Instead of trying to block China, why not offer better products?
In last week’s WWW, we suggested thinking about the possible positive outcomes that could arise from this New Cold War between the US and China; that instead of being threatened by Made in China 2025 and One Belt One Road and trying to ban them, the US should instead offer a better alternative. Instead of saying we shouldn’t buy 5G from Huawei, why not make a better product? Instead of claiming that by building energy and transport infrastructure across Eurasis and into Africa that China is somehow trying to enslave the world in debt (irony alert), why not recognise that denying the third world loans to build power stations because they do not meet first world emissions standards actually keeps them in poverty? Similarly why not see that using the World Bank loans primarily as a means to make emerging markets forever dependent on US basic foods and consumer goods whilst producing lower value added goods and plantation crops for export looks far less attractive than the Chinese offering? Why not copy OBOR and apply it to Latin and South America? Why not announce Made In America 2025? In short why not copy China?
How has the US fallen so far behind?
The question that runs along side all this is how has the US fallen so far behind? For all the bluff and bluster about China stealing IP and producing ripoff goods, the fundamental problem for the US is that when it comes to the so called Fourth Industrial Revolution of 5G, the internet of things, AI, facial recognition, big data, digital banking, material science, electric vehicles and so on, they have totally squandered their advantage. China is not only far ahead in most areas, it also has most of the patents.
2007 was a tech Annus Mirabilis
In doing research for his book ‘Thank you for being Late”, author Thomas Friedman noted how remarkable a year 2007 was – a veritable annus mirabilis for technology. It was the year that Apple launched the iPhone, putting a computer in our pocket seemingly always and for ever. It was also the year that Google launched Android, extending that benefit to the cheaper end of the market. IBM began the AI revolution that year with Watson, its natural language processing machine, while the emergence of software (that most still haven’t heard of ) called Hadoop essentially allowed huge data sets to be analysed, inventing the world of Big Data. The early stages of what we know as cloud computing also began to emerge in 2007. In the same year, Google bought a small outfit called YouTube and both Facebook and Twitter went global. 2007 was also the year that Fracking first appeared in the US, a technology that was to give US corporations a massive cost advantage as well as change the geo-political reliance on the Middle East. For context, Chinese GDP in 2007 stood at $3.5trn, pretty much where the US was in 1983 and with little or no exposure to any of this technology, while US GDP in 2007 was approximately 4x that level, at around $14.5trn.
In $ terms, 12 years later, the US now stands at $21trn while China is at $14trn, going from 24 years behind the US to 12. In PPP terms China is now in fact ahead. In seeking to understand what happened to eliminate the huge US advantage from 2007 we don’t have to look too far for an explanation. It was down to what, almost literally, happened next, the Global Financial Crisis (GFC). Importantly, exactly as we see with this latest crisis, it was not the shock that caused the dislocation, but the reaction to it. The different policies enacted in the wake of the crisis lie behind the relative success of the two countries. It is an uncomfortable truth that while China built a new financial system, the US broke theirs.
The big mistake for the west was not exiting QE in 2013
Until 2008, China’s and the rest of the world had basically been using the western banking system, their own Banks being not really fit for purpose. The initial reaction in response to the paralysis in the western banking (for that is what the GFC was) was to open up liquidity via the big Beijing Banks, which not surprisingly led to some serious misallocation of capital – including the (now occupied) ghost cities that the China bears still talk about. The west meanwhile adopted QE, artificially depressing the cost of capital and leading to a different type of capital misallocation. The paths began to diverge however after 2012 when Xi arrived and began to reset the path with physical infrastructure investment, OBOR and Made in China 2025 while allowing the markets to set prices where they could do so. The west stuck with QE and the steady financialisation of their economies.
Since the GFC, China has invested in the 4th Industrial Revolution while the US has bought back $5trn of equity
In a report last year, JP Morgan pointed out that since 2009 the US corporate sector has tripled its borrowing to over $8trn, while buying back over $5trn of stock. Perhaps the most egregious example is the Airline sector where the four big airlines between them issued $38bn of debt over the last 6 years, while buying back $42bn of equity, the four CEOs pocketing $350m between them personally along the way. While not all borrowing has been to buy back stock on a matched basis, in aggregate, the US corporate sector now has debt to GDP of around 40%, up from less than 20% pre crisis. Throw in another $5trn or so of commercial real estate mortgage debt and you reach 62% debt to GDP, most of which has done nothing to increase productivity. Instead it has enriched insiders, be they Private Equity Barons, CEOs with share options triggered by targets easy to achieve through share buybacks or the banking sector itself, which took (almost) free money and lent it for financial restructuring rather than productive investment.
There is an opportunity for the west to re-learn the importance of productive investment.
Bottom line is that there is a real opportunity for any new Administration to truly Make America Great Again, by grasping the fundamentals of long term productive investment (the same is true in Europe for that matter). The US is behind China because it hasn’t invested in productive capacity. Moreover by loading up balance sheets with debt, US corporations have made themselves hugely more cyclical and a re-equitisation process is now needed. Looking at the latest crisis, one of the big winners has been Amazon, which has invested, while Google and Facebook by contrast are revealed as essentially nothing more than advertising companies and their straying into politics – blocking content they deem inappropriate – is threatening to break their quasi monopoly positions. It goes without saying of course that their ambitions to serve the huge China market are null and void. Meanwhile, Commercial Real Estate, the other big beneficiary of QE, was already at risk from the likes of WeWork – both its existence and its failure – and Air BnB (also created in 2007 incidentally), and looks likely to have some rather awkward moments ahead. Investors should avoid stretched balance sheets and accounting gymnastics and focus on the fundamentals such as cash flow and return on capital rather than return of capital. Governments should do the same.
