Over the last few weeks, I have been spedning a lot of timethings about the risks of China.  More specifically the risks that either are not thought through, are thought to be too low to consider, or are believed to be removed by a third party relationship.  It is a sitution that, as the interview below will show, is almost systematic in the outsourced manufacturing game, and was highlighted by the recent strike at one of Apple’s Suzhou based suppliers two weeks.

It was a strike that particularly frustrated me because Apple has had 3 or 4 other incidents in the past two years, and had in my mind simply not done anything to address the problems in a productive manner.  So, I asked long time friend and labor compliance specialist Pierig Vezin  (Founder and CEO of WethicA) to answer some questions for me based on his experiences in the field

what are the biggest compliance issues that exist in china?
The more common compliance issue in China is about working time. It is found in almost every factory as the Chinese law is quite strict (40 hours per week), but the reality is that the average working time is among the highest worldwide with around 70 to 75 hours per week.

The toughest compliance issue, bounded labour (i.e. young child labour),  is rarely an issue of big factories. Second to the issue of child labor though is that we regularly meet factories that pay workers once a year only, which essentially means that workers can’t resign from their job once they have started. This kind of practice leads workers to be fully dependent on the factory, even in case of major needs to change.

Do firms (buyers)understand the conditions on the ground? do they plan well?

Most of them don’t understand. Actually to be able to claim you are working with compliant factories only is already an evidence of lack of awareness of real situation.When I do training in companies on social situation in factories, I have people astonished by actual situation, and because many figures are not easily understandable , I spend a lot of time helping them understand the meaning of these figures.

For example on working time. When I explain days are often 12 hours long there is always one in each group to explain we were working that long not so long ago in western countries. Ans I also usually have one who claim to work 12 hours a day him(her)self. Then I point out that working in a factory 12 hours is not as working in an office 12 hours as you take break to talk with colleague, take break to eat, having some not fully efficient meeting… When talking about working time in factories it is 12 effective working hours. Then I explain. And what will you do Saturday or Sunday? In factories they will work as usual up to the end of the month. This is when people start to figure out what 12 hours a day 7 day a week really means.

Starting from this gap in understanding the actual situation it is difficult to imagine a proper plan. Experience shows proper plan on this topic can’t be done immediatly as once as to get involved first to be able to define proper goals.

Has anyone learned anything since Nike?
Even Nike haven’t learn anything since Nike.

They were attacked by a Chinese newspaper in November for wages only half the legal minimum in a factory of Jiangsu.

You also still have many brands claiming they are working only with compliant factories, but are still producing in Asia. If we just look at the working time issue, we know it is impossible all goods are done in compliant factories. Thus there are still many people who prefer to claim they don’t know.

Many companies are also having a more pragmatic approach while trying to manage the social f-grade of factories for the best and asking continuous improvement. Thus the understanding is improving, but not everything is done on that topics. Still many need to be taught

Are there industries that have always had high risk or labour noncompliance or cutting corners?
As soon as you work with many workers, that the wages is an important part of your turnover, you are more likely to try to cut “staff cost”. So obviously hand labour intensive users as garment, shoes, jewelry, luggage… small stuff are first in line. But many other industry are huge user of hand labour, even if we don’t think of it. mobile phone, computers,… are high tech goods, but they are also goods that needs to be assembled. The assembly lines are still mainly manual and it is an important part of the production of such goods. Thus they are at risk too.

What are the areas that pose the trouble for firms who are trying to do things right?
The working time is obviously the most difficult one, as it is the one where the gap with the requirement is the biggest. Wages is also a difficult topic as it is directly linked to cost. moreover, the wage system in China is complex and depends on a city level. Thus you can have a factory which pay better wages than another one 10 km away, but this one is not compliant while the other is. The compliance on wages isn’t actually something really important for factories while talking with local government. Thus sometimes you also found factories which give wages lower than legal minimum but many advantages. They could make calculation job to keep wages same level and it appears compliant. they usually don’t bother with that. So asking for improvment in that matter is often not understood as it is always seen as increasing wages.

Safety on the opposite is usually quite achievable while health of workers is a much more difficult topic.

Have things improved over the last 5 years?  Still the same?
Yes things have improved. the average wage has increase, the management of the age of workers is usually better even from time to time we have period of higher child labor. But I guess what has the most improved are the living conditions, with cleaner and healthier dormitories. Safety in China is also usually correct.

