CRACKS IN THE GREAT WALL OF CHINA

China's economic growth surged to an 11-year high of 11.9% in the second quarter. Asia's new economic giant is on course to chalk up its fifth-straight year of double-digit percentage growth. And after leapfrogging the United Kingdom in 2005 to become the world's fourth-largest economy, China is set to overtake Germany for the #3 spot by the end of this year.

Eye-popping economic growth rates notwithstanding, China's reputation for economic invincibility has taken a serious knock in recent weeks. The media barely noticed when Chinese-made drugs contaminated with diethylene glycol led to the deaths of dozens of people in Panama last year. Only when pet food containing the wheat gluten tainted with the chemical melamine was blamed for the deaths of dogs and cats in North America did the mainstream public sit up and take notice. Suddenly tales of toxic fish, defective folding chairs, juice containing unsafe additives and popular toy trains decorated with lead paint inundated the media. My favorite? Chinese candy tainted with formaldehyde, an embalming fluid.

But even I was surprised when a recent Business Week cover story, "Broken China," declared that "China's $1.2 trillion in foreign reserves -- the most ever amassed by any country -- and soaring trade surplus may seem like signs of strength, but they're actually evidence of an over-reliance on exports, weak domestic consumption, and a primitive financial system. That's a startling about face for a publication that only six months ago was going gaga over China's newfound superpower status.

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Cracks in the Great Wall of China: Honeymoon Over?

Even once furor fades over defective Chinese exports, it's unlikely that China will ever regain the uncritical acclaim it enjoyed over the past two years. The world is coming to realize that the very same policies that generate eye-popping GDP figures threaten China's future prospects of developing into a modern economy. Developmental economists have known this for a long time. "Extensive development" -- putting up a factory on land and producing bad quality shoes -- is easy. "Intensive development" -- manufacturing quality products, distributing, marketing and branding them -- is hard.

And there's just something about the Chinese export scandal that made Americans feel a bit queasy. Yes, in the 1960s and 1970s, "Made in Japan" and "Made in Korea" were synonymous with shoddiness. Yet when Japan made shoddy goods, it was because it was on a learning curve. But the fact that mainland Chinese deliberately substitute cheaper toxic materials in medicines to save money crossed the line.

There are other reasons why the bloom is fading off the Chinese rose. China's $1.2 trillion in reserves is matched by the amount of bad debt in its banking system. That's close to 50% of its GDP -- making the U.S. savings and loan (S&L) crisis or current subprime lending woes look like a rounding error.

China is also becoming a country of exaggerated expectations. In spring of 2005, Starbucks CEO Howard Shultz noted on CNBC that in three years (2008) the company would probably have more cafes in China than in the United States. Today, the number of the company's U.S. cafes still exceeds those in China by 10 to one. China spends more than Japan on R&D, but its highest profile "invention" ever was a knock off of a Motorola chip. As Zhu Jian-Gang, director of Carnegie Mellon University's electrical engineering department, pointed out to Business Week: "China is spinning its wheels... They do a lot of research, but it isn't important"

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Cracks in the Great Wall of China: A More Balanced View

Communist political systems and economies tend to consistently overestimate their economic achievements and underestimate the costs that the culture of corruption has on future development. That's how the Soviet Union's rump economy (Russia) went from a global superpower to one whose economy shrunk to the size of Florida. Even after six years of torrid growth, Russia today only has returned (in real terms) to the economic level of Texas.

James Kynge -- a Financial Times reporter who first went to China in 1982 -- authored "When China Shakes the World," the FT/Goldman Sachs book of the year in 2006 that offered a balanced (and sobering) view of China. Oddly, no one writing cover stories for business publications seems to have read this book. James Mann, author of "The China Fantasy: How Our Leaders Explain Away Chinese Repression," writes about the reasons for this:

"The biggest problem is that the media coverage of China tends merely to reinforce whatever is the reigning stereotype or image, or "frame," of China in any particular decade or era. In the 1950s, the coverage in the United States was of Chinese as disciplined automatons. In the 1980s, it was "China goes capitalist." In the early 1990s, it was "crackdown in China." Now, it's "China rising" (and "China gets rich"). Once an impression gels, then the extended press coverage – by which I mean, TV specials, news magazine covers, newspaper features – all either repeat the impression or at least play off it in some way or another."

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Cracks in the Great Wall of China: How to Mend Them

Defenders of China point out that the country cannot be held to Western standards. Tell that to the families of the Panamanians who died of contaminated Chinese-manufactured medicine. Operating in a corrupt, economic system still dominated by state-owned enterprises, Chinese companies just may be uniquely bad. Contrast them with Indian firms, which are genuine private-sector enterprises and compete on the global playing field. Except when they are assembling goods for Western manufacturers, most Chinese companies sell only in the domestic market and none compete on the highest global level.

The elephant in the room is political change. Its naïve to assume that China will build the financial, legal, and administrative systems required to become a modern industrial society without the death of the Communist party. Yes, party apparatchiks have the power to revoke the licenses of food and drug firms and shut down factories. But that's hardly enough for China to become an economic superpower with its own Coca Colas, Nikes or Apples. For that to happen, the Chinese Wall must do more than crack. It must crumble.

Sincerely,

Nicholas A. Vardy
Editor, The Global Guru

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