Simon Johnson at Baseline Scenario, whose work I’ve immensely enjoyed reading over the years, posted a wonderful excerpt from his testimony before a Congressional panel about how best to put pressure on China to revalue the yuan (see Should We Fear China?).

China is the largest holder of official foreign currency reserves in the world, currently estimated to be worth around $2.4 trillion – an increase of nearly $500 billion in the course of 2009 (on the back of a current account surplus of just under $300 billion, i.e., 5.8 percent of China’s GDP, and a capital account surplus of around $100 billion).  These reserves are accumulated through arguably the largest ever sustained intervention in a foreign exchange market – i.e., through The People’s Bank of China buying dollars and selling renminbi, and thus keeping the renminbi-dollar exchange rate more depreciated than it would be otherwise.

…There is a perception that China’s large dollar holdings confer upon that country some economic or political power vis-à-vis the United States and, in particular, that Chinese reserves prevent us from putting pressure on that country’s authorities to revalue (i.e., appreciate) the renminbi.  This view is incorrect and completely misunderstands the situation.

Simon then provides some compelling evidence for why China’s reserves do not provide it much economic or political leverage vis-à-vis the United States. And because of that, he suggests that the U.S. ought to apply more pressure on China with respect to its mercantilist policies.

There is still an open question of how best to push China to revalue the renminbi.

1. Bilateral negotiations, as championed for example by former Treasury Secretary Paulson, have achieved essentially nothing since 2002.  This is not a promising way forward.

2. The International Monetary Fund (IMF) has proved itself incapable of calling China to account.  The IMF’s much vaunted “Surveillance Decision” is a failure and the general Fund mandate of “multilateral surveillance” has (again) proved to be a paper tiger.  Working with the IMF on this issue is not worth any additional effort by the US government.

He settles for what’s behind door number 3.

3. China is obviously a currency manipulator and should be so labeled by the US Treasury in its next report to Congress.  China’s threat to react by selling Treasuries is – as explained above – at worst a bluff and at best a way to help the US with a depreciation of the dollar.  This bluff should be called.

I largely agree with Simon’s points. China’s posturing with respect to the dollar is largely a bluff. It is obviously not in China’s best interest to sell, or diversify out of, its dollar holdings. Moreover, even if it were to spite itself and follow through on such a plan, it’s not entirely clear that would be such a bad thing for the U.S.

That said however, it’s still unclear to me why China might be willing to reconsider its policy and revalue the yuan. For example, Simon writes:

It is in the interests of both the United States and global economic prosperity that China discontinues its massive intervention in the market for renminbi.

Although I agree that it is in the best long-term interest of the U.S. and other countries throughout the globe for China to revalue its currency, it isn’t entirely clear to me that such a maneuver is in the  near-term interests of China, …or maybe even the global economy.

Think about the short-term shock to the Chinese economy, which depends upon exports for a good portion of its GDP. By many accounts, exports make up some 25% of Chinese GDP. A revaluation of the yuan makes Chinese exports relatively more expensive thereby decreasing foreign demand for Chinese-made goods. This negatively impacts local production and creates a feedback loop through to domestic employment and wages. In the extreme, this threatens social stability, and China is certainly not the poster-child for social stability.

Not only that, but given the foreign interests and investments in China, it is not entirely clear to me that a yuan revaluation that catapults China into recession would not result in a global contagion effect. Supply chains are so interconnected around the globe that an upward price movement for intermediate and finished goods coming out of China could have dire consequences for Western companies that rely on Chinese-sourced goods (just ask Wal*Mart).

So although I agree in principle with Simon’s points, the Chinese government (and by extension, the global economy) finds itself between a rock and a hard place when it comes to the revaluation of the yuan. A sudden revaluation to competitive levels could come with socially and economically undesirable near-term adjustments. I therefore think it’s best we proceed with caution…

If the accounts I’ve been reading are true (see Growing Prospects for Bailout for Greece), Greece might be the beneficiary of an imminent bailout. As reported by Bloomberg:

Olli Rehn, who takes over as European Union economic affairs commissioner tomorrow, said support for Greece will be discussed in coming days. Michael Meister, a German legislator from Chancellor Angela Merkel’s Christian Democrats, said lawmakers in that country are considering financial assistance.