How have conditions changed over the last 18 months with the recession?
We thought the economic downturn would lead to less work in factories and decrease the overtime. Actually the opposite happens. As factories had no idea of the future they refuse to hire workers, and ask the present ones to do more. Since this summer the situation is going back to “normal” (not compliant) level. Actually the main consequence has been the stop of some action taken by the government. In January 2008 started the new labour contract. It wasn’t much different from the previous one, but it was a way to claim for its implementation. It as actually started , but then stop soon, and we still find as many workers with no contract at all than before. We also see factories who has understand they won’t be able to continue to compete only on price with other countries. Bangladesh is already much cheaper than China for basic garments. Thus some are changing their approach by trying to upgrade their level. it is going also in a social upgrade as they need to keep the best workers.

How much does it cost to do it right? What are the costs of doing it wrong?
It depends on what right and wrong means. Wrong is sometimes prison where labour cost close to zero. If right means compliant, then you’ll have not to produce in China. You can’t ask a factory to work 40 hours a week when all others are working 70 or 75. Actually if you ask it to strongly and refuse to see it is impossible, then you ask the factory to lie to you. Asking for better than the average is reachable. Asking for compliance is not.

Now on how much it cost, it is very difficult to answer. It depends on the good, it depends on what is expected, and it depends on how you implement it. Workers productivity in Chinese garment industry for example is very low. it is low because of lack of training, of organization, of rest. If you have workers waiting for goods to be worked, and the same workers making overtime all night because they are late, it is not talking about cost, it is talking about organization. Thus you can’t take the cost of social requirements separately of the whole factory organization. Another important topic on cost is the cost of the work on a global product. In a trouser, the cost of the fabric is usually much higher than the cost of the workers who cut an sew it. But pressure is done on this step as it is the most seen. To finish about costs, western buyers should sometimes rethink their buying process. I have seen so often company switching from suppliers for few cents per piece, while cost of changing supplier was to count in dollar per piece.

What do you make of the recent news of Apple’s compliance issues( should apple be doing more? What could they do?
Apple has decided long ago to work with a supplier well known for workers abuse. Every one or two year problems are raised on this topics. this summer it was about the student who “had been jumped” from his apartment window. before that it was about the sickness of girls working on Ipod. Apple has never shown any real action on that matter. We talked about Nike before. Even if not every thing perfect with Nike, when facing such challenge, they act and try to improve the situation. The current situation in Nike factories is better than the average of comparable factories. It is not the case for Apple. I guess that’s my answer about Apple actions.

Do codes of conduct really help? Can suppliers be trusted to follow these?
COC are guidelines, they are just reminder of what is asked; It is just a way to remind “we don’t want you to work with children…”; But they are not dynamic and most if not all of them have the same flaws in. They are not dynamic. They ask the factory to comply today. They are written in a western point of view when they have to be applied in Asia. The very notion of a law or a rule is different in Asia and in western countries. This it is most of the time impossible for factories to comply and sometimes even not fair. Let’s take the example of Young workers. The young workers are the one above child age (usually 16) but still minor. In local legislation young workers must usually be protected (avoid dangerous job…). In India for example (but it is seen in China even not so directly) most of factories forbid workers below 18 years old. Thus they don’t have to manage these workers; Thus young workers can’t found job in structured factories and have to work in unofficial workshops. Should the factory who is hiring young workers from time to time but not perfectly managing them be considered of lower social grade than the one refusing young workers?

What role can the market play to improve conditions?  Are Apple and Nike still at risk of consumers pushing back?
The market can surely play a role. The toy industry is a good exemple. Even if not everything perfect the Mattel case have stressed the risk for the brands of lack of control on the supplier. They have act together on the whole toy industry and worst factories have been closed. But there are still problems of huge subcontracting not always managed by the buyers. Even if they ask factories not to do so, it is not always respected and sometimes they prefer not to know. Managing the supply chain is probably the key factor on that matter as well as consumer safety. To answer your question on Apple and Nike, as Apple has done nothing effective yet, they are still at risk. The last fall example of Nike been attacked for lower wages also shows they are still at risk. But in the case of Nike, an important part of their goods is properly managed and the risk is lower.

