China Airborne

by James Fallows

  The problem for the Chinese economy has become its dependence on stimulus through investment. If by the early 2000s the American economy had become addicted to cycles of borrowing, overconsumption, and further borrowing to propel its expansion, China’s was addicted in the opposite way, through cycles of overinvestment and the resulting need to export. Once a new factory is built, the construction jobs are over—and people can keep working and getting paid only if there’s a market for what they make. Or if new construction projects begin, which eventually add even more to the nation’s productive capacity. In 2007, before the world financial crisis began, investment and capital projects of all sorts, including construction, represented 39 percent of China’s economy. By 2010, that share had risen to 46 percent—an astonishing increase, even as investment was being cut back in most of the rest of the world. But a Wall Street Journal analysis in 2011, which noted this change, pointed out that China could use this tactic to sustain employment only so many times.1 The country had become more and more reliant on build, build, build as a way of keeping its people at work, and the longer that strategy went on, the harder it would be to maintain.

  Any trend that can’t continue won’t, and at some point the Chinese juggernaut will have to “rebalance” itself with the rest of the world. The typical economist’s scenario for this transition is as follows: As China’s own people get richer, they will buy more of what their own factories make, plus more of what foreigners provide as well. China’s growth will be more self-sustaining, and less dependent on chronic trade surpluses with the Americans and new roads in every corner of the country.

  That’s where China is headed, at least in theory. But for now, it keeps people at work through a heavier reliance on “capital formation”—new factories, roads, shopping centers, power plants,2 and government and corporate projects—than any other economy, ever;3 and infrastructure projects, including airports, are an important part of that drive. The construction of a hundred airports at once is a classic illustration of Chinese stimulus through massive investment. The aspirations to match Boeing and Airbus in airplanes, Sikorsky and Robinson in helicopters, Rolls-Royce and GE and Pratt & Whitney in engines, Honeywell and Avidyne in avionics, symbolize the direction in which many Chinese leaders hope the economy will go in order to break its reliance on farms, factories, and construction sites.

  China as the new America, in a bad way

  By the time of the Beijing Olympics, even as China was increasingly seen around the world as the rising economic model of the age, economists inside and outside the country said, in various forms, this cannot go on. This—the Chinese boom—could not go on environmentally, because of the costs to people and the pressure on resources. It could not go on strategically, because of the aberrant relationship in which Americans kept borrowing Chinese money to buy Chinese goods. And it could not go on for reasons within China, because of the social tensions and dislocations it was creating.

  There is one particular aspect of this can’t go on that got much less attention outside the country than it deserved. That is probably because it was a weakness that looked like a strength: It was China’s huge “success” in selling so much more to the world than it bought.

  In politics, press coverage, and barroom talk, it’s natural to consider exports and the resulting trade surpluses as proxies for individual and national merit. And there’s some truth to that: The broken-down economies of the old Soviet bloc could barely export anything to customers who had any choice about what to buy. Boeing’s, Intel’s, and Apple’s victories in world markets are generally points of pride for Americans. The same is true for Siemens and Mercedes in Germany and for their counterparts all around the world. But too one-sided a reliance on exports can ultimately be as destructive and destabilizing as too little success in selling overseas. To illustrate why, think about the similarity between China around the time of the Olympics and the United States eighty years before. That would, of course, be 1928, which few people outside Holland identify as the time of the Amsterdam Olympics but which many people recognize as the eve of the great worldwide depression and subsequent world war.

  An economist and financial-markets expert named Michael Pettis, who was trained in the United States and Europe but has taught since the early 2000s at Peking University, drew out this comparison for me during one of several interviews I had with him in Beijing around the time of the Olympics, this one in 2009. When people say that China is like “what America used to be,” he told me, it’s often meant as a compliment to China and a criticism of the United States. But there was an important opposite side to the story.

  Through the early 1900s, he said, the United States played a role in the world economy surprisingly similar to China’s since about 2000. Until the start of World War I, the United States had long been a “net debtor” country—as premodernized China had also been. Through its first century-plus of development, the young United States had relied on foreign loans and investments to build the factories and lay the railroads that ultimately made it an industrial titan. By the end of World War I, it had become a “net creditor,” as its undamaged industrial base supplied European combatants and the former customers of ruined European companies.

  In the 1920s, its farms and industries made America the workshop of the world. It ran trade surpluses with most other economies, which meant that a disproportionate share of the world’s jobs were in America (that is, it was doing work to create products that other people consumed). By the same logic, a disproportionate share of what it made went for other people’s use. Foreigners paid the difference by transferring gold reserves—the economist John Maynard Keynes complained in the 1920s that the United States was amassing “all the bullion in the world”—or taking on loans and investments from Americans. So far, this is like China’s story. And so far, apparently, so good.

  But its very role as global exporter made the United States unusually vulnerable when global demand collapsed in the 1930s. Having had more than its “fair” share of the world’s jobs to begin with, it had more of them to lose. This doesn’t mean that Americans suffered more deeply than Europeans, overall. Americans got Franklin Roosevelt; Europeans got Hitler, Stalin, Franco, and Mussolini. But as a matter of plain economics, the layoffs and unemployment of the Depression years were worse in the United States.

