China is in the news. Their stock market seems to be in free fall; their economy seems to be slowing down; their real estate market is questionable. So what is happening and how did they get to this point?
40 years ago China was an agrarian society. Today they are the 2nd largest economy in the world, second only to the United States. The change was very deliberate and followed a pattern from history. It is well worth looking at history to see the implications for investments and impact on investments.
In 1661 Louis XIV began his reign in France. At that time France was close to bankruptcy. The French had fought 3 major wars and 2 minor ones. In those days, paper money did not exist. Payment was made in gold and silver. But France had no mines. To pay off war debt and to operate the government France needed a different source of capital. Louis XIV appointed Jean-Baptiste Colbert in 1665 to solve the financial problems.
France had some industry, but it was mostly small crafts that were not competitive world-wide. Colbert settled on building business in new industries like glass and textiles. To do so, he established a network of spies and sent them to other countries to determine who were the best craftsmen and entrepreneurs. They were sent to steal the secrets to the production machinery and processes and technology. They recruited the exceptional craftsmen and entrepreneurs from other countries offering many “Royal Privileges”: no taxes, government financing and guaranteed government purchase orders for their products. Duties were assessed on similar products made outside France so the French companies were given protection from competition. Colbert was ruthless, determined, and able with the full control of the finances of France to make it happen.
France had a large rural population and very high unemployment. That allowed Colbert to build factories that employed over 1,000 workers. That was something new in France. He paid minimal wages, put workers into dormitories, worked them 14-16 hours per day and gave only religious holidays as days off. Colbert got into a dispute with the Roman Catholic Church claiming they had too many religious holidays. Colbert encouraged women to marry before they were 20 years old so their children would increase the workforce.
Having pirated the technical expertise and intellectual property, Colbert needed to make sure it did not leave France. So new Royal decrees were put into effect. Once in France, skilled craftsmen were not allowed to leave. If they did leave, they would end up by punishments from rowing in one the King’s galley ships to execution. It was decreed that French craftsmen could not import products. There were over 15,000 small entrepreneurs executed for the crime of importing foreign cotton cloth.
To ensure quality, Colbert established a corps of state-funded industrial inspectors to verify the quality of products produced in France. French industry became renowned for their quality in many luxury goods. Some of those companies continue today like Gobelin tapestry and St. Gobain glass.
Jean-Baptiste Colbert was thoroughly nasty, widely hated by many, both French and non-French. But he launched France on the path to large-scale industrialization within a relatively short period of time. It is a business or economic model we call “Mercantilism”.
We may be living in the golden age of mercantilism. China is perhaps the most visible example of that today. They have achieved an astonishing success – but not one without problems. We are just beginning to see the problems today.
The Ruling Communist Party controls the land. They can decide where to locate business. They decide on the need for roads, airports, railways and public structures. There are no legal restrictions nor any delay. Development is not accidental. The Party has a long-term development plan and they control the key industries. They promote exports and try to limit imports to build a trade surplus. The Party owns the banks so they can direct who gets financing and who does not. They can carry what they consider “key” companies regardless of the efficiency and profitability (or lack thereof). The Party controls the allocation of resources to different parts of the economy effectively giving them control of the economy itself. The Party controls foreign policy and can use that to direct the business inside and to some extent outside of China. The Party decides what industries are of major importance and can allocate resources to those industries and companies within that industry.
Large companies in critical industries are either fully government owned or majority government owned. Even some of the publicly traded companies are majority government owned. The Party gives significant incentives (like Colbert) to foreign manufacturers. They will give cheap labor (at least in the beginning), with modern infrastructure. 70% of the Chinese exports are from relocated plants. Foxxconn, for example employs over 100,000 just to manufacture Apple products almost all of which are exported. The workers are housed in dormitories.
The Chinese appropriate technology like Colbert. For example, the early high speed trains were joint ventures with the Japanese and Dutch partners’ technologies. Now the Chinese partners have taken that technology, made a few minor changes and claim it as their own intellectual property. The Chinese partners now compete on other projects directly against the Japanese and Dutch.
The Chinese model is not that different from the Colbert model. It has attracted attention from other countries trying to copy it: Brazil, Malaysia, India, Thailand, and Vietnam.
But there are, or at least can be, significant problems in the mercantilism model. State owned companies can easily become unprofitable. The taxpayers end up paying. An example is the Vietnamese Shipbuilding Industries Group which as incurred multibillion dollar losses and debts. Operating losses tend to balloon since it is the government that bails out the companies.
The mercantilism approach is spreading at this time. The companies which are deemed key in those mercantilism countries are very tough competitors because profitability does not matter to them.
As Americans we tend to see the world through American eyes. It is not the same in the rest of the world. Diversifying into international stocks is not the same as investing in US stocks. Even US companies that partner with foreign firms can be hurt.
What we see in the Chinese market today is, in my opinion, the result of the weakness of the mercantilism business model. In America, the growth is slower but directed by demand. That is not true of the mercantilism countries and that is, in my opinion a very significant problem for business in those countries like China.
Much of the information was drawn from the book Entrepreneurship in the Global Economy by Henry Kressel and Thomas Lento.
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