What can brands do together to make improvements? do brands work against each other?
In my opinion the most important thinks brands can do to make improvements is to stop to hide themselves the true. When an audit report is perfect, you have to wonder how it is possible. How can a factory be so different from the prevailing practice. Why (as it is the perfect factory) there is no a queue of 1000 workers waiting each morning to be hired. By accepting lies from factories brands are pushing factories to lie more and more and to invest on better lying system. There is automated IT system to generate compliant time records, wages… simultaneously as the real one. This is pushing to invest on non transparency. So if Brands were wanting improvement they should first accept the actual situation and starting from here instead of starting from where they want Asia to be. Then it would be possible to favor factories that really try to improve and not the one that looks like. So every brand that accept to work with lying factory is working against the ones who push for improvements

A lot of conversation over the last few weeks about what China is for many firms. and what it is not.

It is a conversation that, while recently catalyzed by Google’s announcement that they were looking at pulling the plug, is a conversation that I would say is had on a basis that is more frequent than many would like to admit to at time. Typically preceded by an event of some sort, commercial or political, and can be defensive, self defeating, or well analysed depending on the person, and one of the more interesting analysis I have seen lately comes from James McGregor in his recent piece in Time, The China Fix, where he writes the following:

The foreign business community in China has deep respect and affection for the Chinese people and their hard-earned success. But more than a few foreign business leaders are asking themselves if they have been bamboozled by the system. Multinationals have been solid citizens in China, handing over heaps of capital, technology, training, source code, best practices and proprietary products to joint-venture partners they were forced into bed with. They have funded schools, orphanages, disaster reconstruction, overseas scholarships and all manner of poverty-alleviation programs. But now that the China market matters more to them, it appears that China couldn’t care less. Increasingly difficult China-market access is the immediate worry. But many are looking ahead and losing sleep over expectations that their onetime partners are morphing into predators — and that their own technology and know-how will be coming back at them globally in the form of cut-price products from subsidized state-owned behemoths.

Some would say that this paragraph sums it up nicely, and that what is described above amounts to a big China bamboozling.

For me, while I agree that there is a general negative vibe going on, what I am consistently surprised by (perhaps disappointed is a better term) is that people really will fool themselves into believing anything about China at any given time, and when you look at the recent case of Google.. it is really hard to sympathize on some levels as their executives came in believing they could change the structures of the market.

It is a belief that has lead many bad retail strategies, joint ventures, and investments, and it is a large reason why I typically advise an organic growth strategy.

But, that being said, has the situation changed?  Has a new day dawn upon China?  Have Westerners (firms and managers) outlived their useful shelf life?

Or is this another case of anecdotes clouding sound judgment?

Guest Post from John Solomon, Director of enoVate

The fixed gear bike movement has hit the streets of China. Just three years ago, you could count the number of fixed gear bikes here on your fingers (and maybe toes). But spend an afternoon strolling Shanghai’s French Concession, and your sure to see various youth — Chinese and Foreign — riding fixies. What’s more, this movement is not limited to the Big Two (Shanghai and Beijing). Tyler Bowa, founder of People’s Bike, states China’s biggest fixed gear scenes are actually in Shenzhen and Dalian, where 7 months ago there were no such bikes. This movement is spreading to cities nationwide: Suzhou, Nanjing, Chengdu, Wuhan, the list goes on. But why? The fixed gear industry has done little-to-nothing to popularize this product in China. Besides a handful of local companies, like airwalk (link), fixed gear brands have mostly neglected their relationship with the Chinese consumer. This, of course, will change very soon.

Crucial to the rise of fixies in China has been the internet. For one, the fixed gear scene has become increasingly well-documented. Videos and photos litter the online world. These bikes are popping up on popular websites, blogs, and video sharing websites. Chinese youth can watch popular fixie movies, such as MashSF, on youku. Secondly, the internet has provided a place for riders to organize communities. Threemin, China’s first fixed gear website has an active forum, with roughly 4,000 members for its Southern China forum alone.

Also worth mentioning is the sometimes subliminal cultural magnetism of China’s neighbors — Japan, Korea, and Taiwan — where fixed gears have an already long-established tradition. But Karl Ke, co-founder ofPeople’s Bike, notes that beyond just fixed gears, bicycle culture is experiencing a resurgence in China.

“Basically, I think people more and more fancy riding a bike, based on four key areas: 1) the government began extensive promotion of environmental protection concepts. 2) More and more Western media are promoting the concept of bike riding and healthy living. 3) More people want to escape from depression and immerse themselves in city life. Cycling is one of the most effective and easy ways to escape and control things in one’s daily life. 4) Fixed gear is simple and close to the concept of extreme sports, but has its own unparalleled noble temperament.”

