Why The Sky Isn’t Falling In China

If you’ve spent much time watching the Chinese stock market lately, you can be forgiven for feeling a little bit anxious.  Watching 40% of a market’s value evaporate in 6 weeks is ugly.

Equally, if you listened to the recent quarterly earnings calls of some of the world’s largest multinationals, you might wonder if the Middle Kingdom isn’t on the verge of economic collapse.  Speaking of China, Volkswagen warned of a “bumpy road ahead;” Anheuser Busch InBev cited “economic headwinds.”  Ludovic Subran, chief economist for trade credit giant Euler Hermes summed up the general gloom.  “Companies thought that China was the land of opportunity, but it’s not living up to that promise.  They realize the business environment is changing for the worse.”[1]

When I asked one of my Chinese colleagues about this depressed state of affairs, and whether people in China were as worried as people in the West, the reaction was decidedly calm.  “No,” she said.  “These changes are needed to keep growing in the future.”

What Goes Up…

Start with the stock market.  Although the Chinese government has been desperately trying to prop up falling prices, this is more of a PR exercise than a worry about financial Armageddon.  Thanks to a cooling in the overheated Chinese real estate market, coupled with a liberalization of investment regulations, a significant volume of money has found its way into Chinese stocks, more than doubling the size of the market over the past 12 months:

Add to this the fact that the Chinese stock markets are not systematically important in the way that Western ones, especially US financial markets, are.  Most of the money that’s come into the market over the past year has been from individual investors, rather than large banks or pension funds. 

While it’s painful for individuals to see their savings evaporate, it’s not the same as global companies being unable to roll over their short term paper, or hedge funds losing control of highly leveraged derivatives.  Seen from this angle, the recent stock market woes look more like air coming out of a bubble than the beginning of a regional financial meltdown.

Structural Changes

And what of the other source of worry, China’s slowing economy? 

“That’s been known for a long time,” was my friend’s response.

Since taking office, Xi Jinping and Li Keqiang have said that the Chinese economy needs to transition from export-driven to consumption-driven[2].  That entails significant changes to an economy that has become the world’s largest exporter of goods. 

Even these ongoing adjustments have left the economy in a robust state of growth: because of its larger base, 2014’s “disappointing” 7.4% growth rate was larger in absolute dollar terms than the “miraculous” 19.9% growth rate in 2006.  While the 7.0% growth that so disappoints Mr. Subran is far below the double-digit expansion of the 1990s and 2000s, it still puts China 9^th among all the world’s countries, and 1^st among G20 economies:

On The Other Hand…

Which is not to say that China’s economy doesn’t face real problems, or that something might not throw a wrench into the works of the Chinese economic miracle.  Plenty of black swans are hovering just off stage.

Debt, both private and corporate, has ballooned alarmingly in recent years, reaching $28T, or 300% of GDP[3].  Xi’s sustained anti-corruption campaign is putting pressure on government services (because departments have trouble filling vacancies) and unsettling officials throughout the country, leading many to wonder about a possible backlash.  The middle class is more and more restive for political freedoms that Beijing is unready to grant.  Two years on, it’s still unclear how Xi plans to reconcile the rule of law with fealty to the Communist Party.  Any of which may prove problematic in securing China’s long-term economic prosperity.

But today’s stock market wobbles, and a long-planned set of structural changes to move the economy into a lower gear, are not signs that the sky is falling in China.  If anything, these teapot tempests draw attention from more threatening storm clouds gathering in other parts of China.  Which, unfortunately, is quite a justifiable reason to wonder if the sky might someday fall.

