China Crisis goes Mainstream

Whilst I have been banging on about the unfolding crisis in China only now has the mainstream press sat up and taken notice.

The FT as always leads from the front with quality articles on the subject. In fact, the number of column inches in today's paper shows that they have taken up the challenge with gusto.

Here are some links to the juicy bits. Regular readers will be aware of most of these issues or ready. The trigger for these articles comes from the confirmation of a rapid fall in growth that has been clear from the anecdotal evidence for months.

Asian Financial Crisis Deepens [FT]

Asia’s largest economies showed stark new evidence on Thursday of contagion from the global financial crisis as China reported its slowest growth in seven years and Japan’s central bank admitted it faces two years of contraction and deflation.

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China said its economy expanded by 6.8 per cent in the fourth quarter compared to the same period the year before, confirming the rapid cooling that has seen the rate of growth fall by nearly half over the past 12 months. For the year as a whole, the economy grew 9 per cent, down from the revised 13 per cent growth rate in 2007.

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Fearing social unrest if the economy slows too quickly, China has unveiled a huge fiscal spending plan and has significantly eased monetary policy.

One essential aspect of any recovery is the need for Asian countries to use their large surpluses to lessen the damage. This does appear to be happening but Asia and the West must not reply on Asian consumers to increase spending to save us. In all likelihood saving rates will be flat or even rise in this recession.

Only by spending can Asia save itself [FT]

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China, a country that has become accustomed to double-digit growth, may now be flirting with contraction. Indicators such as electricity usage suggest a sudden, juddering slowdown. Even the imaginative massaging of China’s official state statisticians has not been able to hide a slowdown in their analyses.

These nations cannot simply wait for the crisis to end. As long as they are built to export, they will siphon off whatever demand the deficit countries can whip up. This helps keep their customers in crisis. It is in Asia’s interests that it should correct its imbalances by increasing consumption at home. This should not be a bitter pill for the region to swallow, especially when the alternative is a prolonged world recession.

The key issue I have tried to highlight in previous posts is China's reliance on trade which I believe is far more important than commentators seem to suggest. The domestic market is simply not developed enough to take up the slack. This appears only now to be sinking in (and China's economy with it).

Region pays dear for its dependence on trade flow [FT]

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China appears to be giving the matter due attention. It is also suffering an external shock, compounded by the consequences of overly successful efforts at cooling an economy that was rampaging along at 13 per cent only a year ago. By the fourth quarter of last year, growth had fallen back sharply to an annualised 6.8 per cent.

Beijing has changed tack rapidly. It is now promising to spray $586bn through stimulus measures. In response, bank lending surged in the fourth quarter, raising hopes that public funds are seeping into the real economy. Authorities in both Washington and London must be watching enviously. As Andy Rothman, China strategist at CLSA Asia-Pacific Markets, says, new bank lending has been engineered by "the world's most liquid financial institution, the Chinese Communist party". Even retail sales have held up, rising more than 20 per cent last year.

Amazingly, some policymakers in Beijing are now worried that provincial and municipal leaders may use the stimulus package as cover to pour their own money into pet projects. The concern is that, in six months or so, authorities may have the headache of tackling inflation once again. That may be the most optimistic thing anybody has said in months.

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Research Papers: "China and the Manufacturing Exports of Other Developing Countries"

In January 2008 Gordon Hanson and Raymond Robertson published a paper on China's exports and how they impacted on other developing countries exports.

The data is for 2000-2005 and they use a standard gravity approach. COMTRADE data are used and this paper and it is useful as an empirical approach for PhD students and masters students wanting to study empirical trade.

China and the Manufacturing Exports of Other Developing Countries [PDF]

Abstract. In this paper, we examine the impact of China’s growth on developing countries that specialize in manufacturing. Over 2000-2005, manufacturing accounted for 32% of China’s GDP and 89% of its merchandise exports, making it more specialized in the sector than any other large developing economy. Using the gravity model of trade, we decompose bilateral trade into components associated with demand conditions in importing countries, supply conditions in exporting countries, and bilateral trade costs. We identify 10 developing economies for which manufacturing represents more than 75% of merchandise exports (Hungary, Malaysia, Mexico, Pakistan, the Philippines, Poland, Romania, Sri Lanka, Thailand, and Turkey), which are in theory the countries most exposed to the adverse consequences of China’s export growth. Our results suggest that had China’s export supply capacity been constant over the 1995-2005 period, demand for exports would have been 0.8% to 1.6% higher in the 10 countries studied. Thus, even for the developing countries most specialized in export manufacturing, China’s expansion has represented only a modest negative shock.

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The beginning of the China crisis as unemployment rises?

In this blog I have commented on numerous occasions about the possibility of social unrest in China arising as a result of the export crash and the on going global recession.

To me I felt like I was in the middle of a strange conspiracy. At last the mainstream press and more importantly China's press are beginning to acknowledge what I have been trying to point out for a while:

1. The fall in demand for Chinese goods from the US, Europe and Japan will cause huge unemployment and will not and cannot be absorbed by domestic consumption. This was never even a remote possibility given China's rates of personal saving.

2. Chinese citizens are becoming more vocal and more liable to protest. The Internet and the ability to get information out of the country means that social instability is a real concern.

There is no doubt China's government is still strong enough to quell any trouble and is not afraid to use all the resources at its disposal but at least the issue is quietly sneaking into the real world.

What I like about this article is that China's primary concern is "employment". Forget the global crisis or inflation - employment is all important. Western governments would do well to remember this when asking for favours from China.

The key is that 8% growth is not as great as it seems given China's population structure. If we fall below 7% I would be worried.


Beijing forecasts grim employment outlook [FT]

China's employment outlook is becoming "grim", say officials, as the global financial crisis triggers fresh factory closures in the export sector.

Urban unemployment has begun to rise and will increase next year, Yin Weimin, minister of human resources and social security, said on Thursday.

"Stabilising employment is the top priority for us right now," said Mr Yin, in comments reflecting growing worries about the potential threat to social stability.

"The current situation is grim, and the impact is still unfolding," he said. "Since October, our country's employment situation has been affected along with changes in international economic conditions."