For many young Chinese today, the bicycle stands for much more than just a means of transportation. It is now a fast-growing culture, that consists of a large community dispersed throughout China. This is especially the case for fixed gears. Websites like People’s Bike and Threemin keep riders all over connected, while events like Alleycat (video here) have united riders from all over for races in Beijing, Shanghai, and this weekend Guangzhou. This community will continue to grow. The second half of 2009 saw a real explosion in China’s fixed gear scene, but that was just a taste of things to come as we enter a new decade.

We expect to see brands hoping on the bandwagon in the immediate future. Brands like Puma and Thule have already associated themselves with local bike culture by sponsoring the Shanghai Alleycat. Expect more of this, but also expect the fixed gear industry to open its eyes to the China market. It’s an open playing field. Giant will be entering the fixed gear market soon with a new brand called Momentum. This is smart. Fixed gear aficionados tend to stay away from mega-brands when building their cycle. This demographic seeks a personal relationship with their bike. A Giant branded bike would ultimately fail. As Tyler Bowa states, “we don’t want to walk into a big store and pick something off the wall, that’s why small bike companies thrive throughout the world.”

For some great Shanghai fixie photos, check out Tyler Bowa’s portraits on flickr: http://www.flickr.com/photos/peoplesbike. All photos are from Tyler Bowa and People’s Bike.

john solomon is founder and managing director of enoVate. enoVate is an insights and design firm based in shanghai. we publish daily insights and develop creative solutions for China’s youth market. visit enoVate’s website for more information.

This afternoon I was asked by someone why I am involved in CSR and sustainability.  It is a question that I seem to asked frequently, but one that I am not sure I ever answer with any measure of clarity as I have worked in a very wide range of issues related to these big topics, and my interests for each issue hit me in different spots.

But, if there is one common thread that I feel binds each of the issues I work on (see a recent list of 35 projects I am managing through my class at CEIBS), it is that of responsibility… or the lack there of.

That, regardless of the issue under the microscope, at any one time there are up to 5 different groups that share a role and responsibility, and that should one of those groups fail to assume their responsibility, or should one of those groups act in a deliberate manner to upset the balance, then they are by their very nature irresponsible and are taking on a measure of risk to their person or organization.

If this sounds a bit alien, then think back to Nike circa 1996-1997 when the entire world was given a glimpse into the realities of Indonesian labor standard.  It was a classic case of a model that was unsustainable. Nike outsourced all their manufacturing to largely Asian owned/ operated contract manufacturers (still does today), but with little oversight or belief that they had any responsibility of the conditions on the ground.  It was a denial of responsibility that lead to a huge PR disaster for them, and they took win huge losses as consumers walked away from them in what I would call an act of consumeristic responsibility.

Fast forward to 2006 when the international press got wind of an issue related to the dormitory conditions of the Suzhou factory that manufactured Apple’s famed iPod.  It was a story that immediately became controversial as Apple and Foxconn tried to skirt the stories and admit no wrong, but ultimately Apple did send over a team of investigators to Suzhou who:

In response to the allegations, we immediately dispatched an audit team comprised of members from our human resources, legal and operations groups to carry out a thorough investigation of the conditions at the manufacturing site. The audit covered the areas of labor standards, working and living environment, compensation, overtime and worker treatment. The team interviewed over 100 randomly selected employees representing a cross-section of line workers (83%), supervisors (9%), executives (5%), and other support personnel (3%) including security guards and custodians. They visited and inspected factory floors, dormitories, dining halls, and recreation areas. The team also reviewed thousands of documents including personnel files, payroll data, time cards, and security logs. In total, the audit spanned over 1200 person-hours and covered over one million square feet of facilities.

.. and what they found was:

Our audit of on-site dormitories found no violations of our Code of Conduct. We were not satisfied, however, with the living conditions of three of the off-site leased dorms that we visited. These buildings were converted by the supplier during a period of rapid growth and have served as interim housing. Two of the dormitories, originally built as factories, now contain a large number of beds and lockers in an open space, and from our perspective, felt too impersonal. The third contained triple-bunks, which in our opinion didn’t provide reasonable personal space.

To address this interim housing situation, the supplier acquired additional land and is currently building new dormitories. These plans were in place prior to our audit, and will increase the total living space by 46% during the next four months.

