Guest post by Junheng Li, author of Tiger Woman on Wall Street. Li also runs the independent equity research firm JL Warren Capital LLC, a China-focused research firm aimed at plugging the gap between the business reality in China and American investors.
When foreigners visit China, they are often impressed by the countrys spectacular hardware: the modern architecture of the coastal areas, the fancy international hotels and luxury shopping malls, a high-speed railway that runs at more than 180 miles per hour while still providing passengers with Wi-Fi access.
The continuous news cycle that contrasts Chinas economic success with the lukewarm economic recovery in the U.S. and E.U. reinforces this view. A poll released in July by the Pew Research Center shows that many people around the world believe China is poised to overtake the U.S. as the worlds leading superpower. Chinas economy continues to chug along at more than 7.5%, with projections showing that it will surpass the American economy by 2030. Many Americans think that it is merely a matter of time before China takes over the world.
But what is conveniently dismissed, amidst the popular American declinism, is that China still lacks the software to support and sustain the impressive hardware. By software, I refer to the rule of law, accountability, governance, and most importantly the quality of its people, as citizens, workers and managers. Chinas educational system has failed to produce either an honorable or an innovative labor force defined broadly to include those who make their living by their hands and by their brains.
Investing in a business is ultimately about investing in the people who run it. I learned from my investment career on Wall Street that a business is only as good as its managers and its corporate leadership. Assessing the integrity and quality of management should be an investors priority in performing due diligence, especially in emerging markets such as China. If the manager is a crook or has serious character flaws, none of the other business factors will make the target a good investment.
Chinas success story is based on a single economic mode, that of mass production of low-value manufacturing products using abundant and cheap labor, massive capital investment and endless economies of scale. That growth prescription has lost its efficacy. The countrys changing demographics make this system increasingly unsustainable, as Chinas aging population and rising wage costs eat away at the abundant supply of cheap labor.
The policy of accelerated urbanization, using carrots as well as sticks to cajole 200 million sometimes reluctant rural residents into the cities, will not reverse the trend of rapidly rising cost structure. In fact, unheeded urbanization could turn into a costly economic, human and political failure. After all, China still has yet to deliver equal rights to more than 200 million migrant workers in its cities, rural citizens who are denied access to many urban social services under Chinas restrictive hukou system of household registration.
In addition, the environmental degradation that is a byproduct of the countrys capital-intensive, externality-ignoring development model is undeniable. Chinese citizens are seeing their life spans cut short by the poisonous air in the largest cities most pronounced in the capital Beijing the worsening water quality, and the polluted soil and food grown out of it.
The weakness of Chinas civil society, including the absence of free media, freedom of religion and freedom of speech, is another manifestation of how the lack of human and social capital hurts the quality of life and sustainable growth prospects. Chinas leaders increasingly view the formation of a civil society as a threat to the government a sort of insecurity on view in ongoing crackdown on social media and the mid-September arrest of a Chinese businessman known for promoting civil society.
These measures show Chinese society is moving in the wrong direction, with negative implications for its economy. To upgrade and invigorate its current economic model, China has to adopt a more open, pluralistic political system. To transition to a more value-added, service-oriented economy, the country needs a society with a judicious mix of what Albert O. Hirschman, the Nobel Prize-winning development economist, termed exit, voice, and loyalty: freedom of choice, freedom of expression and the ability to work together toward a common goal.