The EU (in particular France and Germany) ought to be very careful in how it approaches the bailout so as to prevent moral hazard. And in this case I am not referring to moral hazard in the sense that the bailout provides Greece an incentive to behave badly again in the future, but moral hazard in the sense that Portugal, Ireland (maybe Italy too), and Spain now have the incentive to continue to behave badly. After all, if France and Germany come to the rescue of Greece, it sends a signal to other fiscally troubled European nations that they are likely to receive similar treatment, …and especially for the more consequential economies of Spain and Italy (see Euro Perspective).

If the EU comes to the aid of Greece, what incentive does Spain, Portugal, Italy, or Ireland have to bring their fiscal house in order. In fact, what’s to prevent them from going on a bigger fiscal bender? For after all, although Greece represents only a small fraction of European GDP, allowing Spain and Italy to falter could be disastrous for the Union.

The New York Times ran a feature article on Sunday about China’s dominance of the alternative/clean energy space (see China Leading the Race to Make Clean Energy). Although the author points to some interesting stylized facts, not one suggests cause for concern.

China vaulted past competitors in Denmark, Germany, Spain and the United States last year to become the world’s largest maker of wind turbines, and is poised to expand even further this year.

MY COMMENT: So what? Does this make them the technological leaders in that space? No! Why? Because most of the technological advances in alternative energy (the knowledge creation portion of the value chain) are a product of the West – Europe and the U.S., …and to a lesser extent Japan and Korea.

China has also leapfrogged the West in the last two years to emerge as the world’s largest manufacturer of solar panels.

MY COMMENT: Again, why is this a bad thing? See above.

President Obama, in his State of the Union speech last week, sounded an alarm that the United States was falling behind other countries, especially China, on energy. “I do not accept a future where the jobs and industries of tomorrow take root beyond our borders — and I know you don’t either,” he told Congress.

These efforts to dominate renewable energy technologies raise the prospect that the West may someday trade its dependence on oil from the Mideast for a reliance on solar panels, wind turbines and other gear manufactured in China.

MY COMMENT: Nonsense. To the extent that China is reliant on the knowledge/technology developed in the West to manufacture equipment, it’s good for both sides. Western alternative energy firms have a market in which to sell their valuable knowledge and Chinese producers have a market to sell the output from the factories that use those productive knowledge inputs. This is how international trade works. In fact, without demand from the Chinese market, development costs for firms in the West would be much, much higher. This allows our alternative energy firms not only to prosper, but to create jobs in the nascent sector.

So although the title of the Times article is appropriate – China certainly is “making” more clean energy in the manufacturing sense, the West is specializing in the higher value-added, higher margin, higher growth activities (see Globalization Discontents and Globalization Revisited). I don’t know about you, but I’ll take the latter.

Interesting cover story this week from The Economist about the Chinese economy (see China’s Economy: Not Just Another Fake). In that article, The Economist questions whether asset prices in China are becoming unsustainable, and if China resembles Japan circa the 1980’s. To be a bit of a spoiler (if you have no interest in reading on), their take-away is NO.

The similarities between China today and Japan in the 1980’s may look ominous. But China’s boom is unlikely to give way to a prolonged slump.

CHINA rebounded more swiftly from the global downturn than any other big economy, thanks largely to its enormous monetary and fiscal stimulus. In the year to the fourth quarter of 2009, its real GDP is estimated to have grown by more than 10%. But many sceptics claim that its recovery is built on wobbly foundations. Indeed, they say, China now looks ominously like Japan in the late 1980s before its bubble burst and two lost decades of sluggish growth began.

On the face of it, the similarities between China today and bubble-era Japan are worrying. Extraordinarily high saving and an undervalued exchange rate have fuelled rapid export-led growth and the world’s biggest current-account surplus. Chronic overinvestment has, it is argued, resulted in vast excess capacity and falling returns on capital. A flood of bank lending threatens a future surge in bad loans, while markets for shares and property look dangerously frothy.