It was a report, a process, and reaction that while initially grabbed some press, was  in the end chalked up to  just another problem that overseas brands faced when outsourcing.  As the Wired article Judging Apple’s Sweatshop Charge seemed to conclude in their assessment:

The situation is too murky for a rush to judgment on Apple’s ethics here, and it may well meet minimum global standards. But for a company that has staked its image on progressive politics, Apple has set itself up as a potential lightning rod on global labor standards. Sweatshops came back to bite Nike after its customers rose up in arms; and Apple can expect a similar grilling from its upscale Volvo-driving fans in the months ahead.At this point,

It is at this point that Apple appears to have been genuinely woken up, or at least rattled, because 18 months later Apple released its first supplier Responsibility report (download here) where the findings of a complete review were released.  It was a report that was opened with the passage below:

Apple is committed to ensuring the highest standards of social responsibility throughout our supply chain. The companies we do business with must provide safe working conditions, treat employees with dignity and respect, and use environmentally responsible manufacturing processes wherever Apple products are made.

For the past several years, Apple has required suppliers to commit to a comprehensive Supplier Code of Conduct as a condition of their contracts with us. We drive  compliance to the Code through an aggressive monitoring program, including factory audits, corrective action plans, and verification measures.

Apple’s approach to supplier responsibility extends beyond compliance monitoring. We also provide detailed standards and ongoing training support to help suppliers continue to meet our expectations. And by making social responsibility part of the way we do business, we ensure that suppliers take our standards as seriously as we do.

.. but, it was a report whose contents were shocking as more than half of their suppliers were not in compliance.  There were material issues that were across the board (as the graphic below shows) with overtime, wages deductions, age limits, and so on, and regardless of whether or not these could be explained away or were “problems of the past”, the fact is that Apple should have at this very moment stopped dead in their tracks, realized that they were sitting on a problem, and made changes.  Changes in their partner relationships, changes in the way they monitor and measure relationships, and changes in their attitude about who is ultimately responsible for labor abuse (and other issues of corporate responsibility) within one’s supply chain.  Outsourced or not.

Sadly though, their own internal document did not provide the “come to Jesus” that it should have and last summer, again at a Foxconn site, a 25 year old employee committed suicide after he was interrogated by Foxconn employees over the theft of a prototype iPhone.  an event that I covered in my article Apple’s China Supply Chain Issues Require IMMEDIATE Attention and Action, and believe to this day that Apple should have taken the following actions:

1. Contact Nike to learn lessons of how to develop an IN-HOUSE program that manages and monitors the factory conditions
2. Get boots on the ground.  Pay the money for a team of people who will make inspections and be given the power to make corrections
3. Invite in third parties to not only verify what Apple has found and done, but to give public credibility to the process in place
4. Do the right thing and begin making better decisions about who their suppliers are, and what is expected.  If the profit from an iPhone is 50USD, spend the extra buck now to do the right thing.  It is not an expense, it is an investment
5. Make materials improvements, or make materials adjustments.  Give suppliers a chance to change, but do not wait long.  Begin developing parallel supply lines and force suppliers to comply through the threat of lost business (partial or whole).
6. Open Up

Once again, this event would not serve as a learning lesson for Apple either (they largely skirted their responsibility of this once again), and 7000 employees of another Suzhou based supplier Wintek went on strike in May of 2009 over poor working conditions, and another 2000 employees again went on strike this week over working conditions and pay.   As the China Daily article Workers protest over pay, toxic chemicals highlights:

He said at least four workers had died from overexposure to hexane, a toxic chemical workers had been asked to use for cleaning touch panels manufactured at United Win (China) Technology Ltd Co. The company is a subsidiary of Taiwan-based Wintek Corporation, one of the world’s leading producers of small mobile phone panels and touch panels. [...] Media previously cited local authorities as saying workers had been provoked by rumors that the company planned to cancel a year-end bonus, which company executives later dismissed and promised to distribute before the Chinese Spring Festival that is less than a month away.

But Zhu said it was not just about the money. “What we feel angry about is the company authorities’ apathy to our workers’ health,” he said.

Unconfirmed deaths aside, the fact that employees are being exposed to these chemicals at all should have been something that Apple’s inspectors should have picked up on.  Unless of course the team of inspectors were outside to Apple’s process, and really had no idea what they should have been looking for.  Plausible?  But, if it was Apple’s team, then they should have been looking for this type of issue, and had they found a chemical exposure issue, they should have taken action right away to make sure that employees had the equipment (suits, ventilation, etc) to protect themselves from exposure.

It just begs the question.  Does Apple feel any real sense of responsibility for the conditions of their supply chain, and why is it that a firm that is trying to crack the China market so willing to risk so much?

Is it that Apple is ignorant of the fact that these problems exist? Is it that they believe the brand is impermeable?  Or are they just scared of standing up their suppliers?