China's official urban unemployment rate is 4 per cent. But this figure includes only registered urban residents. Tens of millions of rural migrants who have moved to cities to work in factories over the past decade are generally not included in unemployment data if they lose their jobs.

The national economy has been slowing gradually since the start of the year. However, the pace at which it is cooling accelerated sharply in September and October, prompting a steep drop in confidence among companies and some consumers.

Even when the economy was growing strongly, China witnessed a stream of localised protests. Recent trouble has included strikes by taxi drivers in three cities and rioting in a city in Gansu province this week.

Statements by Chinese leaders have shown that they were worried about the social impact of a sharp downturn. In an article in a Communist party magazine this month, Wen Jiabao, the premier, said: "We must be crystal clear that without a certain pace of economic growth, there will be difficulties with employment, fiscal revenues and social development . . . factors damaging social stability will grow."

Zhang Xiaojian, vice-minister of human resources and social security, said on Thursday competition for jobs among growing numbers of college graduates would intensify if the economy slumped. The authorities jast week unveiled a huge fiscal stimulus programme aimed at keeping growth at about 8 per cent a year.

The slowdown began in the housing market, spreading to related industries such as steel and cement. With Europe now in recession, and many of its other markets slowing, some economists think that Chinese exporters are about to face an extremely tough patch.

In one indication of the gathering slowdown, Japan saidits exports to the rest of Asia recorded their first decline for seven years last month, with exports to China dropping 0.9 per cent compared with the same period last year. Japanese companies have been large suppliers of components and other products to the array of factories in China that assemble goods for export.

Two provincial governments this week announced measures aimed at deterring businesses from laying off workers. Hubei and Shandong said companies trying to lay off more than 40 staff would need prior approval from the local authorities.

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China's Threat to other Southern Exporters?

There is an ongoing debate on the impact of China on the competitiveness of China's near neighbours and indeed is an area where I have done some work.

The World Economy recently published a paper looking at this threat.

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"Measuring the Competitive Threat from China for Other Southern Exporters"

World Economy, Vol. 31, Issue 10, pp. 1351-1366, October 2008

RHYS JENKINS

LINK HERE.

In recent years there has been a growing literature which analyses the threat which Chinese exports pose to the exports of other developing countries. This paper provides a critique of the standard measures of export similarity which have been used to estimate the threat from China in these studies. Two alternative indices, the Static and the Dynamic Index of Competitive Threat, are developed and estimated for 18 developing countries and compared with estimates for the standard measures. It is shown that the latter tend to underestimate the extent to which countries are threatened by China. They also distort both the rankings of countries according to the extent to which they face competition from China and the direction of change in the competitive threat over time.

FT: "Bilateral Thinking" - UK-China trade patterns

On October 20th 2008 the FT released a pullout on the general topic of "Doing Business in China."

Included are a number of excellent articles that I will be linking to over the next few days.

The first article reveals the extent of UK bilateral trade with China and discusses the potentially rich rewards. I highlight below some of the more interesting paragraphs.

Bilateral thinking [FT]

It is the second largest exporter of goods and will become the number one within a few years. It is the largest consumer of metals, the biggest emitter of carbon dioxide and will quite soon be the world’s largest consumer of primary energy.

It also offers unrivalled opportunities for British businesses, which already export more to China than to any other Asian country and invest more in the country than any other European nation. Unsurprisingly, the UK government is keen to further strengthen trade and investment links and has increased its support for British-based organisations hoping to enter the Chinese market.

Yet the impact of the global credit crunch has dented investor confidence, as the world waits to see just how sensitive the Chinese economy will be to the slowing economies of Europe and North America. Moreover, the business environment in China remains challenging, with some sectors off-limits to UK businesses, continuing problems in protecting intellectual property rights and inflation boosted by rising commodity prices and labour shortages in the biggest centres.

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The evolving relationship is illustrated by the sharp increase in bilateral trade between the UK and China, which has more than doubled in the past five years. British exports of goods and services to China surged more than 40 per cent in the first half of 2008, while imports increased 10 per cent. The UK is investing in 6,000 projects in China worth more than £8bn, and is by far the biggest recipient of Chinese foreign direct investment in Europe – capturing 11 per cent of the total.

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China’s desire to increase energy efficiency and reduce pollution and carbon emissions is also providing lucrative opportunities for British companies. Investment in renewable energy increased 91 per cent in 2007 to £6.1bn, with most going into mini-hydroelectric generation, solar water heating and wind power.

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Fuel and Chinese exports

The rapid increase in the price of fuel has obvious knock on effects on transport costs. There are two issues here.

1. There will be an addition fuel cost per shipping container so price goes up

or

2. The ship will go slower to conserve fuel but also resulting in higher transport costs in terms of time.

This has important implications for the study of international trade, offshoring, outsourcing and globalisation in general.

A recent China Economic Review article commenting on a Washington Post piece touches on this development:

China’s getting too expensive. Back to America! [China Economic Review]

We’ve heard plenty in the news this year about rising prices hurting export-oriented businesses in places like Guangdong and, more recently, Zhejiang. Clearly some areas of China that were once “workshops” for the world’s cheap goods are pricing themselves out of the market, with the slashing of export rebates, inflation, currency appreciation (though that appears to be slowing viz. the US dollar) and rising labor, material and fuel costs all playing a part. The next step for these areas, local governments hope, is to climb the greasy pole value chain and start producing higher-value goods.

So who’s going to make our cheap furniture and sleeping bags now? Americans?

Not as strange as it sounds. In some cases, according to this interesting article by the Washington Post’s Ariana Eunjung Cha, some low-cost American manufacturers are headed back home. Transportation costs are a big part of it, according to Cha:

With fuel prices at record highs, the cost of sending a standard 40-foot container of goods has gone from $3,000 in 2000 to about $8,000 today, squeezing profit.

So this summer Kazazian, chief executive of Exxel Outdoors, a Los Angeles-based maker of recreational equipment, did something radical: He moved the manufacturing back to Haleyville, Ala.