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[1] FT.com “Corporate giants sound profits alarm over China slowdown” http://www.ft.com/cms/s/0/8dacba88-36c4-11e5-b05b-b01debd57852.html#ixzz3hiDqtf5u

[2] Economist.com, “Why China's economy is slowing”  http://www.economist.com/blogs/economist-explains/2015/03/economist-explains-8

[3] BusinessInsider,com.au Blackrock: soaring Chinese debt is a big concern and history suggests it won't end well http://www.businessinsider.com.au/blackrock-soaring-chinese-debt-is-a-big-concern-and-history-suggests-it-wont-end-well-2015-6

A Sow's Ear Out Of A Silk Purse

The failure of the WH IPO shows that Chinese companies are still not ready for the world stage.


Explaining a $600M payout was never going to be easy.  Nor was stitching together two giant regional meat companies into a global superstar, or floating that company just nine months after it was created.  But those were the tasks that Shuanghui International and its parent WH Group (WH) set themselves following their $7B acquisition of US pork producer Smithfield Foods (Smithfield) last year.  Buoyed by the obvious logic of combining the world's largest pork seller (WH) with the world's largest pork supplier (Smithfield), as well as the enthusiasm of would-be punters, WH confidently expected to be the season's hottest share offering.

In the event, however, the deal was beset by a host of problems, most of them self inflicted.  WH managers proved unable to deliver a coherent story about the company's future plans.  Despite having two executives (one Chinese and one American) tasked with finding synergies, efficiencies were conspicuously absent from the deal.  Dodgy executive pay practices on both sides of the Pacific (including the now-infamous $600M payout to two WH executives) raised uncomfortable questions about self-dealing.  Pricing hubris resulted in an inability to find a lead underwriter for the deal, causing the company to enlist a gaggle of 30 "joint sponsors" instead.  On April 29, after three downward revisions in the offering value, and faced with a cooling IPO market, the company finally admitted defeat and cancelled the flotation.  Speculation is now rampant about how WH will meet the debt obligations it undertook in acquiring Smithfield.

The WH story vividly illustrates the opportunities and challenges that face Chinese companies going abroad.  Having skillfully ridden China's demographic wave over the past 30 years, and having bested rivals in the hurly-burly market that developed since the implementation of Deng Xiaoping's economic reforms, many Chinese companies find themselves flush with cash and seeking new worlds to conquer.  WH grew out of a state-run slaughterhouse, fully privatizing along the way, and developed into the world's largest distributor of pork.  One can only admire the genius of Wan Long, WH's 73 year old CEO, who built the company from an unknown local abattoir into a mammoth agribusiness.  Unfortunately, this genius hasn't translated into success on the global stage. The failure of the WH IPO demonstrates that many Chinese businesses are simply not ready to go abroad.

One of the most basic manifestations of this unreadiness is that Chinese companies don't think they have a problem.  Cross-border deals bring rich rewards, in terms of both money and status, to Chinese executives who carry them off.  One of the most striking features of the $600M payout WH made to the CEO and one other executive for completion of the Smithfield acquisition was that the Chinese side saw nothing amiss in it.  Significant, profile-raising deals in China are often accompanied not only by kudos, but also by cash for the executives lucky enough to be involved.  The pace and value of these deals are at record highs, with Western icons like Volvo, AMC Theaters and Manganese Bronze being acquired by previously unheard of Chinese companies like Geely and Wanda.  The volume of such deals is steadily increasing; Rhodium Group, a US consultancy, estimates that Chinese outward foreign direct investment over the next decade will top $1 trillion.

At the same time that Chinese companies find themselves looking outward, the West is seeking Chinese money in vast quantities.  Delegations from cash-strapped companies and investment-hungry municipal governments converge on Beijing and Shanghai every day seeking Chinese sponsorship.  A cottage industry has grown up around servicing these visitors, promising access and face time with Chinese investors and officials.  Before selling out to WH, Smithfield entertained rival offers from Thailand's CP Foods and the Brazilian meat producer JBS, but both offers paled in comparison to Chinese cash and growth potential.