It is a horrible miscalculation in my opinion, and when speaking to a friend this evening who is in the audit business about the situation we were stuck on why a company with Apple’s size and cash position wouldn’t spend the 2-3 million USD it would take to fix this problem.

For me,it is a sign that Apple’s model is broken.  That regardless of how well they are selling now, or what the next gadget will be, that they will at some point experience the loss that Nike did in the late 90s, or larger.  That while there seems to be little recognition of Apple’s supply chain issues in the U.S, and no sustained pushback in China, Apple is playing with fire.

It has clearly set up a supply chain that allows suppliers to structure their operations in a manner that exploits the living conditions of employees.

A structure that, getting back to my first point, will become an issue of economic sustainability for Apple.

In what may be the biggest sign of the problems that China’s energy infrastructure faces, a recent Alibaba article China’s spreading power shortage by province listed out the provinces that are going through shortages (Henan, Hubei, Chongqing, Zhejiang, Shandong, Shanxi, Yunnan, and Guizhou), and by how much (5-20% short), and it is clear that something is gonna give.  and soon.

Go back 2 years when China was hit by a blizzard the knocked out many of China’s North to South rail lines, which resulted in 17 provinces losing power, and fast forward to today (in a time where the export economy is off) … and there are still problems.

The recent Jan 6 WSJ article Europe and Asia Struggle With Travel, Power Woes says:

China faces potential power shortages as parts of the country struggle with the coldest weather in decades, authorities said. The cold spell is expected to persist through the week, driving up demand for heating and electricity.

… but in the China based Global Times December 31 article Power shortages worsen in Wuhan, the issue was already highlighted as one that Wuhan (Hubei province) was already fighting, and had been fighting for a very different reason:

“As the coal used for power generation is still in short supply, residents’ lives would be affected without the ban on industrial sectors,” said Fu Jianjun, deputy general manager of Wuhan Power.”

The severity of the problems which ultimately were highlighted in the Clean Techica article Coal-Power Shortage Threatened in China:

Any time coal reserves go lower than three days, coal-fired power plants must shut down. Eleven percent of the key coal producing provinces’ power plants are close to getting to that point. Coal reserves at power stations are in dangerously short supply.

As of Sunday, coal reserves in 598 major power plants were decreasing and were only enough to last for nine days. Coal storage in 205 power plants will last for seven days, an alarming level, the National Power Dispatch and Communication Center said.

Which takes me back to the Steel Guru piece Chinese utilities accept 2010 coal price hikes in regions from December 26, where I think we hit bedrock on the issue:

A power company executive said that a few coal groups in China’s top coal producing province Shanxi have asked to raise term prices by CNY 30 per tonne to CNY 50 per tonne with coal with calorific value of 5,000 kcal per kilogram at around CNY 500 per tonne after the hike. In the northern province of Heilongjiang, utilities and coal miners have agreed on a price hike of CNY 50 per tonne to about CNY 390 per tonne.

So, on Dec 26 an increase in the price of coal was agreed upon, a week later the capital of Hubei province was reporting coal shortages, and now you have 10 provinces short of power.  It is a condition that of course will have immediate economic and societal impacts, and is perhaps the key reason why the December Smartgrid conference in Beijing was packed.

One of the more interesting discussions I had last week was surrounding how one (a firm or an individual) could position themselves against China in the markets. That, if one believed, China’s economy was in a bubble – and that the bubble was going to pop – how would one position themselves favorably.

It was an interesting discussion as the person I was speaking with historically would have loaded their portfolio with short positions on those he thought would be the first to fall. In China this option is largely negated by the fact that you can’t short Chinese stocks in China, and that there aren’t really enough firms listed overseas (or at least not the right ones should the fit hit the shan).

Typically a topic I would avoid on All Roads, I figured it was worth a post as the “recession” seems to be over, people are turning back into good consumers, but then there was an article that forced me out of my cave. So, in my first random act of amateur journalism, let’s get right into it and take a look at the Pulitzer prize winning author Thomas Friedman’s latest article  Is China the Next Enron. Friedman, , who is a leading expert on war, globalization, global warming, and NOW US/ China economic structures, writes a piece that questions the logic of James Chanos who recently said that China is “Dubai times 1,000 — or worse”, and he offers up two gems of advice for Mr. Chanos:

First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves
Second, it is easy to look at China today and see its enormous problems and things that it is not getting right. [...] I am reluctant to sell China short, not because I think it has no problems or corruption or bubbles, but because I think it has all those problems in spades — and some will blow up along the way (the most dangerous being pollution). But it also has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so (unlike us).

