China's false dawn

PORTFOLIO POINT: Contrary to everything you might think, since the 1990s China's economic position has in many ways declined relative to the United States. The mismatch between falsehood and reality is not only leading to poor public policy, but could hurt your portfolio.


Like most things in Washington, last week's State of the Union address by Barack Obama was widely seen as a re-election manifesto. To different commentators that 75-minute manifesto was about different things – inequality, balanced budgets, military power, energy security – but according to the computers at the Washington Post, his entire platform could be summed up in two words: American jobs.

Most commonly used words in Obama's State of the Union

Source: Washington Post, Wordle

Despite being the most competitive and dynamic country in the G20 – no mean feat when you're also the world's largest economy – and despite still being the world's largest recipient of foreign direct investment (although it did drop 8% year-on-year), 13 million Americans remain unemployed. For all the fact that America's economy is now growing strongly, at 2.8% for the last quarter, this is not enough to put a dent in the ranks of the long-term jobless by November, especially in the blue-collar swing districts that will decide then whether Obama stays in the White House.

In this environment Americans, Republican and Democrat, are looking for scapegoats. Most prominently, there's been Wall Street greed (now also private equity greed, judging from the debate surrounding Republican contender Mitt Romney's career at Bain Capital). The “1%” has also been blamed; fat-cats not paying their fair share of taxes (again, it's charged that Romney paid only 15% on the $42.5 million he earned in the last two years). And then there's perfidious oil exporters, the destabilising influence of hedge funds, the insidious military-industrial complex, Congressional wrangling, and, perhaps most hypocritically, something called “Washington”, a shadowy bureaucratic machine that dares to tax hard-working Americans for such things as pensions and medical care.

Obama addressed all these bogeymen, even setting up a new task-force to investigate alleged mortgage foreclosure fraud said to be holding back an overdue recovery in the housing market. But the biggest bogey of all, and also to be handled by a new task-force, was China, specifically the China that dares to export cheap goods, thereby uprooting American factories and displacing American jobs.

China bashing is nothing new and is indeed one of the few bipartisan pastimes in politics today. Obama can hardly be blamed for tapping into the zeitgeist, but like the other geopolitical rogue in recent memory, the Soviet Union, the threat of China is largely presentational; something to galvanise the country against, but which in reality faces its own far bigger internal threats.

Presentational threats and manufactured crises are largely the preserve of Orwellian conspiracy, but just as with the presentational threat of an EU collapse – being used so effectively to speed along fiscal reform in the periphery and closer union in the core (see Europe faces recession, not regression) – the threat of a rising China may be politically expedient but otherwise doesn't bear up too much analytical scrutiny.

Scrutinised, however, it should be. Not only is this geostrategic straw-man shaping global politics, but it is probably shaping your portfolio as well. When I talk to most local fund managers they cite the rise of China as reason for their enthusiasm for mining stocks, the Australian dollar and Asian equities. But while China's strong economic growth to date has certainly been good for mining stocks, the Australian dollar and (most) Asian equities, their enthusiasm needs to be put into a bit of context.

Since the early 1990s, when China's earlier economic reforms really gathered stride, on many measures the country's status has actually declined relative to the United States, whether in terms of wealth, innovation or military power.

What's more, that decline looks only set to accelerate as America emerges out of recession and China faces limits to its own model of growth. On China's false dawn, the mismatch between falsehood and reality is not only leading to poor public policy, but could hurt your portfolio.

Declinism is a topic I covered several months ago, contrasting the Spenglerian worldview of social decay (think of the Roman Empire, Easter Island, manners, rock music since the 1980s), with the Schumpeterian worldview, which sees change, innovation and “creative destruction” as not only essential to renewal and rebirth, but inherent in the world we are currently experiencing (see Old World charm). Yet while declinism's cultural shibboleth may be useful as a call to action or platform for reform, not only can it frame irrational economic and asset allocation choices, it can lead to greatly damaging public policy. One need only look at the history of the Cold War for examples. And as for China, overstated paranoia could do more than just inhibit commerce, curtail investment and limit the positive effects of globalisation (see Free trade on the bloc).

Still, whatever its merits, declinism is a narrative that's hard to ignore. According to recent surveys, most Americans believe China is a stronger world power than the United States, despite the fact that the US economy is still twice as large in GDP terms and 10 times bigger in GDP per capita terms. Respected analysts who should know better seem to agree. Arvind Subramanian of the Peterson Institute described China as “the inevitable superpower”, while the Financial Times' Gideon Rachman says of American decline: “This time it's for real.”

Every week, it seems, more and more of these kinds of reports come out (click here and here for recent examples), and every day there's someone wondering when their farm, house or job will be taken over. Even The Economist, the mouthpiece of Western liberal predominance, heralded China's arrival as a superpower this weekend by launching a new weekly section: its first since it launched one for the US in 1942. One of the best economic sellers of 2009 was Martin Jacques' When China Rules the World and we can only expect equal success from the more racily titled Are we becoming China's bitch?, which will be published later this year.

Yet as I've written before, it was common in the 1980s to believe that Japan would supplant America as the world's number one economy, just as it was common in the 1950s to believe the Soviet Union would take over. And while on present trends the relative rise of China to the US in GDP terms looks seemingly undeniable, based on trend lines advanced by other economists over the past 60 years, the Philippines should be by now Asia's richest country, and Liberia should be the Switzerland of Africa.