  That was the prospect for China, as the world economies began their series of shocks and contractions soon after the triumphant Beijing Olympic Games. China’s several-trillion-dollar war chest of foreign holdings, built up from its long string of trade surpluses, gives it advantages. But China’s reliance on foreign customers is a serious vulnerability.

  Pettis wrote in 2009 that China’s worldwide trade surplus, “the cleanest measure of overcapacity”—factories that are running and workers who are employed only because of foreign customers—was by one measure about as large as America’s had been in 1929. China today, like America then, has a trade surplus equal to about 0.5 percent of global economic output. But as a proportion of its own economic output, China’s trade surplus has been much bigger than America’s ever was. In proportional terms, China has in recent years been five times as reliant on foreign customers to create domestic jobs as America was in 1929. So unless China can find a sustainable way to keep selling when its customers have stopped buying, it will face proportionately greater employment shock.

  China’s response to that shock in 2008 and 2009 was to ramp up its public-spending surge even further. That buffered the shock of this recession but didn’t change the reality that China was still too dependent on customers everywhere else to provide markets that would keep its own people at work. As of 2010, net exports still represented more than one quarter of China’s total economic output, an astonishingly high number. (That manufacturing powerhouse Germany, in comparison, had net exports of less than 4 percent of its GDP at the same time.)

  “The next decade for China is arguably just as important, if not more so, than the last t
hree combined,” the analyst Damien Ma, of the Eurasia Group, wrote in 2011, about the overall efforts to shift the economy from its infrastructure-and-export frenzy. “The curtains on the era of easy ‘catch-up’ growth are being closed, and a transition to a prosperous and equal society is the fundamental issue facing Beijing. It’s not that the Chinese leaders don’t get what’s at stake—they know such a reckoning must be had. But recognizing what must be done is quite different from summoning the political chutzpah to achieve it.”4

  The word “chutzpah” might seem odd in this context. Mustering the kind of cheek and daring it suggests is only part of the Chinese central government’s challenge. The rest involves incentives to governors, mayors, managers, bureaucrats, to pull in the direction the government wants—plus the means of figuring out whether they are doing what they say. The system has to keep growing fast enough that most people continue to feel that things are overall getting better rather than worse, and that the disadvantages of a one-party system are outweighed by its effectiveness. All the evidence suggests that, despite their complaints, most Chinese people have felt this way through the country’s decades of growth. But it has to change course enough to accommodate all the tensions that growth itself has created: a radically unequal income distribution (some people are buying jets with cash, while others pull oxcarts down the streets) and a perception of life being rigged, chronic trade frictions with the Americans and others, a devastated environment, and a steady demand for the daily liberties increasingly prosperous people would like to enjoy.

  The way ahead for the economy

  How could the Chinese model “change” or “rebalance” to address these concerns? Although reckoning time in units of Five-Year Plans seems strange outside China, the shifting emphasis from the Tenth plan, released in 2001, to the Eleventh, in 2006, to the Twelfth in 2011, does help illustrate a significant shift in strategy, and sets the context for ambitious projects like the dream of aerospace preeminence.

  The Tenth plan, still in effect when Hu Jintao assumed power,5 emphasized economic growth at the highest speed possible. Then, starting in 2006, as Hu and his premier Wen Jiabao solidified their hold on the government, and as much of the country prepared for the Beijing Olympics and the Shanghai World Expo, the Eleventh Five-Year Plan was supposed to reflect the spirit of the “Harmonious Society” (in Chinese , or hexie shehui). In practice, a more harmonious China was supposed to be one that paid more attention to the devastated environment and took better care of the hundreds of millions of farmers and migrant workers left behind by the Chinese miracle. That aspiration was reflected in a variety of social-welfare measures—for instance, relaxing the hukou, or residence-permit, system that had made it near-impossible for migrant workers to enroll their children in schools outside the family’s officially “registered” home or to be eligible for medical treatment without trekking hundreds of miles back to their home villages. It also lay behind a number of “Green China” initiatives, from funding wind- and solar-energy projects to judging provincial bureaucrats in part on their environmental record, to allowing and even encouraging journalistic exposés of environmental problems.

  By the end of the Eleventh Plan, the major imbalances remained: a huge trade surplus with the United States, an infrastructure and construction boom that was gaining rather than losing momentum, an ever more extreme gulf between rich and poor. Anything the Chinese or others said about “rebalancing” or “harmony” would be a mockery, as long as the economy kept racking up huge trade surpluses and relying on foreign markets, as long as the building and industrial boom kept ravaging the country’s own environment, as long as Chinese society kept indulging the most extreme Gilded Age excess with little sign of correction or balm on social unease.