Soaring energy costs, the falling dollar and inflation are cutting into what U.S. manufacturers call the “China price”– the 40 to 50 percent cost advantage once offered by Chinese producers.

The export model that has powered China and other Asian countries for three decades will be compromised if fuel prices continue to rise, said Stephen Jen, a managing director for Morgan Stanley.

“Globalization has gone a little bit too far. It has overshot,” Jen said. “We’re not saying Asia is going to crumble, but we are saying Asia enjoyed extraordinary conditions in the past. Now the conditions are changing very quickly because of the energy shock, and Asia is coming under pressure.”

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Chinese sofas fight back

When Chinese exports are discussed the issue of quality is never far behind.

Thousands injured by 'toxic gas from Chinese sofas' [Times]

Thousands of people who suffered severe allergic reactions after sitting on their sofas were victims of a toxic gas emitted by an anti-mould agent, a study has concluded.

Hospitals across northern Europe have treated thousands of patients with symptoms which appeared to range from skin cancer and chemical burns to severe eczema.

The British cases have been linked to an estimated 100,000 sofas sold by Argos, World of Leather and Walmsley Furnishing manufactured in China by a company called Linkwise.

How Much of Chinese Exports is Really Made in China?

Interesting NBER working paper to go on my "must read" pile.

"How Much of Chinese Exports is Really Made in China? Assessing Domestic Value-Added When Processing Trade is Pervasive"

NBER Working Paper No. W14109

ROBERT KOOPMAN, U.S. International Trade Commission
Email: Robert.Koopman@usitc.gov
ZHI WANG, U.S. International Trade Commission
Email: Zhi.Wang@usitc.gov
SHANG-JIN WEI, Columbia University - Columbia Business School, National Bureau of Economic Research (NBER), Centre for Economic Policy Research (CEPR)
Email: sw2446@columbia.edu

As China's export juggernaut employs many imported inputs, there are many policy questions for which it is crucial to know the extent of domestic and foreign value added in its exports. The best known approach - the concept of vertical specialization proposed by Hummels, Ishii and Yi (2001) - is not appropriate for countries that engage actively in tariff/tax-favored processing exports such as China, Mexico, and Vietnam. We develop a general formula for computing domestic and foreign contents when processing exports are pervasive. Because this new formula requires some input-output coefficients not typically available from a conventional input-output table, we propose a mathematical programming procedure to estimate these coefficients by combining information from detailed trade statistics with input-output tables. By our estimation, the share of foreign content in China's exports is at about 50%, almost twice the estimate given by the HIY formula. There are also interesting variations across sectors and firm ownership. Those sectors that are likely labeled as relatively sophisticated such as electronic devices have particularly high foreign content (about 80%). Foreign-invested firms also tend to have higher foreign content in their exports than do domestic firms.

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China loses in WTO case on autoparts

WTO rules against China over tariffs [FT]

China on Friday suffered its first legal defeat since joining the World Trade Organisation seven years ago, after the global trade body ruled against Beijing’s import tariffs for car parts.

A WTO dispute panel confirmed an interim judgment made in February, which upheld complaints by the US, European Union and Canada that China violated fair trade rules by discriminating against imported parts. Responding to the verdict, Peter Power, EU trade spokesman, said: “We hope China will act swiftly to remove discrimination and create a level playing field in the automotive sector in China.” And Susan Schwab, US trade representative, added: “The panel report leaves no doubt that China’s discriminatory treatment of US auto parts has no place in the WTO system.”

Dealing with China's Quality Fade

I am currently doing a little work on Quality Fade in China. I will use this post to collect relevant articles. Many articles are from last year but are interesting enough to read again.

Dealing With China's 'Quality Fade' [Forbes Paul Midler 07.26.07, 11:11 AM ET]

Recent media reports detailing a series of quality problems with Chinese-made exports--pet food tainted with prohibited chemicals, toys covered with lead paint and tires that fall apart at high speed--have understandably alarmed the American public and resulted in a number of international product recalls.

But supply chain professionals not directly affected by these recalls remain unusually calm. "Everything will be all right," said one U.S. importer on a buying mission to China. "As the country continues to develop, the quality of its products will naturally rise."

It's the sort of comment that sounds logical, but is not necessarily true. Quality does not always rise over time, as China's own history shows. At the end of the 19th century, the West rushed to buy China's beautiful silk products. Demand quickly expanded, and new players moved into the market. As competition intensified, manufacturers began to cut corners on quality, and silk products out of China soon gained a reputation as inferior goods.

By the beginning of the 20th century, traders were already looking elsewhere, and Japan, which had been building a reputation for delivering a more consistently high-quality product, became an attractive alternative. By 1930, Japan was exporting twice as much silk as China.

One of the problems facing China is that manufacturers continue to engage in a practice I call "quality fade." This is the deliberate and secret habit of widening profit margins through a reduction in the quality of materials. Importers usually never notice what's happening; downward changes are subtle but progressive. The initial production sample is fine, but with each successive production run, a bit more of the necessary inputs are missing.

What is maddening to importers is that quality fade often occurs in the last place an importer thinks to check. One American company had been importing a line of health and beauty care products for over a year when the cardboard boxes that held its product suddenly started collapsing under their own weight. There was no logical explanation for the collapse except quality fade, and the supplier in this case blamed subsuppliers for replacing an acceptable cardboard box with ones that were inferior.

The Case Of The Missing Aluminum

Some quality issues are not all that serious, but others are downright frightening. One of the most disturbing examples I have encountered while working in China involved the manufacture and importation of aluminum systems used to construct high-rise commercial buildings. These are the systems that support tons of concrete as it is being poured, and their general stability is critical.

The American company that designed and patented the system engineered all key components. It knew exactly how much each part was supposed to weigh, and yet the level of engineering sophistication did not stop the supplier from making a unilateral decision to reduce the specifications. When the "production error" was caught, one aluminum part was found to be weighing less than 90% of its intended weight.

Where did the missing aluminum go? Into the factory owner's pocket as a cost saving. The only thing passed on to the customer was an increase in product risk. Quality fade is like the straw that broke the camel's back--only in reverse. Suppliers push the limit by taking more and more out of the equation until they are caught, or until disaster strikes.