Now, correct me if I am wrong, but neither of those have ANYTHING to do with the real estate market, and while I would agree that having 2 trillion in reserves and a focused government help, perhaps Friedman is just a bit overly optimistic about China? or perhaps it is just that he is so pessimistic about the US that anything looks better?

The second half of his article gets even better as he lays out WHY China is long term in the stronger position. Having lunch with some students from HK, he comes to understands (not sure if this is a watershed moment for him) that China’s sea turtles are retyrning home (note: a sea turtle in Chinese is someone who goes abroad to study, perhaps work for some time, and then returns home), and that the represents a long term advantage for China:

One of the biggest problems for China’s manufacturing and financial sectors has been finding capable middle managers. The reverse-brain drain is eliminating that problem as well.

On this point, I would agree, but I would also say that this belief that all sea turtles are coming home is not only false, it is misleading. Many are only returning because there is an opportunity right now, but few that I have spoken to plan on staying in China forever. This is, for many (not all), a short term proposition, a feast of you will, where everyone is trying to get their piece of the action and then go home with as much fat sotrage as possible.
These are not people returning to the “motherland” to build the nation, and that is the flaw in Friedman’s belief.

Friedman wraps up his article with the following assessment on a China Short:

“So I asked several Taiwanese businessmen whether they would “short” China. They vigorously shook their heads no as if I’d asked if they’d go one on one with LeBron James.”

.. damn, he is a good writer, but is he write? (UPDATE: Read this post by Barrett Brown who really tears into Friedman)

In short, no.  I think that Friedman’s analysis is flawed, his sourced (based in TW and HK) are the wrong ones for the story, and there are signs that I would say present a concern for many.  Including Chinese leaders, banking officials, and those in commodities.

At the heart of it for me, the main issue I see everyday, the low hanging fruit, comes in the form of real estate.  Walk down Huai Hai road, Nathan in HK, or visit the latest SOHO project in Beijing, and you will see that retailers are turning over.  A LOT.  Some will say that it is a heathy sign of an economy that there is turnover, and typicallly I would agree, but at this time what I am seeing instead is a phase where established retailers are closing shops and landlords are offering up firesale deals to fill spots.  Spots that vacate after 4-6 months becuase the concept did not work.  A condition that is not limited to a single store, but to entire blocks.

Looking a bit higher, and moving  bit further from the inner ring roads, and it becomes clear that the next real problem is in the vacany rates in all the recent commerical and residential buildings that have been built.  18 months ago, these projects were DEAD. Cranes were idle. Trucks were not moving. Workers were clearly on a siesta.  Then, 9 months ago everything changed over night (hello stimulus!) and my entire district become a construction pit with 24/7 dump trucks going down the road, cranes whirling steal beams around, and migrant laborers flowing back into the city.

It was a period of manufactured economics, and it has created a condition where many supporting industries began to find themselves in a situation where there was more capacity in the market than demand.  Everyone rushed in for stimulus money, and with that largely drying up we are looking at some very interesting times as China’s banks (who issued the largest proportion of the debt) will now be left to collect on that money.

This was just one sector of the domestic expansion that was inflated to offset the export market deflation.  there are others.

Which leads me back to how I would place a short on China.

For me, China has been a market that offered a diverse number of opportunities for years, and while there may be a move from low to high end, the fact is that the leading indicators of this economy are still (and going to be for a long time) in the raw materials  sectors.  Ore. Coal. Metals. Oil.

It was in the immediate aftermath of the financial crisis that these prices plummeted, and it is in recent weeks following the snow storms that we saw an equal inflation in energy inputs.

So, that is where I would start (were I one to believe that the economy was about to double dip).

Next, I would look at the stocks overseas of firms who service these sectors – Autralian resource firms, American construction equipment, bulk logistics, etc – as candidates, keeping in mind that there are some who are more exposed than others

Finally, and this option is the option that should only be exercised were there be a serious meltdown…  look at all those companies who saw China as their holy grail market.  Easy to identify, if there are firms who are counting on China to return 30-40% of their future growth targets, then their stocks are going to get hammered.

Now, all this being said, would I short China at this point, and are there areas of growth that I see going forward?  I am an optomist by nature, and while I would not short China on a broad base just yet, there are some stocks that I am pretty sure are rip for a reduction in growth expectations and are certainly candidates for a reduction of their share prices.

