Tocqueville Got It Right – Quality Matters: Perplexities of China, Part 2
August 15, 2011I’ve recently been reading Alexis de Tocqueville’s Democracy in America and marveling that many of his observations about life in America from the 1700s became the chief building blocks in the growth of our great nation. Religious beliefs, entrepreneurial spirit, participation in representative government, strong philanthropic and civic organizations—Tocqueville rightly saw these intangible qualities as having extraordinary potential. Beneath all the statistics, all the numbers lay certain realities about a country (and its economy) that are foundational to its past and its future. These realities—I’m calling them qualitative factors—determine the destiny of a nation; whether it is America, Brazil, India, or in our current discussion, China.
The first article in this series reviewed the incredible growth in China over the past decade as well as the central challenge created by its “GDP by overinvestment” strategy. Here we delve deeper into several
qualitative factors that will shape the future in China. These factors tend to be little understood and even less appreciated. But, just as surely as the Japanese qualitative factors of “societal cohesion” led to zombie corporations and two lost decades, these China factors will have huge impact for the coming years.
Price of Liberty Must Always be Paid
For the better part of a century the former Soviet Union attempted to build a great society on the foundation of government command and control. It failed, spectacularly, not by military defeat, but by the implosion of an economy that could no longer sustain itself. Like a massive bridge built on inadequate foundations, repression of liberty on such a large scale must always be paid for. China has worked to improve on the Soviet model, but is currently running up against the limits. As cracks begin to form in the bridge, people get restless and martial law moves to the fore. Tellingly, in 2011, for the first time, China will spend more on internal security than on the military.1 Repression of dissidents is increasing.
Either the price of personal liberty is paid to achieve it (i.e., the American Revolution, Civil War) or the price is paid through the structural flaws of its absence. Those structural flaws take an increasing chunk out of the economic potential of a nation. Chief among these are 1. Lower confidence—personal safety concerns being primary; 2. Cost inefficiencies—various necessities of hiding from the government; and 3. Low information quality—created by “shoot the messenger” fears. These three flaws sap the vitality and growth potential of an economy. Think for a moment how vital it is to have good data for decision-making in business and investing. Despite all the flaws and conflicts of interest in government data collection in the United States, at least there is ample opportunity for third parties to collect and distribute dissenting views. In China, dissenting views can land you in a prison on a good day (and not the country club variety). Think of the costs to growth in a place where the government admits that their statistics are not to be taken seriously. And, where one commentator said good data is “practically impossible and politically undesirable.”
Rule of Law Matters, as does its Absence
A number of highly respected investment managers were burned badly in 2008 when the U.S. government made unprecedented moves that effectively picked winners and losers. Never in their many
decades of experience had these managers witnessed such a changing of the rules. Some still question the legality of the whole episode, but the point remains for everyone in business—once bitten, twice shy. Much of what holds back the economy today is uncertainty about U.S. government action and the rule of law. Multiply that uncertainty by a factor of 10 and you get the situation in China. From a recent article in The Economist:
“… there is no legal certainty that trades will be honoured, particularly if the loser is a politically connected company. An informed trader with a contrarian opinion may thus not gain from his insights.” 2
So, the laws that are enforced consistently tend to be repressive of personal liberties; rules can be created on the fly that take away profits and gains; and finally, the absence of protective laws inhibit innovation and creativity (think patents, trademarks). Another quote from The Economist: “… although Chinese businessmen may be among the world’s most enthusiastic hagglers, the Chinese government is perpetually at war with the market, whether the issue is the level of its currency or what a private company charges for soap: witness the fine recently handed out to Unilever, a consumer-goods firm, for talking about price increases.” As times get more difficult, expect multinational corporations to face increasing taxes, fines, use levies, etc., as profits get “nationalized” in a more elegant fashion than the Russians might employ to take over oil assets of Exxon, for instance. This type of behavior is what led to the emerging markets concept of “profits before stealing.”
A Culture of Innovation Must Emerge
Somewhat tongue in cheek, the easy part is over. The recipe for every emerging economy has been “export raw materials and cheap labor.” Real, future growth eventually has to come from innovation. A recent
article in the South China Morning Post hits this straight on when it says the current approach (driven by state enterprises, government-directed loans and massive taxpayer-funded research projects) “has a good chance of success in industries requiring scale, such as the passenger jet scheme, or where foreign companies can be persuaded to share technology in return for market access, like high-speed rail. But it is not a system that breeds innovation. The world’s number two economy may have lifted millions out of poverty, but it has done so without a trace of fresh business ideas. A simple measure is in branding. Not one Chinese firm makes it into Interbrand’s list of top 100 global brands (Coca-Cola is ranked first; the highest Asian firm is Toyota at 11th). Among the tens of thousands of companies that have built China into an export powerhouse, it seems that none has leveraged that into a major global branded business.”
“China’s economic landscape, dominated by powerful government agencies and state enterprises, allows no room for the less measurable or ‘soft’ essentials, such as a culture of collaboration and tolerance of failure.
Underlying all of this is a one-party political system that breeds selfcensorship more than bold thinking.” 3
Hard to Quantify But Hugely Important
It is difficult to quantify the consequences of these factors when thinking of the future. And, there are really two pieces—the immediate hard and soft costs, then the longlasting cultural effects. The cultural effects take decades, if not longer, to change. For instance, tax evasion in the country of Greece has been almost a national pastime for hundreds, or maybe even thousands of years. There is even a description for the typical audit process called the 4.4.2. If you owe $10 to the government, you pay the auditor $4, keep $4 for yourself and pay the government $2; the result? Tax rates for those who actually pay are extremely high and overall collections as a percent of GDP are extremely low. There are all sorts of secondary and tertiary problems that grow out of this. Interestingly but not surprisingly, trust between citizens of Greece registers extremely low. They live in daily corruption and it has an impact.
Alexis de Tocqueville had it right about America. The qualitative characteristics proved foundational to a highly successful economic experiment, albeit through many bumps and bruises. Again, there are no shortcuts to greatness. One gets the sense that despite its recent successes, there are significant structural flaws in the China story that will become even more apparent in the coming years.
1 Financial Times, Lex Column, 3/9/2011
2 The Economist, “The Price is Wrong,” 5/14/2011
3 South China Morning Post, “Sand in the Growth Engine,” 3/10/201
