Welfare for whom?

Charts this week 12

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I recently left China, moved away after years making my life there. Seasons change and mine changed. I’m not one for why I left China explainers. Please don’t expect or ask for one. Anyway, this is the reason for the lack of postings.

“There are no solutions. There are only trade offs.” - Thomas Sowell

Today I’m going to write about a realization I had. The main ingredient was Michael Pettis’ and Matt Klein’s explanations about China and the global trading system (balance of payments). Other sources were my experience living in China and books I’ve read over the years.

Underpinning this realization is the idea that a country cannot have a fixed competitive advantage in manufacturing—temporary, yes, but not fixed. This is mainly because manufacturing doesn’t rely on natural endowments (like resources, climate, or location). Manufacturing is a knowledge-intensive industry.

As an industry, manufacturing benefits greatly from technology and (temporary?) global environmental factors, such as the following:

1. An open, safe and easily insured global trading environment,

2. Modern digital technologies to allow ultra large-scale operations (perhaps allowing increasing returns to scale!),

3. Standards and software to share, collaborate and send designs,

4. Plastics - light weight and malleable material that’s easy to transport,

5. Continued advances in automation (scale, again),

6. Digital communications networks to send information (orders, instructions) and capital ($$$), and

7. Open trading partners to absorb exports.

Welfare for whom?

The realization is that China’s system is actually one of massive welfare, conveniently not the kind Xi worries about when he warns against “welfare-ism”. China’s is a corporate¹ welfare system. (Note: check footnote 1 for why “corporate” isn’t a great term for China.) Another term for this is industrial policy, but I think there’s a spectrum that goes something like this:

ZERO INDUSTRIAL POLICY → → INDUSTRIAL POLICY → → CORP. WELFARE

Money and resources (including a “clean environment”) are accumulated by the Chinese State and redistributed to businesses for their use. And before some people get upset—”businesses” includes foreign companies and their suppliers (foreign company benefits from cheaper inputs).

I see the symptoms everywhere I look, with stories about local governments reviving bankrupted Electric Vehicle companies (for the local jobs), “hidden debts”², weak household consumption, poor consumer confidence…

Examples of subsidies, incentives

I read about the extent of the direct subsidies³ in “Make it in America” where Liveris, ex-Chairman of Dow Chemical shared a story about Bridgelux, an American startup that “builds small, light-emitting chips that are only one hundredth the size of a typical light bulb, but emit the same amount of light using 80 percent less electricity.” They were looking for a place to build their next plant, fighting to stay in America. But they ended up going elsewhere.

One Asian country even offered to pay 80 percent of Bridgelux’s workers’ salaries for a decade. Sweetening the deal even further, the government offered tax breaks, low interest loans and free land.⁴

Liveris doesn’t mention the name of the Asian country, but with that trifecta of tax breaks, low interest loans and free land, I figured it must be China. Bridgelux ended up being acquired by the state-owned China Electronics Corporation (CEC) in 2015⁵, after they received an investment from CEC subsidiary-JV Kaistar in 2012⁶, a year after Liveris’s book was published.

The Bridgelux example was over a decade ago, but variants of this are alive and well. More recently, I’ve heard (hearsay warning) stories of factories that move to China being offered free transport of their machinery and the usual free land, roads and electrical connections and zero/low taxes for a number of years. I’ve also heard that if companies mention they are considering leaving, sometimes they’ll get offered some “incentives” to stay.

Of course, no business wants to tell the world what kind of subsidies they got and how much. Liveris wrote his book as a warning with suggestions for America to correct course.

Also, as far as I can tell, there’s no central repository in China of how much subsidies are handed out.⁷ They are often negotiated by local governments, who benefit professionally⁸ from the GDP boost and job creation. Why would they disclose exactly how much “spending” went into that GDP boost? The subsidies were paid for by debt, and there’s plenty of stories about China’s hidden debts (cough, LGFVs). And there are periodic audits that uncover more and more hidden debts.

Wait… aren’t there benefits to this development model?