So, that wraps up my first post for the year.  Hope you enjoyed it.

With the launch of its newest, fastest, and most expensive rail projects, you too can now pass through 20 cities, go over 600 bridges, and pass through 200 tunnels to on your way from Wuhan to Guangzhou to help to create better cooperation between Hubei, Hunan, and Guangdong. … and in about 1/3 of the time of the old snail rail method.

When asking for a white Christmas in China, I guess you gotta be careful.. cause you might just get what you ask for.  It’s like a blizzard outside .. hard to see.. don’t advise anyone to go outside.. yet, as it is smog and not snow, it just isn’t the same.

In what might be the regulation that slipped through the traditional media wires, Jay Boyle of EXPAT CFO just forwarded me a potential bombshell of a regulation where China will look to tax all those offshore transactions that investors have come to rely upon when setting up their China vehicles.

… and it went into effect January 1, 2008

In short, the circular is meant to specifically address the offshore sales of China based assets, and Deloitte has already put together their thoughts on what this means for investors (download file here):

Circular 698 makes it clear that the Chinese government intends to tax indirect transfers, many uncertainties still need to be clarified. It is unclear how the 12.5% effective tax rate of the offshore intermediary holding company is to be determined; for example, will the minimum 12.5% rate criterion be met if the jurisdiction of the intermediary company has a tax rate higher than 12.5% but does not tax capital gains? In the case of a direct transfer of a Chinese resident enterprise by a foreign entity, the SAT will easily be able to identify the transferee as the withholding agent; this will be more difficult in the case of an indirect transfer of a Chinese resident enterprise.

It is unclear how the tax bureau will enforce taxation of such offshore transfers in practice. Where transactions involve a large group of companies in a global merger or acquisition, the requirement to disclose all of the information concerning the transaction may create an overwhelming administrative burden and involve the submission of information that will be irrelevant. From the buyer’s perspective, the impact and consequences of a seller’s noncompliance are not entirely clear.

Where I myself am a bit lost in this new “clarification” is the simple fact that the very reason why many firms chose to set up offshore is to effectively dodge authorities who might otherwise block the sale of an asset. That, tax aside, the ability of a firm to sell their HK or BVI shares to another firm without the approvals of Beijing was a huge asset in itself. So much so that those who were able to “clean” a mainland asset and structure it offshore were typically paid a premium for their effort.

An effort that may no longer be enough.

At the same time, my personal opinion is that this clarification will be used as the exception vs. the norm, and that it will be used as a negotiation chip for firms who have found themselves past another red line. Simply getting access to the data in some of the “standard” islands is going to be tough, but if Beijing wanted to force the issue they clearly could under the guise of this law (recognized outside of China or not) as firms would be force to comply or face roadblocks/ fines in other areas.

So, regardless of whether or not we see a team of investigators start opening up the HK books, I think investors would be wise to see that things are getting tighter all around, put down the rose colored glasses, and begin reassessing the risk levels of “traditional” China models.

Any lawyers want to weigh in on this issue?

Update 1: While emailing back/ forth to a Beijing based lawyer, he also was unsure of how the enforcement of this would be possible/ take place, and in my most recent reply to him I asked whether this rule was actually geared for chasing overseas Chinese IPOs vs. domestic M&A.  I do not have his answer yet.

Anyone have thoughts on that possibility?

1. Chengdu’s Metro Line 1 laid completely, to start trial operation next October
On November 30th, the municipal government of Chengdu held a press conference, announcing that the track-laying of the Metro Line 1 of Chengdu has been completely finished, and the trial operation is predicted to begin next October.

2. Chengdu expected to become emerging growth pole in Asia Inland in future
On December 5th, the third Chengdu Economic Development Forum sponsored by the Chengdu Economic Development Institute was inaugurated, and around the topic of “Chengdu Economy in fifty years”, guests from the National Development and Reform Commission, the China International Economic Exchanger Center, Chengdu-based higher learning institutions and research organizations and relevant governmental departments of the city, have discussed the road of future development of Chengdu. Experts thought that in about 20 years, Chengdu is expected to become an emerging inland growth pole in Asia and an innovative international hub city.

3. Among most investable new energy cities in 2009, Chengdu ranked No. 1
At the 2009 China Economic Development Annual Meeting of New Energy Industry held recently, Chengdu was awarded the title of the “most investable new energy city of China in 2009”, and ranked No. 1 among the 15 cities on the list, learnt the journalist on December 8th from the municipal economic commission.
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