adequately incorporated the risks into stock prices. There's a gap between the optimism presented on Wall Street and the difficulties of doing business in the Middle Kingdom, in part because CEOs are reluctant to speak publicly about these risks due to fear of Chinese retaliation against their businesses, which would make matters even worse. Think about the shock that greeted General Electric CEO Jeffrey Immelt in 2010 when he wondered aloud whether China wanted any foreign firm to "be successful." Two years later, Immelt said in a speech at Stanford University that "China is big, but it is hard," prompting a Wall Street Journal article explaining how Australia is set to generate more revenue for GE than China in 2012.

Indeed, China has been known to punish companies that publicly complain about doing business there. In Europe, EU Trade Commissioner Karel De Gucht even floated the idea of speaking out against abuses on companies' behalf -- and taking the heat -- sparing companies from retaliation triggered by the filing of official complaints. "It is undeniable that many European companies are unwilling to come forward and make justified trade defense complaints due to fear of consequences for their business," he said in May. The result of all this silence is that information about the downsides of working in China doesn't get priced into the market.

Hundreds of companies have been suckered into pursuing China strategies based on faulty expectations. Currently, the expectations of the market are high. When Caterpillar announced in April a slowdown in the growth of its China business -- China makes up only 3 percent of its global sales -- its stock fell 5 percent. That was in spite of the company earning a quarterly profit of $1.6 billion. When Apple reported in late July that sales in China had fallen 28 percent from the previous quarter (though they had risen 48 percent from the year before), Apple's stock fell 5 percent.

The question isn't whether companies can continue to operate in China, but whether they can earn margins on their investments that justify the risk. The American Chamber of Commerce survey found that 61 percent of companies surveyed report operating margins that are comparable to, or less than, their worldwide margins. From a shareholder's point of view, that's hardly a glittering statistic. Only one of three companies, in other words, is more profitable in China than elsewhere in the world -- in spite of the added risks. If companies adequately factored risks into their investment decisions, few would find China investments passing their profitability thresholds for long-term investments. And many CFOs would disqualify investments that have only a 39 percent chance of exceeding average profits, in a country much riskier than their home market.

Analysts and executives, however, will no doubt continue to portray the growth potential of China as too big to miss, highlighting the potential profit and discounting the growing challenges and risks. But as analysts tally the current value of verifiable long-term cash flows, the stock prices of firms built on the China story will weaken. Investors, once they appreciate the meager potential, will drop the stocks. And prices will follow. CEOs, beware.

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Everything You Think You Know About China Is Wrong

Are we obsessing about its rise when we should be worried about its fall?

For the last 40 years, Americans have lagged in recognizing the declining fortunes of their foreign rivals. In the 1970s they thought the Soviet Union was 10 feet tall -- ascendant even though corruption and inefficiency were destroying the vital organs of a decaying communist regime. In the late 1980s, they feared that Japan was going to economically overtake the United States, yet the crony capitalism, speculative madness, and political corruption evident throughout the 1980s led to the collapse of the Japanese economy in 1991.

Could the same malady have struck Americans when it comes to China? The latest news from Beijing is indicative of Chinese weakness: a persistent slowdown of economic growth, a glut of unsold goods, rising bad bank loans, a bursting real estate bubble, and a vicious power struggle at the top, coupled with unending political scandals. Many factors that have powered China's rise, such as the demographic dividend, disregard for the environment, supercheap labor, and virtually unlimited access to external markets, are either receding or disappearing.

Yet China's declining fortunes have not registered with U.S. elites, let alone the American public. President Barack Obama's much-hyped "pivot to Asia," announced last November, is premised on the continuing rise of China; the Pentagon has said that by 2020 roughly 60 percent of the Navy's fleet will be stationed in the Asia-Pacific region. Washington is also considering deploying sea-borne anti-missile systems in East Asia, a move reflecting U.S. worries about China's growing missile capabilities.

In the lead-up to the Nov. 6 U.S. presidential election, both Democrats and Republicans have emphasized perceived Chinese strength for reasons of both national security and political expediency. Democrats use China's growing economic might to call for more government investment in education and green technology. In late August, the Center for American Progress and the Center for the Next Generation, two left-leaning think tanks, released a report forecasting that China will have 200 million college graduates by 2030. The report (which also estimates India's progress in creating human capital) paints a grim picture of U.S. decline and demands decisive action. Republicans justify increasing defense spending in this era of sky-high deficits in part by citing predictions that China's military capabilities will continue to grow as the country's economy expands. The 2012 Republican Party platform, released in late August at the Republican National Convention, says, "In the face of China's accelerated military build-up, the United States and our allies must maintain appropriate military capabilities to discourage any aggressive or coercive behavior by China against its neighbors."