Even when importers catch suppliers in a quality fade, they frequently don't do much about it. Many quality problems are seen as too minor relative to the difficulties involved in rectifying them. Customers may not notice a product flaw, but they most certainly notice when a product is not delivered on time. The chance of a product failure is usually remote, but the penalty for late delivery is an almost certain loss of business.

Some importers bravely attempt to fight back against quality fade by insisting a supplier replace substandard goods at the factory's expense. A savvy supplier--and most are extremely savvy--can respond to such demands by threatening to terminate the supplier relationship. Or the supplier can respond by raising prices. Importers might then say they will switch suppliers, but the factory owner knows this is an empty threat as finding and cultivating a new supplier can take a long time. And anyway, there is no guarantee that the next supplier won't engage in the same willful behavior as the first.

The factory owner who practices quality fade knows exactly where he stands with his customer in these cat-and-mouse games. He has virtually nothing to lose and only margin to gain--and, having gotten away with it once, no one should be surprised when he goes for it again. When the factory owner offers his most sincere apologies and promises that it won't happen a second time, importers simply close their eyes and hope for the best.

If Adam Smith were around today, he would have had to write a separate chapter on global outsourcing. Because it takes importers a long time to find suppliers and to get them up to speed, importers keep their suppliers a secret. The last thing that an importer wants to do is let his competitors know the source of any supply chain advantage he may have. Even when it is in their collective interest to share information, importers keep to themselves.

As a result, factories pay little, if any, reputational cost for production shenanigans. The invisible hand doesn't work well when the manufacturers themselves are unseen.

This lack of accountability also has legal implications. When a product is recalled in the U.S., the importer pays the cost of that recall. It remains next to impossible to take legal action in China, and only in the rarest case can an importer successfully sue the supplier responsible for a product failure.

Since most suppliers are paid in full well before goods leave the factory, the importer doesn't even enjoy the leverage that comes with owing payment to the supplier. The average importer has far less leverage than imagined.

Outwitting Third-Party Testers

In the wake of quality problems, many are looking to third-party testing as a solution. In theory, testing works well. Prior to exporting a product, the supplier takes a sample and sends it off to a reputable and international testing laboratory, which then checks to make sure the product is safe. Unfortunately, testing doesn't work well when a supplier sets out to circumvent the system.

I recently worked with one supplier that was encountering difficulties making a quality liquid soap for export to the U.S. To get around problems the supplier was having with laboratory results, the supplier created 10 random samples and sent them to the same lab for testing.

Nine of these samples failed, but one passed. The supplier took the one test result marked "passed" and sent it off to the customer. The U.S. company never knew about the failed results, and a purchase order was promptly issued.

Third-party testing is far from fail-safe. Consider one study conducted by the U.S. Consumer Product Safety Commission in 2001. In a review of nearly 200 recalled electrical products from China, the CPSC found that more than 25% had had prior approval by an international third-party testing agency such as Underwriters Laboratories (UL), Intertek Testing Services (ETL) or the Canadian Standards Association (CSA).

Both The Wall Street Journal and the New York Times have suggested that the solution to China's quality problems lies in greater vigilance on the part of importers, but the question remains: If professional third-party testing agencies are failing to catch product failures, how is the average importer expected to do so? After all, third-party testing agencies have far better resources, and their people are much better trained.

Private quality assurance programs may also be put in place, but suppliers can circumvent such controls as well. In one case, after a load of plywood was rejected at one factory, the supplier simply mixed a portion of it with product that was perfectly good in later shipments. Working the bad into the good is a common way for a factory to reduce loss.

A supplier can bury substandard product knowing full well that warehouse workers in the U.S. do not have the time to examine each piece that comes in. And detailed contracts cannot succeed in bridging any moral gap. In order for supplier relationships to work successfully, there must be a basic level of trust.

Get Rich Quick

In an effort to reduce risk, American companies are also looking to suppliers that are larger and seem more capable. The unfortunate fact about China's larger factories, however, is they charge more for product than smaller factories do. It is as if economies of scale do not apply in China. There are several reasons why China suffers from such a problem, and one has to do with the role government plays in manufacturing.

Where a small factory may have been funded entirely by the government, future expansions are more often privately financed. Making the matter worse are extremely short payback periods on private investment. Many factories hope to pay off investments in as few as three years. One of the worst things an importer can hear is, "We want to show you our most recent expansion." The more a supplier invests, the quicker it raises prices.

There is a sense of urgency in China, the feeling that one must work fast before the window of opportunity closes. For factories, that means taking shortcuts on quality. Many factory owners can't see beyond the next purchase order.

One reason for the short-sightedness may have to do with China's political environment. The one-party government does what it wants, when it wants. And while there may be some advantages to a government that can operate without restraint or controversy, such a system limits predictability and leaves the business sector keenly aware that it is subject to the evanescent whims of officials who may or may not know which policy is best.

The U.S. administration has recently been applying pressure on China to revalue its currency in order to close the growing trade gap between the two countries. To appease the U.S., China has responded by reducing the tax rebates it offers to manufacturers.

For some suppliers, the tax rebates have constituted a major portion of their bottom line. Massive and sudden changes such as these only confirm the factory owner's paranoid suspicions that the manufacturing opportunity could disappear at any moment. No one in China is sure how long anything will last--a situation that keeps many focused on the immediate present.

Chinese manufacturers that engage in quality fade unfortunately subscribe to the view that business is about increasing one's share of the pie rather than growing the pie over time. They often focus on extracting profit through short-term maneuvers that inevitably militate against long-term development. This approach, it should be noted, contrasts sharply with the success strategies of such economies as Japan and Korea, which focus on building market share and developing strategic relationships.

Playing It Short

Some blame quality problems and product recalls on the relentless pursuit of lower prices. Importers most often go to the cheapest supplier, so the supplier who quotes low and quietly cuts corners on quality is the one who wins. Honest suppliers who prefer to quote higher and offer a better quality product lose out. The supplier who obfuscates catches orders first--and most often.