Either way, however, GDP is entirely the wrong measure to use when assessing either strategic or economic power. By way of example, India's GDP was actually larger than Britain's, according to late economist Angus Maddison, when it came under imperial rule. And at no time in fact – despite ruling history's greatest empire – was Britain ever the world's largest economy. As for China, it should also be remembered that throughout what its leaders call its “century of humiliation”, the country's GDP remained number one; even despite the two Opium Wars, Japan's occupation of Manchuria and the West's colonisation of Hong Kong, Shanghai and other treaty ports.

When scholars attempt to analyse national power, generally a mix of wealth, innovation and military indicators are used (see the RAND Corporation's Measuring National Power in the Post-industrial Age). And of the wealth indicators, it is surplus wealth, not total wealth that matters, as said by political scientist Klaus Knorr in his 1956 War Potential of Nations. While this doesn't mean Norway or Qatar will ever dominate the Security Council, it does explain the continued presence of former powers Britain and France, despite the long era since imperial greatness.

Using these indicators, Harvard academic Michael Beckley has published a seminal study in International Security, which demonstrates that the US has actually increased its lead over China since 1991, when China emerged from the Tiananmen Square crisis with a renewed focus on becoming rich. Although China has been rising, Beckley writes, it is not catching up.

America surpasses China on wealth (per capita
income, 1991-2010, USD current prices)

Source: Michael Beckley, China's Century?, International Security, 36:3, p. 59; IMF

America surpasses China on innovation (total R&D spending,
1991-2008, purchasing power terms, USD millions)

Source: Michael Beckley, China's Century?, International Security, 36:3, p. 65; OECD

America surpasses China on military spending (1991-2009, USD current prices)

Source: Michael Beckley, China's Century?, International Security, 36:3, p. 74;
Stockholm International Peace Research Institute

Several years ago I attended a conference in Switzerland where a local trade expert decried “Europe was in danger of becoming a suburb of Shanghai.” Judging from the mood in the room, he wasn’t alone in that fear either.

Yet going by Beckley’s data, I can’t understand why the gentleman, who had spent many years in China helping Swiss firms establish wholly-owned foreign enterprises (or “woofies”) would think that way. Almost half of China's total exports and over 90% of high-technology exports are produced by woofies, most of whom – like Apple – are in the business of export processing, where components are assembled but very little value is added. When it is commonly cited that only 5% of the value of an iPad is made in China, it would seem that Shanghai is in danger of becoming a suburb of Europe (and America).

Made in China, owned offshore: composition of exports in China (1991-2009)

Source: Michael Beckley, China's Century?, International Security, 36:3, p. 68; MIT; University of California, San Diego

And while, of course, those figures are changing, especially with the emergence of “national champion” companies like telecom equipment maker Huawei or oil producer CNOOC, it can thus be seen that China has been in many ways a net loser in the globalisation game, having built its economy on an edifice of low-value export industries, much of them foreign-owned; a kind of neo-colonial economic model, though without the gunships, godowns and gweilos.

According to Beckley and others – including Edward Steinfeld (Playing Our Game: Why China's Economic Rise Doesn't Threaten the West) and Yasheng Hang (FDI in China; An Asian Perspective) – this process has both retarded technology transfer and productivity catch-up, as well as crowded out Chinese domestic firms from local and international markets. Whereas Japan and Korea enjoyed their economic miracle with virtually no FDI or foreign ownership (although American loans and military assistance were essential), China's modern economy has been built on this to the extent that its internal market – measured by imports and consumption as a proportion of GDP – has actually shrunk. Further, the number of Chinese firms engaged in research and development has also shrunk, from about 60% to between 24% and 37%, as businesses are compelled to compete on cost and volume, not technology or quality.

And it is in the various measures of innovation that China most noticeably lags the developed world. While China has tripled its global share of scientific articles (from 2% to 6%), and employs more scientists and engineers than anywhere else, much of this work is performed within the foreign-owned sector and most scientific equipment is purchased overseas, Beckley writes.

Moreover, much of China's scientific output is low-end and half of China's engineers are vocational college graduates (zhuanke). A flood of new patents belies the derivative nature of much research and, in some cases, outright fraud and misconduct. While the United States, with 5% of the world's population, has 15 of the top 20 universities, according to the Times Higher Educational Supplement, China has none. Indeed, of the Chinese students who receive their PhDs from American universities between 1987 and 2007, tragically for China 90% of them joined the US workforce.

There is a lot more that I could write on this topic, and I will, but amid the myriad challenges that China faces this year (see Enter the dragon, China risks out of the shadows, and Pincer closes on China) it would be premature, at the very least, to assume China’s leadership over America is assured. It would be equally premature to write-off the recent rally in US stocks or indeed undercook your exposure to this asset class (I will be profiling a dozen cheap US blue-chips this Friday that you can invest in).

As Shane Oliver noted on Friday, the US is enjoying something of a manufacturing renaissance and while that may be jeopardised somewhat by a stronger US Dollar, should the chips for China fall, America is still the world's major safe-haven economy. What's more, if the greenback does appreciate – whether on such a dynamic or a fall in the value of other major trading currencies like the Euro and the Aussie – then US investments in Australian dollar terms (currently at a wild valuation of $US1.06) will still currently be better bets than most.

Whoever the President of the United States is at the end of the year, they will have an enormous task in stimulating job growth amid a deleveraging private sector and a sclerotic property market, not to mention a divided Congress. Yet there’s more going for America than against both in the short and the long-term. Moreover, as many have noted, in a presidential election year, equities tend to do well, unlike factual, objective reporting.

And to paraphrase Mark Twain, rumours of America's death – let alone China's ascent – are greatly exaggerated.

Follow Michael Feller on Twitter @MFellerEureka

* Edited story published 31 January