It’s actually a stellar strategy if you ignore the costs or imagine they will never come home to roost:

China tries to pick industries that are of increasing importance, subsidizes the hell out of them, which results in too many being created/funded/subsidized, which results in a wild competitive environment, which results in some clever innovations and cheaper stuff (price war anyone?), which results in overcapacity (hello trade wars👋), which results in a ton of mergers and losses for those don’t make it. Then China is left with a few dominant firms with major economies of scale in industries that may turn out to be important (and some maybe globally important!).

Who’s the bag holder?

Remember: “There are no solutions, only trade offs.” - Thomas Sowell

You may be thinking this is genius strategic thinking. But there is an embedded trade off = the bag holder. The final bag holders are China’s households. The local governments funded subsidies with funding from local banks (through LGFVs, hidden or otherwise). These debts were repaid through funds raised from land sales. Land prices went up, receipts from land sales went up and home prices went up too—forcing households to pay more for a home. This cycle repeated and home prices went sky-high. This is how property (apartments mostly) became 70-80% of household wealth!

The price increases made early buyers fabulously wealthy. And made risk-loving, bet-the-farm, leverage-everything -types even more fabulously wealthy. The risk averse who kept their savings in the banks got robbed with unreasonably low deposit rates, effectively subsidizing businesses and the State⁹ in yet another way.

Now households are sitting on a mountain of real estate wealth that is slowing eroding away as the “Homes are for living” mantra lets air out of the bubble. This is why an economic crash can quickly become a political crisis—many people instinctively understand there was a trade-off with households on one end, though they may not be able to articulate it.

Going forward, China’s big problem is the corporate welfare spigot is hard to turn off. Instead of pivoting to another system, China is doubling down on the same system but tweaking the targeted industries. This has created a tale of two cities where some industries are thriving and others are like, dude, where’s my customer?

Some clarifiers

To be clear, there isn’t anything wrong with encouraging business with subsidies. We believe industrial policy is important. Also, China was in hardcore development-mode and used every tactic available. We may write more about solid strategies to encourage industry and create competitive advantages.

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That’s all for today. Thanks for reading.

1. A friend and reader of an early draft pointed out that “corporate” is the western word for this, it’s helpful for western audiences but it doesn’t fit perfectly on China’s economic system. We agree. Here we mean that redistribution in China mainly benefits corporates over households. Corporates being larger businesses on the state or private side of the economy. In the west we have three classes of economic entities (1) households, (2) businesses, (3) public government or “the State”. In China business and the State are mixed to an extreme degree. See our post “The Brief: State vs. Private Enterprise” for more:

There is no publicly available official data on the current scale of the hidden debt. But research by a team including Hu Jiayin, an assistant professor of finance at the NSD, showed that interest-bearing LGFV debt had ballooned to 54.6 trillion yuan ($7.8 trillion) as of the end of 2022 from 32.6 trillion yuan four years before, up two-thirds, despite the central government’s persistent efforts to resolve it. Local governments are obliged to repay some of the debt, according to the research.

2. https://www.caixinglobal.com/2023-09-19/in-depth-chinas-trillion-dollar-local-government-hidden-debt-dilemma-102110275.html

3. “Subsidies” here is of the very broad sort, just as easily called “incentives”.

4. Make it in America by Andrew Liveris, page 57.

5. LED Startup Bridgelux Acquired by China Electronics Corp. - Greentechmedia.com

The acquisition will allow Bridgelux to drive down costs in an increasingly competitive LED market and compete globally on stronger footing. “This was a transaction that we have designed Bridgelux to be able to enter into,” said Bridgelux CEO Brad Bullington.

6. Bridgelux Wins $25M From China for GaN LEDs on Silicon Substrates - Greentechmedia.com

7. Imagine for a second a State Owned Enterprise filling out some form listing all the ways they’ve been supported.

8. Perhaps personally too?

9. State meaning local governments and SOEs who receive preferential rates on bank loans compared to smaller private enterprises, who have a much harder time securing bank financing.