Unfortunately, bulging cash reserves and parades of foreign suitors obscure the fact that Chinese managers are largely deficient in the skills needed to successfully manage complex cross-border deals.  At the best of times, realizing synergies in a merger is maddeningly difficult; a much-cited study by Harvard Business School claims that three-quarters of all acquisitions destroy more value than they create.  In the case of WH, little evidence was produced to support CFO Guo Lijun's assertion that the "acquisition generated synergy effects in terms of resources, costs, markets and development in both China and the USA."  Investors were left with the impression that within the merged organization there was no significant linkage between ultra-efficient American production techniques and sky-high Chinese demand.

The yawning gulf between the qualifications of the Smithfield and WH managers points to another problem - a general lack of global experience among Chinese executives.  Prior to the acquisition, Smithfield had done a credible job of building up a significant European operation, catering to the demands of newly emerging middle-class consumers in Eastern Europe.  Many Smithfield managers had participated directly in this facet of the business.  But only one Smithfield executive, CEO Larry Pope, made it onto the board of the merged company, leaving the other directorships in the hands of managers who had never worked outside of China.  This parochialism did little to sensitize the company's management to global perspectives on efficiency, transparency and self-dealing.

For Chinese companies, correcting these deficiencies will require painful changes, not least because many of the needed skills are contraindicated by managers' experience within China.  Whereas increased efficiency has been an imperative for Western managers since the Industrial Revolution, the past 30 years in China have been a time of limitless (albeit poorly skilled) labor supply.  Reducing headcount is always unpleasant, but it's the backbone of most M&A synergies; such reductions are virtually unheard of in China.  Transparency is a similar issue.  Until recently, there was almost no incentive for a Chinese company to disclose details of their operations to the prying eyes of rivals and the public.  One of the reasons WH executives didn't have a better explanation for the bonus paid to its CEO is that they never imagined it would be disclosed.  

Most glaringly, Chinese executives often lack basic business skills and experiences that are taken for granted in the West.  Many Chinese managers have no formal business training, and the quality of those who do is often low; one of WH's finance executives, 37 year old Liu Songtao, has a degree in "chrematistics" (the art of "getting rich"), from Henan University.  This deficiency is a product of the post-reform economic climate in China - during a time of explosive and chaotic growth, the ability to read a balance sheet matters little compared to the ability to seize opportunities.  Getting already-successful Chinese executives to go back and master the basics of financial literacy and corporate governance promises to be a challenge.

Nevertheless, failing to acquire the right skills will inevitably lead to more problems.  Japan's early forays into buying foreign assets in the 1980s resulted in political friction and significant write-downs.  American companies entering Russia and other emerging markets in the late 1990s faced similar challenges.  China, now entering its first significant wave of outbound investment, is likely to make its own unpleasant and expensive mistakes.

Which is not to say that Chinese companies should eschew cross-border deals, or that they are incapable of making such investments pay dividends.  If the Chinese have proved anything since rejoining the global economy in 1979, it's that they're fast learners, having repeatedly defied naysayers' expectations in regard to mastering production quality, high technology and sophisticated service offerings.  There's no reason to expect that that cross-border M&A will be any different.  But getting there looks like a bumpy ride.

Top 10 Ways Of Losing Face Video

http://youtu.be/IOd_wAXwNAo

The Top 10 Ways of Losing Face

Unfortunately, in the same way that certain things will give face to your Chinese counterpart, many things will also cause them (and you) to lose face.  The following are some of the most common face-losing mistakes that Westerners make.

Pressing for an answer - To a Western ear, Chinese answers often sound maddeningly vague and noncommittal and with good reason: they are MEANT TO BE vague and noncommittal.  Giving an answer to a question or requests requires a commitment and commitments may put the answer's giver in a face-losing position.  What if the answer given is wrong?  What if it is not the answer the boss wants to be given?  What if it requires a commitment that cannot be fulfilled?  Pressing a Chinese person to give an answer may cause them to lose face and, following the reciprocal nature of face, cause you to lose face as well.  Don't press for an answer if you can avoid it; the answer will come out over time.