The disconnect between the brewing troubles in China and the seemingly unshakable perception of Chinese strength persists even though the U.S. media accurately cover China, in particular the country's inner fragilities. One explanation for this disconnect is that elites and ordinary Americans remain poorly informed about China and the nature of its economic challenges in the coming decades. The current economic slowdown in Beijing is neither cyclical nor the result of weak external demand for Chinese goods. China's economic ills are far more deeply rooted: an overbearing state squandering capital and squeezing out the private sector, systemic inefficiency and lack of innovation, a rapacious ruling elite interested solely in self-enrichment and the perpetuation of its privileges, a woefully underdeveloped financial sector, and mounting ecological and demographic pressures. Yet even for those who follow China, the prevailing wisdom is that though China has entered a rough patch, its fundamentals remain strong.

Americans' domestic perceptions influence how they see their rivals. It is no coincidence that the period in the 1970s and late 1980s when Americans missed signs of rivals' decline corresponded with intense dissatisfaction with U.S. performance (President Jimmy Carter's 1979 "malaise speech," for example). Today, a China whose growth rate is falling from 10 to 8 percent a year (for now) looks pretty good in comparison with an America where annual growth languishes at below 2 percent and unemployment stays above 8 percent. In the eyes of many Americans, things may be bad over there, but they are much worse here.

Perceptions of a strong and pushy China also persist because of Beijing's own behavior. The ruling Chinese Communist Party continues to exploit nationalist sentiments to bolster its credentials as the defender of China's national honor. Chinese state media and history textbooks have fed the younger generation such a diet of distorted, jingoistic facts, outright lies, and nationalist myths that it is easy to provoke anti-Western or anti-Japanese sentiments. Even more worrisome is Beijing's uncompromising stance on territorial disputes with America's key Asian allies, such as Japan and the Philippines. The risk that a contest over disputed maritime territories, especially in the South China Sea, could lead to real armed conflict makes many in the United States believe that they cannot let down their guard against China.

Sadly, this gap between the American perception of Chinese strength and the reality of Chinese weakness has real adverse consequences. Beijing will use China-bashing rhetoric and the strengthening U.S. defense posture in East Asia as ironclad evidence of Washington's unfriendliness. The Communist Party will blame the United States for its economic difficulties and diplomatic setbacks. Xenophobia could become an asset for a regime struggling for survival in hard times. Many Chinese already hold the United States responsible for the recent escalations in the South China Sea dispute and think the United States goaded Hanoi and Manila into confrontation.

The most consequential effect of this disconnect is the loss of an opportunity both to rethink U.S. China policy and to prepare for possible discontinuity in China's trajectory in the coming two decades. The central pillar of Washington's China policy is the continuation of the status quo, a world in which the Communist Party's rule is assumed to endure for decades. Similar assumptions underpinned Washington's policies toward the former Soviet Union, Suharto's Indonesia, and more recently Hosni Mubarak's Egypt and Muammar al-Qaddafi's Libya. Discounting the probability of regime change in seemingly invulnerable autocracies has always been an ingrained habit in Washington.

The United States should reassess the basic premises of its China policy and seriously consider an alternative strategy, one based on the assumption of declining Chinese strength and rising probability of an unexpected democratic transition in the coming two decades. Should such a change come, the geopolitical landscape of Asia would transform beyond recognition. The North Korean regime would collapse almost overnight, and the Korean Peninsula would be reunified. A regional wave of democratic transitions would topple the communist regimes in Vietnam and Laos. The biggest and most important unknown, however, is about China itself: Can a weak or weakening country of 1.3 billion manage a peaceful transition to democracy?

It is of course premature to completely write off the Communist Party's capacity for adaptation and renewal. China could come roaring back in a few years, and the United States should not ignore this possibility. But the party's demise can't be ruled out, and the current signs of trouble in China have provided invaluable clues to such a highly probable seismic shift. U.S. policymakers would be committing another strategic error of historic proportions if they miss or misread them.

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