Chinese suppliers are excellent at playing the short game. When an importer discovers a quality problem late, the factory turns around and suggests, "But you signed off on the original production sample yourselves." When goods arrive damaged in the U.S., the factory claims that the importer has been making up the story in order to lower import costs. Arguments like these work in the short term. Over the longer term, however, importers get wise, and alternative markets start to look increasingly attractive.

China's quality situation is by no means hopeless. Japan was known decades ago for making inferior products, but that changed. The key to turning the situation around is to incorporate a habit of quality into the culture. China, however, has not shown that it has any interest in doing so.

Recent accusations of unreliability in Chinese products are now being met with tit-for-tat claims that U.S. products are faulty. This is an unfortunate strategy for China, and it means that we will continue to see quality problems. China will not be able to succeed so long as manufacturers are competing in a race to the bottom.

Paul Midler is the founder and president of China Advantage, a services firm that provides outsourcing and supply chain management to U.S. and European companies. He has been involved with China for more than 15 years, and in the course of his manufacturing career, has had dealings with thousands of Chinese factories.

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US assets in Chinese hands

The debate over the large and increasing holdings of US assets by China. Bloomberg investigates.

China Adds to Holdings of U.S. Assets, Buys More Agency Debt [Bloomberg]

June 17 (Bloomberg) -- China is adding to its holdings of U.S. assets, data from the U.S. government showed yesterday, easing concern the Asian nation will sell dollar investments.

Total holdings of U.S. equities, notes and bonds among foreign investors rose by a net $115.1 billion in April from $79.6 billion the previous month, the Treasury Department said yesterday in Washington. China's holdings of Treasuries gained $11.4 billion to $502 billion, holdings of U.S. agency debt rose $11.9 billion and U.S. corporate bond investments increased $6.9 billion, data showed.

``China was a big buyer of U.S. securities,'' wrote Win Thin, a New York-based senior currency strategist at Brown Brothers in a research note today.

China is the second largest holder of U.S. Treasuries after Japan, investing almost one-third of its $1.68 trillion in currency reserves in U.S. government debt. The U.S. dollar's decline has triggered concerns that Beijing would seek other forms of investments for its currency reserves.

``I don't think it's a smart move to invest in U.S. bonds,'' said Cheng Siwei, former vice chairman of the National People's Congress, China's legislature, at a Beijing conference on June 13. Cheng had said on Nov. 7 that China should improve the structure of its foreign reserves by favoring stronger currencies.

`No Sign'

The data showed ``there has been no sign that either China or Japan are decreasing dollar holdings,'' Win wrote in his report. ``Rather the data continued to show diversification by the two within U.S. securities.''

Japan decreased its holdings by $8.5 billion to $592.2 billion in April, the data showed. Its holdings of U.S. agency debt gained $2.6 billion, corporate bonds rose $1.1 billion and U.S. equities increased $1.1 billion.

The drop in Japan's total net holdings of U.S. assets in April ``really isn't worrisome as it comes on the back of three straight months of gains totaling $51.5 billion across all categories,'' Brown Brothers wrote in the note. ``It is important to look at the entire spectrum of investment holdings and not just on the narrow U.S. Treasury holdings,'' it said.

China Financial Markets comments in more detail (excellent reading as always):

Of course Chinese dollar holdings rose, but something changed drastically[China Financial Markets]

It now seems that China’s rate of reserve accumulation, seemingly unsustainable even two years ago, has reached even higher levels, but what is powering it now is not the (relatively) stable trade surplus and FDI accounts but rather highly unstable speculative inflows (for an explanation of how reserve accumulation has been generated see “What? $74.5 billion? Is this a mistake?”). If I am right, it seems to me that there has not just been a quantitative change in China’s and the world’s balance of payments accounts in recent months (i.e. even more rapid growth in an already unsustainable rate of Chinese foreign currency reserve growth), but also a qualitative change – the cause of China’s reserve growth has shifted significantly. The old mechanism, large trade deficits in some countries balanced by rapid reserve accumulation in others, has been converted into something much more complex and maybe even pro-cyclical (hence volatility enhancing): large trade deficits in some countries plus massive speculative inflows in others are being balanced by even more massive reserve accumulation in the latter countries.

I still need to work out in my mind what some possible implications are, but I would be lying if I said I didn’t find this change worrisome. My instinct is that because of the intensely pro-cyclical nature of speculative inflows, this new system is a lot less stable than the old one.

BERGSTEN on China's trade challenge

Foreign Affair have an interesting comprehensive (6 page) China bashing story.

The summary is given as:

Summary: Beijing is shirking its responsibilities to the global economy. To encourage better behavior, Washington should offer to share global economic leadership.

I concentrate here on trade but the whole article is worth reading.

A Partnership of Equals: How Washington Should Respond to China's Economic Challenge[Foreign Affairs]

Some salient paragraphs:

China poses a unique challenge because it is still poor, significantly nonmarketized, and authoritarian. All three characteristics reduce the likelihood that it will easily accept the systemic responsibilities that should ideally accompany superpower status. The integration of China into the existing global economic order will thus be more difficult than was, say, the integration of Japan a generation ago. The United States and the EU would like to co-opt China by integrating it into the regime that they have built and defended over the last several decades. There are increasing signs, however, that China has a different objective. In numerous areas, it is pursuing strategies that conflict with existing norms, rules, and institutional arrangements.

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Moreover, Chinese recalcitrance seems to be increasing rather than decreasing over time. At the outset of its economic reform process, in the late 1970s, China was eager to join (and to replace Taiwan in) the International Monetary Fund (IMF) and the World Bank. These institutional ties subsequently played important, and apparently welcome, roles in China's early development success. Later, Beijing not only endured lengthy negotiations and an ever-expanding set of requirements in order to join the World Trade Organization (WTO) but also used the pro-market rules of that institution to overcome resistance to reform among die-hards inside China itself.

On trade - something we are particularly interesting in at China Economics Blog:

On trade, China has been playing at best a passive and at worst a disruptive role. It makes no effort to hide its current preference for low-quality, politically motivated bilateral and regional trade arrangements rather than economically meaningful (and demanding) multilateral trade liberalization through the WTO. Since China is the world's largest surplus country and second-largest exporter, this poses two important challenges to the existing global regime.

