WHITHER CHINA? Part 1

By John Tulac

China is a $10 trillion economy.  China directly and indirectly impacts us. What happens in China affects all of us, wherever we may be and whatever we may be doing.  Even Mom-and-Pop main street businesses are connected to China by the products they sell.  Thus, it is vitally important for U.S. businesspeople and policymakers to know what is going on in China and to keep up with rapidly developing changes.

China is not likely to collapse. However, its economy dramatically slowed in 2015 and it did not achieve its growth target, which was revised downwards three times during the year.  After decades of double-digit annual growth, China failed to achieve 7%.  It probably grew at about 5%, which is still more than twice the annual growth in the United States.  China has substantially reduced its purchases of commodities and raw materials, supplied primarily by developing countries. As a result, China is pulling much of the world into recession.  The European Union and the United States will eventually follow, perhaps somewhat sooner in 2017 than otherwise.

China will also likely fail to achieve its official target rate of growth for 2016.  While 6.5% is robust growth, China can no longer pad its growth with highways nobody will use, apartment complexes nobody will occupy, and production from state-owned enterprises that nobody will buy.  China will try to use command-and-control processes to ease its way from a low cost producing country to a services-and-consumption economy.  The transition will be awkward and painful.  It will create not only great risks, but also significant new opportunities.

Evaluating risk and reward whether buying from or selling to the Chinese is hampered by a lack of good data and transparency.  A lot of data from China is manipulated.  Some data are deliberately false.  Due diligence is a challenge in any event, because the business culture does not favor full disclosure, even long after a good, strong business relationship is established.  There are lies, damned lies and statistics, as the saying goes. This proverb is writ large in China.

The Chinese stock market has caused worldwide jitters. Despite its small size, its psychological impact has been large. The Chinese government encouraged business owners to invest in stocks listed on the Shanghai exchange.  As the market dived, the government interventions were heavy-handed, clumsy, inept, and ineffective; in fact, the interventions made the crash worse. The decline isn’t over.  The market is down 50% and business owners have felt their wealth being wiped out. The natural tendency is then to cut costs and cut corners to improve profits and rebuild what has been lost. Quality control will suffer. If you have Chinese suppliers, be more vigilant in assuring quality control.

The Chinese currency tied to the dollar was the second bubble waiting to burst. The yuan has been devalued and could free fall.  Whatever the yuan is, it is not yet a true world currency. After postponing IMF membership, China began its deliberate devaluation before having to abide by IMF rules applicable to a currency in the basket. This was a smart, but unloved action. Is it currency manipulation? Sure, but no more or less than what the Federal Reserve does.

The third bubble is Chinese real estate. The run up in prices is amazing considering how overbuilt most major cities are. There are numerous empty apartment buildings, whole ghost cites of them on the outskirts of the major port cities and Beijing and throughout the interior cities. When the real estate bubble bursts, as it inevitably must, the Chinese business owners will feel even more beset, which will lead to more cost and corner cutting.

Chinese businesses are already laying off employees and in some cases completely shutting down. The Chinese worker has no safety net. The ability to laterally move is restricted, since job creation at comparable wages has slowed or stopped in many industries.  Returning to small towns or rural areas is a dead end. Labor unrest will increase and violent protests will occur. The supply chain is vulnerable to labor unrest, particularly if your products or component parts are originating in the interior.

Any U.S. business that depends on a supply chain originating in China or including China should have contingent plans in place.  Strategic planning should include developing one or more alternative to China for the long run.  Any U.S. business with an exportable product, service or intellectual property should consider creating an export plan to sell to China.

In the next installment, I will analyze the significant actions being taken by the Chinese government and how these impact U.S. businesses.

John W. Tulac is an international business attorney practicing in Claremont, adjunct professor of law at University of La Verne College of Law, and Lecturer Emeritus (retired) at Cal Poly Pomona.  He is peer recognized as preeminent in international business law and holds the highest ratings for competence and ethics from the Martindale Hubbell National Law Directory.