  The Twelfth Five-Year Plan included very long lists of strategic initiatives and “areas of focus,” but the ideas for “rebalancing” and “harmonizing” the economy fell into a few main categories. Aerospace is affected by each of these, and its progress will be an indication of the Chinese planners’ overall success in realizing their new goals:

  1. “Apex industries” and escaping the “smiley curve”

  Will it be possible to move from assembly factories, which capture a small share of the value, to the brand names that get most of the profit? And therefore to convert China from a workhouse of the world to one of its sources of innovation? Few politicians or outside observers dwell on such questions. They obsess economists and business leaders within China.

  In the mid-2000s, I heard a way of thinking about these questions that has stayed with me ever since. It is the concept of the “smiley curve,” and I heard about it from Liam Casey, an Irish businessman who had lived and worked for nearly ten years in Southern China.6

  The smiley curve is a U-shaped graph (named after the smiley-face symbols of the 1970s) that covers the different stages of a product’s development. On one end of the curve, at the highest point on the left side, are corporate brands, with the extra market value they bring—Apple, Mercedes, GE, Samsung, all of which command a premium compared with their generic counterparts. Next comes product concept and industrial design—thinking up the iPad, the S-class car, GE’s new turbine engines. Then, moving down the curve, come high-value components—turbine blades, graphics chips, advanced displays. Then the commodity components, like simple memory chips. At the bottom of the curve comes assembly—the process of combining the elements into a finished product. Moving up the other side of the curve, as it rises, are transportation—DHL or FedEx—and then retailer’s margin, and then after-sale service.

  The height of the curve indicates the relative profitability of each stage of the process. The highest values are at its two extremes—the extra profit that goes to an Apple- or Mercedes-branded product, and the margin from retail sales and service. The lowest value is at the bottom of the curve, where the actual manufacturing takes place. And that lowest niche is the one that China has occupied throughout the first thirty years of its growth. The work was done in China, and the money went everyplace else.

  The smiley curve and its implications became so famous that Wen Jiabao began mentioning them in speeches and negotiations with U.S. officials. Of an iPhone costing four hundred dollars or a computer costing a thousand, at most one tenth of the total profits stayed with anyone in China—even though every iPhone and iPad in the world, and most computers of any brand, are produced in Chinese factories. Much larger shares of the profit stayed with Apple, Philips, or the other international brand holders, or with the Japanese, Korean, or German chip-makers who produced the advanced components, or the retailers and deal-makers in North America and Europe, or with others. The curve also accounted for distortion in trade figures: While the entire value of an iPad or iPhone is treated as a Chinese “export” and thus a component of China’s trade surplus, nearly ten times as much of its value comes from Japan or Germany as from China. An Asian Development Bank study released late in 20107 used the example of an iPhone, with a wholesale cost of $178.96 and a retail cost of as much as twice that. A total of $6.50 of the value of each phone went to workers in China, according to the report, even though all the phones were physically assembled in China, in plants from the Foxconn company.8 Twenty-five to thirty times that much could go to wholesalers, distributors, and retailers. The biggest surprise of the Asian Development Bank analysis was what it illustrated about the fallibility in normal trade statistics. While every penny of the wholesale cost of an iPhone was listed as a Chinese “export” to the United States—which together made iPhones seem to account for more than 1 percent of China’s total trade surplus with America—in reality, when all the components were traced to their source, each iPhone represented a small but net export from the United States to China. The ingredients of each iPhone that came from U.S. suppliers to China were worth considerably more than the small value added from Chinese assembly. Statistical artifacts like this made the American trade situation look more hopeless than it really was, a
nd made the Chinese economic model seem unrealistically triumphant.

  This pattern is generally not known outside China (except by the corporations doing the outsourcing) but is very well understood by China’s political and economic leadership. “In the United States and Europe, the manufacturing industry was created due to technology innovation,” Helen Wang, author of a book about China’s middle class, wrote in 2010. “In China, the manufacturing industry is being created in response to global demand. Chinese manufacturers take orders from Western companies that have designed products for their home markets. They have no involvement with product development, innovation, market research, and even packaging.”9 Yet those factories churning out goods for foreign markets are miracles of high-value productivity, compared with much of the rest of China’s vast workforce in stores, offices, and government bureaus. Even the slightest exposure to China anywhere outside a high-output factory leaves foreigners (and well-traveled Chinese people) asking, Why does it take so many people to do this job?

  An American teacher who had lived for years in a second-tier city in China began cataloguing the make-work jobs of modern China, in order of superfluousness. First came the “bus line monitors,” who walk around and observe as snarls of passengers struggle to get on buses but who have no apparent influence over the process. Then the “receipt stampers,” who stand by the exits of even fancy Western stores and add an extra stamp, in red ink, to receipts as people leave, certifying the sale as official. Then the separate staffs of ticket-sellers and ticket-takers at museums and other public buildings, usually with several people assigned to each role. And on through a list that any foreign—or Chinese person—could match, or top. Yet as the teacher noted, in the end the reason for this countrywide featherbedding was really no mystery at all. It mainly indicated how low prevailing wages still were, and how important it was to keep everyone on someone’s payroll.10 With a more ruthlessly efficient approach to output-per-man-hour, many Chinese enterprises could get twice the results with half the staff, and could afford to pay the remaining staffers much better. But what would those laid-off receipt-stampers and ticket-takers do?