First, China's refusal to contribute positively to the Doha Round of international trade negotiations has all but ensured the talks' failure. Beijing has declared that it should have no liberalization obligations whatsoever and has invented a new category of WTO membership ("recently acceded members") to justify its recalcitrance. Such a stance by a major trading power is akin to abstention and has practically guaranteed that the Doha negotiations will go nowhere. And since the global trading system does not stay in place, but is always moving either forward or backward, a collapse of the Doha Round would be quite serious: it would represent the first failure of a major multilateral trade negotiation in the postwar period and place the entire WTO system in jeopardy. China is not the only culprit in the Doha drama, of course. The United States and the EU have been unwilling to abandon their agricultural protectionism, other important emerging economies have been unwilling to meaningfully open their markets, and several poor countries have resisted contributing to a global package of reforms. But China, with its major stake in open trade, exhibits the sharpest contrast of all the major players between its objective interests and its revealed policy.

Second, China's pursuit of bilateral and regional trade agreements with neighboring countries is more about politics than economics. Its "free-trade agreement" with the Association of Southeast Asian Nations (ASEAN), for example, covers only a small share of its commerce with the countries in question; it is simply an effort to calm their fears of being swamped by their huge neighbor. Again, it is true that the United States and other major trading powers also factor foreign policy considerations into their selections of partners for regional and bilateral trade agreements. But they also insist on economic standards that largely conform to the WTO's rules. China is able to escape legal application of those rules by continuing to declare itself a "developing country" and by taking advantage of "special and differential treatment." But for a major global trading power to hide behind such loopholes provokes substantial international strains.

China is also hurting the global trading system by supporting the creation of a loose but potent Asian trading bloc. The network of regional agreements that started with one between China and ASEAN has steadily expanded to include virtually all other possible Asian permutations: parallel Japanese-ASEAN and South Korean-ASEAN deals; various bilateral partnerships, including perhaps a Chinese-Indian one; a "10 + 3" arrangement that brings together the ten ASEAN countries and all three Northeast Asian countries, and possibly even a "10 + 6" agreement that would broaden the group to include Australia, India, and New Zealand. All this activity is likely to produce, within the next decade, an East Asian free-trade area led by China.

Such a regional grouping would almost certainly trigger a sharp backlash from the United States and the EU, as well as from numerous developing countries, because of its new discrimination against them. Even more important, it would create a tripolar global economic regime -- a configuration that could threaten existing global arrangements and multilateral cooperation.

China's challenges to the global trading system are most visible in its opposition to the U.S. proposal, launched at the Asia-Pacific Economic Cooperation forum in 2006, for a free-trade area of the Asia-Pacific. The APEC initiative, immediately endorsed by a number of those smaller member economies that fervently want to prevent trade conflict between the group's two superpowers, seeks to head off the looming confrontation between an Asia-only trading bloc and the United States, which could draw a line down the middle of the Pacific. The initiative would eventually consolidate the many preferential pacts in the Asia-Pacific region and offer an economically meaningful Plan B for widespread trade liberalization if the Doha Round definitively fails. China has led the opposition to the idea, demonstrating its preference for bilateral deals with minimal economic content and its lack of interest in trying to defend the broader trading order.

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"Wrong number": On the reliability of Chinese Data

Following on the heals of the last post and thanks to Chinalawblog for the pointer.

As an economist who works with large amounts of Chinese data this issue has arisen many many times without a satisfactory solution. The Economist discusses this issue at length. I tend to use province level data - this raises a set of problems that this article also covers.

An aberrant abacus

AS CHINA'S importance in the global economy increases, investors are paying more attention to its economic numbers. Yet the country's official statistics are notoriously ropy. Some commentators accuse China's government of overstating GDP growth for political reasons, others complain that the official inflation rate is fraudulently low. So which data can you trust?

One reason to be suspicious of GDP figures is that China is always one of the first countries to report them, usually only two weeks after the end of each quarter. Most developed economies take between four and six weeks to produce them.

So which data to trust. From Statistics that Don’t Add Up [China Business Services]

The Economist also provides a guide (developed by Goldman Sachs) to the reliability of official Chinese numbers. It gives a score to different sets of stats, 5 being the most reliable, and 0 the least:

• Foreign Trade: 5
• Money Supply: 5
• Industrial production: 4
• Consumer Prices: 4
• GDP: 3
• Retail Sales: 3
• Fixed Investment: 2
• Employment: 2
• Average Earnings: 1
• Unemployment: 1

On the issue of province versus country level data:

Chinese provinces independently report GDP, and a weighted average of their figures consistently gives higher rates of output and growth than those reported by the central government (see chart). True, local officials have an incentive to inflate growth numbers because promotion depends upon economic performance; however, experience suggests that number crunchers in local government are more accurate than Beijing's. For instance, the figures first published for 2004 showed that the sum of the provincial GDPs was 19% bigger than the reported national figure. Lo and behold, in 2005, after a national economic census picked up more services, the NBS revised its GDP up by 17%; it also lifted the annual growth rate over the previous decade.

Finally, as someone who uses a lot of trade data here is the good news:

Foreign trade is perhaps the most accurate economic indicator. Critics accuse China of fiddling its trade figures, because the value of its exports as measured by the importing country is always much bigger than what the Chinese report. This discrepancy reflects the fact that China's bilateral trade figures exclude goods shipped to Hong Kong before being re-exported. But this should not affect total export figures and detailed Hong Kong data are available to adjust bilateral trade flows.

An interesting topic.

Zero Profit in China

An interesting article from Far Eastern Economic Review (thanks to China Game and Paul Midler for the HT and writing the article).

The arguments expounded in this article are fairly sound and provides a number of interesting insights. First, that economics is a long term game, second, that profits are not the only motives of individual firms (at least in the short run). Finally, he points out that many foreign economists (including myself) predicted non-performing loans would cripple the banking sector. Whilst I think this is still a potentially serious problem I think Midler makes a good point in this article.

This discussion on over supply and copyright issues is also interesting.

It is worth reading in full.