Discussing controversial topics - To a greater or lesser extent, Westerners believe everyone is entitled to their own opinion, and disagreements about non-personal topics are not taken amiss.  Even so, there are topics like religion, politics and sex which are usually avoided except among very close friends.  However, for the Chinese, and especially when they're speaking with foreigners, the list of problematic themes is often longer.  Controversial topics include Taiwan, Tibet, Tiananmen Square, the Communist Party, Mao and US foreign policy.  Brining up such topics can be deeply embarrassing to Chinese people, and will strain even the friendliest business relationship.

Speaking too directly - The Chinese speak in an indirect way that is alien to most Westerners, and speaking too directly is often a source of problems.  For instance, in the thousands of business conversations I've had with Chinese colleagues, I have only once been told that I was wrong or had made a mistake (about a relatively minor issue, as it turned out).  Every other time, objections to what I'd done was registered as an observation, often about someone ELSE'S performance or idea.  Saying, "I disagree" or "that's wrong" is often considered to be quite rude.  Speaking too directly, especially in registering disagreement or disapprobation, will frequently embarrass the Chinese and is considered face-losing.

Ignoring the details - Part of the indirect style of communication used by the Chinese is that it often relies more on noticing details and non-verbal clues than Western communication styles do.  For example, a Chinese person may not ask if they can have a ride to the grocery store, but instead comment on how far away the grocery store is.  Concerns are often repeated in the form of questions or innocuous sounding observations, but anything which has been mentioned more than once is likely to be a significant issue for your Chinese colleague.  Failing to notice these details can make your Chinese colleague feel that he must speak directly (thereby giving offense) or let the concern go unacknowledged (thereby causing resentment), both of which can be face losing.

Pointing out mistakes - No one especially likes having a mistake pointed out, but the Chinese are VERY sensitive to this and it is considered extremely face-losing to do so in public.  In fact, publicly pointing out a mistake is often considered a significant punishment in Chinese companies.

Showing impatience - Chinese people allow an incredible range of behavior in meetings that would strike a Westerner as very rude; taking phone calls, openly working on an unrelated project, answering emails, ignoring the speaker, holding side meetings.  I have personally witnessed executives playing computer games and shopping online during meetings that they themselves called.  However, it is considered very rude and face-losing to show impatience.  The meeting will go on as long as it needs to go on.  You are expected to sit and listen (or play computer games) until the topic has been thoroughly discussed and everyone's opinion has been heard.  This rule is somewhat relaxed if it is your meeting - the chairperson can hurry people along.  Otherwise, showing impatience is face losing.

Ignoring the hierarchy - The Chinese tend to be much more formal about hierarchies than Westerners, and failing to acknowledge and take account of the relative rank of people can be seen as insulting.

Leaving no way out - One of the cardinal rules of face, is that all participants must have a face-saving way to change their mind.  Creating a situation whereby a Chinese colleague has no choice but to admit to a mistake or reverse themselves in public is almost guaranteed to end badly.  The situation may be so stressful, that they would rather suffer whatever consequence follows from sticking to a bad position, rather than suffer the loss of face that comes with being forced to publicly admit a mistake.  Additionally, every Chinese person involved in the situation will understand that you created such a situation, which will result in a significant loss of face for you, as well.

Disagreeing in public - Openly disagreeing with your colleague, boss or host is the height of bad manners and face-losing behavior.  A much better strategy is to do as the Chinese do and speak indirectly, e.g. "That's a good idea, but I need to think of the best way for us to implement it."

Getting angry - Showing anger in public is considered very face-losing for everyone involved. It also plays into one of the negative stereotypes Chinese people have about Westerners, namely that they will fly off the handle without warning.  Westerners often cannot believe that the long meetings, frequent distractions, half-answers and unclear statements that characterize meetings and negotiations and meetings with the Chinese aren't DESIGNED to make them angry.  Certainly, it often seems that way.  But that's almost never the case.  So don't lose your temper.  It almost never helps.

The number of ways you can lose face when dealing with the Chinese often seems endless.  It can all be very  frustrating.  But avoiding these common mistakes will help smooth things with your Chinese colleagues, and that pays dividends when you are doing business with the Chinese.

Itchy Feet Video

http://youtu.be/uFRLKGU8N1Y

Itchy Feet

Why the Chinese have dramatically increased their overseas investments
Seven point one billion dollars has a way of catching people's attention.  When it comes from a developing country for the purpose of buying a pig farm, it has a way of making people question their assumptions.

And so it has proved with the $7.1B acquisition of American Smithfield Foods by China's Shuanghui International.  Besides the eye-popping spectacle of someone paying billions for what amounts to a farm/butcher shop (who knew there was so much money in pig farming?), the deal has drawn attention to the recent run-up in Chinese overseas investments.  Suddenly it's not just the Middle Kingdom's giant state-run oil bureaucracies that are making big-money deals in far-away places, it's movie theater operators (Wanda's $2.7B acquisition of AMC), battery makers (Wanxiang's $257M acquisition of A123), car makers (Geely's $1.5B purchase of Volvo) and, yes, pork producers.  The Rhodium Group, which tracks Chinese overseas direct investment, shows investments in the US alone increasing from $500M in Q2 2009 to $2.5B in Q3 2013.

After years of conservative, domestically focused corporate growth, the Chinese have developed a significant appetite for foreign assets.

Although the fact of China's growing overseas investment is clear, the drivers behind it are less so.  These drivers are complex and varied, but they generally fall into business and non-business categories.

Taking Care Of Business
There are six main business reasons why the Chinese have recently begun to accelerate their acquisition of overseas assets:
The old China, Inc. business-model is losing power
A critical mass has been reached in terms of deal-making infrastructure
Buying assets and expertise has become less expensive than building it
Increased wealth accumulation is driving a greater need for diversification
The need to climb the value chain has increased
Greater maturity has driven a desire for greater vertical or horizontal integration
The first factor drives all others, and the second has lowered the cost of Chinese firms going abroad, whatever the motivation.

Since 1992, when Deng reaffirmed the country's commitment to economic reform, the business model that created China, Inc. has been based on cheap labor, imitation (sometimes theft) of existing technologies, easy credit and frenetic entrepreneurialism.  Although still present, these factors have largely diminished or run their course:  the average yearly wage in China has risen from approximately 2,400 RMB ($200) in 1992 to 46,769 RMB ($7,667) in 2013; the technology gap in most manufacturing disciplines has all but vanished; today interest rates in the West are routinely 3.0% to 5.0% lower than in China; the country's domestic startups of twenty years ago (Huawei, Vanke, ZoomLion) are now global giants and cannot afford to be frenetic.  All this has left Chinese businesses looking for a new growth model.

During this same 20 year period, an army of business majors have graduated from university (China currently graduates more than 6 million students per year, compared to 2.7 million the US) and a generation of business consultants, lawyers and accountants has matured.   When Lenovo acquired IBM's PC division in 2005, even routine deal support tasks had to be handled by foreign consultants.  Now, domestically grown bankers, lawyers and accountants carry much more of the load.  While these specialists are still far rarer in China than in the West, they at least exist as a body of professionals today, which was not the case before.  This talent pool, small as it is, makes it far easier for Chinese companies to do cross border investments and acquisitions.

Chinese businesses have long had an appetite for things that are hard to find in China - management experience, technology, access to Western markets - but they've only recently accrued the confidence and money needed to buy those things on a large scale.  Geely's purchases of Volvo and Manganese Bronze were both for the express purpose of getting access to technology and design capabilities that Geely lacked.  Lenovo was making computers long before it purchased IBM's PC division, but IBM's brand and technology turned the Chinese company into a global player.  Whereas Chinese business previously had to settle for organic development of technology, brand, and management expertise, many are now in a position to buy them wholesale.