Why Profit Zero Works in China [Far Eastern Economic Review]

Profit zero scenarios are a product of Chinese business history. Back when state-owned factories acted in place of a social welfare program, manufacturing’s primary goal was not profitability, but job creation. Throughout the 1980s and into the 1990s, when the planned economy failed to stimulate enough job growth to approach full employment, the Communist Party looked to private industry, and entrepreneurs who could put people to work garnered a degree of political clout with government officials. Profitability was important, but it took a back seat to the achievement of political aims. Manufacturers consequently found themselves motivated to sign cross-border agreements with foreign companies.

While one benefit was the acquisition of new technologies, even more important was the opportunity to learn how business was done in a market-driven economy. It was in this environment that Chinese companies willingly gave up short-term profit opportunities. Some manufacturers viewed their first big contracts the way a college graduate looks at an unpaid internship—a sacrifice made with the understanding that it would pay off later. Labor in China was already cheap, and factories willing to forgo a profit margin made themselves even more attractive. With prices held artificially low, importers rushed into the market.

On the banking sector:

Of course the opportunity for profit zero would not have been made possible without help from the banking sector. Chinese banks loaned money to manufacturers for years without pressuring them to make payment, and, while foreign economists suggested that nonperforming loans would cripple the economy, China ultimately proved the value of a profit-zero strategy. Some of the bad lending that went on was occasionally the result of corruption, but the average loan made to a manufacturer was legitimate. Industry in China has long been in the habit of building production capacity well in advance of any actual need. Importers hesitated to place orders unless they saw a factory that at least on the surface looked capable. Manufacturers and bankers understood that a shining new factory was like a billboard. In most economies, an entrepreneur must prove a need for a capacity expansion before money is lent.

An excellent article.

China's Local Comparative Advantage

An interesting new paper for trade economists. This relates to a number of papers I have written in this area.

I always have some concern when unit values are used for China but otherwise this appears to be an interesting paper.

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"China's Local Comparative Advantage"

NBER Working Paper No. W13963

JAMES HARRIGAN, Federal Reserve Bank of New York, National Bureau of Economic Research (NBER)
Email: james.harrigan@ny.frb.org
HAIYAN DENG, The Conference Board
Email: haiyan.deng@conference-board.org

China's trade pattern is influenced not just by its overall comparative advantage in labor intensive goods but also by geography. We use two variants of the Eaton-Kortum (2002) model to study China's local comparative advantage. The theory predicts that China's share of export markets should grow most rapidly where China's share is initially large. A corollary is that exporters that have a big market share where China's share is initially large should see the largest fall in their market shares. These market share change predictions are strongly supported in the data from 1996 to 2006. We also show theoretically that since trade costs are proportional to weight rather than value, relative distance affects local comparative advantage as well as the overall volume of trade. The model predicts that China has a comparative advantage in heavy goods in nearby markets, and lighter goods in more distant markets. This theory motivates a simple empirical prediction: within a product, China's export unit values should be increasing in distance. We find strong support for this effect in our empirical analysis on product-level Chinese exports in 2006.

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Hot money and the calls for a maxi-revaluation

Brad Sester over at RGE monitor has a neat little article (with good figures) outlining the dangers of holding off the revaluation much longer.

For the record I cannot see it yet. The political implications are too great (the perceived job losses associated with a loss of competitiveness).

A good article and worth reading.

What keeps Zhou Xiaochuan up at night [RGE monitor]

Friday’s Lex column highlighted the possibility that China’s real reserve growth may be far higher than the published increase in its reserves – and thus a lot more hot money may be flowing into China than the published increase in China’s reserves implies. Michael Pettis – drawing on the work of Logan Wright of Stone and McCarthy - and I have both published online estimates of the “true” pace of Chinese reserve growth. Wang Tao – formerly of the Bank of America – and Stephen Green of Standard Chartered have done similar work.

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On the Rising Sophistication of China's Exports

I am doing some work in this area. This new NBER paper appears to have some excellent data on product level trade between cities. One to add to the "to read" pile.

From the abstract I am not overly convinced by these results. It all depends on how the authors have attempted to measure sophistication.

What Accounts for the Rising Sophistication of China's Exports?

NBER Working Paper No. W13771

ZHI WANG, U.S. International Trade Commission
Email: Zhi.Wang@usitc.gov
SHANG-JIN WEI, Columbia Business School, National Bureau of Economic Research (NBER), Centre for Economic Policy Research (CEPR), International Monetary Fund (IMF)
Email: shangjin.wei@columbia.edu

Chinese exports have become increasingly sophisticated. This has generated anxiety in developed countries as competitive pressure may increasingly be felt outside labor-intensive industries. Using product-level data on exports from different cities within China, this paper investigates the contributing factors to China's rising export sophistication. Somewhat surprisingly, neither processing trade nor foreign invested firms are found to play an important role in generating the increased overlap between China's export structure and that of high-income countries. Instead, improvement in human capital and government policies in the form of tax-favored high-tech zones appear to be the key to the country's evolving export structure. On the other hand, processing trade, foreign invested firms, and government-sponsored high-tech zones all have contributed significantly to raising the unit values of Chinese exports within a given product category.

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Aid from China and Human rights abuses

Excellent article reflecting on a recent academic paper on Chinese aid and human rights abuses.

Instead of going through the arguments again I point you to Chris Blattman's Blog that has the appropriate links. I believe the economists have got it about right here - it is crucial to identify the order of causation.

I believe that this will become an increasingly important topic for empirical researchers and something I will be looking at in the near future data permitting.

Do trade and aid from China increase human rights abuses?

Yesterday, the New York Times lamented the worsening war in Sri Lanka, the rise in human rights abuses, and the emasculation of rights observers. "Gone are the Nordic monitors," it writes, "independent journalists are not allowed anywhere near the front lines."

Today, the blame is apportioned. "Take Aid From China and Take a Pass on Human Rights" proclaims the newspaper. The argument: unconditional aid and trade from China insulates regimes from Western mores and threats of sanctions in a dirty war.

China fear-mongering? Taking the story beyond the evidence? Maybe not.

The Times misses a paper posted last week by economists Erik Meyersson, Nancy Qian, and Gerard Padró-i-Miquel, but it gets the story right. Here newspaper anecdotes get support from some powerful statistics: trade with China predicts human rights abuses. At least in Africa.

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Economics is the enemy of the community - or is it?

A link to Dani Rodrik's post on a new book out called "The Dismal Science: How Thinking Like an Economist Undermines Community.". Rodrik is not entirely convinced.

Economics is the enemy of the community

Dani has done work looking at Chinese exports and the possible impact of government intervention on the increasingly high tech nature of Chinese trade.

The paper is called "What's So Special About China's Exports?"

Abstract:
Much more than comparative advantage and free markets have been at play in shaping China's export success. Government policies have helped nurture domestic capabilities in consumer electronics and other advanced areas that would most likely not have developed in their absence. As a result, China has ended up with an export basket that is significantly more sophisticated than what would be normally expected for a country at its income level. This has been an important determinant of China's rapid growth. What matters for China's future growth is not the volume of exports, but whether China will continue to latch on to higher-income products over time.

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Asian interdependence and the US recession

After writing the previous "Has China's growth peaked" I hinted at the interdependence of Asian countries and their subsequent relationship with the US and EU.

When one looks at the raw numbers, e.g. the % of exports to the US it might not appear to be that high. However, when one takes its account the exports of intermediate goods to other Asian countries that are then exported to the US and EU you can see that the problem goes a lot deeper. There are many academic papers that are looking at production networks and fragmentation in Asia and I may even have written one of two of them.

This is the important quote with numbers. Intuitively they appear to be about right.

Asian exports to the US appear to be just 18 per cent. But, the real amount, including all the “goods in process”, might be more than 30 per cent, he calculates.

I do not believe the de-coupling story. This is one of those pre-recession stories of hope that "the world has changed" when it hasn't. A US recesission will bite hard let there be no doubt.

Asia economies hope for happy divorce [FT]

Asia’s export-dependent economies are hoping that decoupling – the notion that the rest of the world can grow even with the US in recession – will hold true.

There have been signs. Over the past year, Japanese shipments to China have risen by 15 per cent, to Europe and other Asian nations by 11.5 per cent, and to the “rest of world”, including the oil-flush Middle East, by 25 per cent.

Still, exports to the US have been fading fast, down 1.7 per cent on the year, and because Japan’s eagerly awaited recovery in domestic demand has never materialised, its economy has been running on only one (export-led) engine. This fiscal year its economy is expected to grow by what analysts describe as a disappointing 1.3 per cent.

Peter Morgan, chief economist for Asia Pacific at HSBC, says that one of the chinks in decoupling’s armour is Europe.

The region has been happily sucking in Asian imports thanks to its strong currency and reasonably good economic performance. But as Asian currencies appreciate, against the euro as well as the dollar, and European economies slow, that will change. “That is going to take away one of the legs of the stool,” he says.

Exports to the Middle East, which accounts for a fairly modest but rapidly growing portion of Asian exports, should hold up assuming demand for oil stays firm. But the foundations of intra-Asian trade, on which much of the argument about export diversification rests, could be more rickety than they appear.

“One thing to remember is that a lot of exports to China are just passing through,” says Mr Morgan, referring to China’s role as an assembly plant for Asian components.

Asian exports to the US appear to be just 18 per cent. But, the real amount, including all the “goods in process”, might be more than 30 per cent, he calculates.

Thailand is a good example. Recent economic growth has been powered primarily by exports, about 12.5 per cent of which went directly to the US last year, down from about 20 per cent when the previous US recession struck in 2001.

Yet Thailand is not as insulated as this might suggest. Sethaput Suthiwart-Narueput, chief economist at SCB Securities, says Bangkok remains vulnerable to a US slowdown since most of its exports to China – about 9.5 per cent of total shipments, up from 4.4 per cent in 2001 – are components used to make goods bound for the US.

The picture is not black and white and decoupling is not an “either/or phenomenon”, says Paul Sheard, global chief economist at Lehman Brothers. Asia emerged relatively unscathed from the 1991 US recession but was much harder hit by the “tech recession” of 2001. Similarly, this time, depending on the precise nature of any downturn, commodity-rich Australia, Indonesia and Malaysia might fare better than, say, countries specialising in electronics, such as Taiwan or South Korea.

Indonesia, for example, has already noticed its non-oil and gas exports slowing to the US. Mari Pangestu, trade minister, told the Financial Times: “Our strategy now is to diversify markets and diversify products. We think the growth market is still Asia, although if the US does fall into recession it will have an impact on the high-growth economies.”

The US remains India’s largest export market, reducing the country’s chances of surviving a US downturn unscathed. The Reserve Bank of India says it has already seen a slowdown in the crucial software and services exports.

By contrast, Australia’s reliance on US exports has substantially diminished. Tim Harcourt, chief economist at the Australian Trade Commission, points out that the US share of Australia’s exports has fallen from 10 per cent to just 6 per cent as “Australia has benefited from the global economy firing on more cylinders than usual.”

China and the health of its economy could be a key factor for many others in Asia. If China’s role as the world’s assembly plant is vulnerable to a US downturn, its infrastructure-led demand is less so. Barring the truly unexpected, even a US recession is not likely to push Chinese growth much below 9 per cent, against 11.4 per cent last year.

Depending on the components of that growth, there could be more demand for, say, raw materials and construction equipment and less for components and factory machinery.

That could slow, but not throttle, growth in some Asian economies. For example, both Singapore and Malaysia have seen a slowdown in their biggest export category, electronics.

But, according to Kit Wei Zheng, a Citigroup economist, Singapore is unlikely to suffer as big a slump as in 2001 because it has diversified into other export areas, including pharmaceuticals. Likewise, Malaysia is partly cushioned by the global demand for palm oil.

Diversification will only go so far, however, particularly if US consumption nosedives, says Mr Sheard. “Asia, centred on China, has become even more interlinked into the global economy, the driving impetus of which has been the US,” he said. It is hard to be global and decoupled at the same time.

Exactly.

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