As Chinese enterprises have grown and the limits of China's domestic market have been reached, diversification of risk has become a priority.  The drive to diversify geographically is exemplified by China Vanke, the country's largest property developer; the company began making investments in the US as a way of balancing its high-risk, high-return Chinese portfolio with lower-risk, lower-return assets in a developed market.  In part, this is just common sense, a way of not putting all your eggs in one basket.  In part, however, this is a nod to the realities of operating in China - the legal system is arbitrary, political winds shift, and social stability is questionable.   The need to diversify into a new line of business drove Lenovo's abortive attempt to acquire Canada's Research In Motion; the computer company wanted to accelerate its entry into the cell phone market by purchasing the maker of Blackberry.  This trend towards diversification overseas has begun to pervade Chinese businesses in a range of industries.

Looking to the example of Taiwan, Korea and especially Japan, a goal of the Chinese government is to climb the value chain.  This has already happened within the borders of the People's Republic, as a country once known only for making clothes and plastic toys has become a serious player in industries from telecoms to shipbuilding.  However, as Chinese businesses have matured, they have also started making strategic investments overseas to accelerate their progress up the value curve.  In 2010, when Tenzhong Heavy Industries, an obscure Sichuan manufacturer, made a bid for the iconic American Hummer brand, it was for the express purpose of moving out of a low-margin construction equipment business and into a higher-margin vehicles one.  Climbing the value chain has now gone global for the Chinese.

The final business reason for the growth of China's overseas investments is vertical and horizontal integration.  Buying related businesses plays to the strengths of the Chinese, who are by nature conservative.  The practice of buying minority stakes in existing successful businesses is a typically Chinese integration strategy, and one that has come to dominate some sectors (e.g. Chinese oil companies' fracking operations).  Chinese companies prefer to start with a small ownership percentage, and then increase it over time as they learn more about the new business.  Integration is usually less about gaining efficiencies (as is often the case with Western companies making such acquisitions) and more about increasing footprint and capturing a larger proportion of the customer's pocket.

Not Just A Matter Of Dollars And Cents
Non-business reasons have also played a role in pushing Chinese firms to invest in cross-border transactions.  The PRC's government has pushed this concept for years, as part of a larger campaign to increase the prestige and competency of Chinese industry.  Although Chinese government's direct influence over Chinese businesses tends to be overplayed in the West, companies everywhere are sensitive to the wants of their political leadership.  Chinese companies are no different and almost all at least give lip service to an ambition to operate and sell outside the PRC.  To some extent, this explains why the Chinese oil bureaucracies have concentrated on acquiring second-rate operations abroad, rather than developing oilfields off China's coast.

Perhaps even more powerful is the drive to enhance 'face.'  Culturally, the Chinese tend to be concerned with outward appearances, both on a personal and organizational level.  In a way, for the Chinese foreign operations are like football teams; whether they make or lose money, their very existence confers cache on their owner.  Cross border investments and acquisitions instantly raise the profile and stature of the Chinese company doing the deal.  Though intangible, this is an important consideration for Chinese companies and their management.

Whether any of these motivations, business or non-business, justifies China's new outward bound investment focus remains to be seen.  The Japanese lost hundreds of billions of dollars learning that success in one hemisphere doesn't guarantee success in another.  The Koreans have largely opted for organic growth and a "steady as she goes" approach.  Even Western companies, with their advanced management structures and deep expertise, regularly destroy more value than they create when making overseas acquisitions.  Managing assets and operations in a foreign country is tough, and the Chinese, with only 30 years of capitalism under their belt, may not be ready for the intensity of the competition they will face.  But $7.1B says that they are serious about playing the game.

The Rules Of Face Video

http://youtu.be/DytYRqVWT-Y