Just as in the late 1980s, when Japan’s economy was tipped to overtake America’s, China’s strong rebound has led many to proclaim that it will become number one sooner than expected. In contrast, a recent flurry of bearish reports warn that China’s economy could soon implode. James Chanos, a hedge-fund investor (and one of the first analysts to spot that Enron’s profits were pure fiction), says that China is “Dubai times 1,000, or worse”. Another hedge fund, Pivot Capital Management, argues that the chances of a hard landing, with a slump in capital spending and a banking crisis, are increasing.

Scary stuff. However, a close inspection of pessimists’ three main concerns—overvalued asset prices, overinvestment and excessive bank lending—suggests that China’s economy is more robust than they think.

Start with asset markets. Chinese share prices are nowhere near as giddy as Japan’s were in the late 1980s. In 1989 Tokyo’s stockmarket had a price-earnings ratio of almost 70; today’s figure for Shanghai A shares is 28, well below its long-run average of 37.

China’s property market is certainly hot. Prices of new apartments in Beijing and Shanghai leapt by 50-60% during 2009.

Average home prices nationally, however, cannot yet be called a bubble. On January 14th the National Development and Reform Commission reported that average prices in 70 cities had climbed by 8% in the year to December, the fastest pace for 18 months; other measures suggest a bigger rise. But this followed a fall in prices in 2008. By most measures average prices have fallen relative to incomes in the past decade (see chart 1).

The most cited evidence of a bubble—and hence of impending collapse—is the ratio of average home prices to average annual household incomes. This is almost ten in China; in most developed economies it is only four or five. However, Tao Wang, an economist at UBS, argues that this rich-world yardstick is misleading.

Furthermore, Chinese homes carry much less debt than Japanese properties did 20 years ago. One-quarter of Chinese buyers pay cash…China’s property boom is being financed mainly by saving, not bank lending.

Although I agree that there are some important differences between China today and Japan in the 1980’s (see my recent interview in the Effective Executive), I remain skeptical about whether China’s recovery is legit and that it is, in fact, not experiencing another bubble. For the flip side of the argument I point interested readers to the work of Andy Xie (see China has become a Giant Ponzi Scheme or Trapped Inside a Property Bubble):

Many would argue that China isn’t experiencing a bubble. The high asset prices just reflect China’s high growth potential…

I want to make myself perfectly clear on China’s asset markets today. They are a big bubble. Its bursting will bring very bad consequences for the country.

The most basic approach in studying bubbles is to look at valuation. For property the most important measures are price to income ratio and rental yield. China’s average price per square meter nationwide is quite close to the average in the US. The US’s per capita income is seven times China’s urban per capita income. The nationwide average price is about three months of salary per square meter, probably the highest in the world. As far as I can tell, a lot of properties can’t be rented out at all.

The stock market is in a final frenzy again. The most ignorant retail investors are being sucked in by the rising momentum. They again dream of getting rich overnight. As in the past, retail investors usually lose, especially like the ones jumping in now. The final frenzy usually doesn’t last.

from Trapped Inside a Property Bubble:

The biggest risk to China’s economy is the desire to maintain past economic growth rates by maximizing investments in property — an unproductive asset. It supports short-term growth by sacrificing long-term growth as capital’s average productivity declines over time.

Bubbles exaggerate reality but are not formed out of thin air. Cheap money and strong growth are the usual ingredients for bubble-making. Both existed over the past five years. But now, China depends entirely on cheap money to support overvalued assets. Cheap money came from past exports and was warehoused in banks. Cash also came from hot money inflows due to the yuan’s peg to the dollar and weak Fed dollar policy.

Neither money source is sustainable.

So there you have it – two opposing views on China. Funny thing. These arguments sound vaguely familiar to me. They seem to parallel the ongoing debate as to whether the U.S. is experiencing a sustained recovery or whether its asset prices are similarly over-inflated. Nevertheless, when it comes to China, I think that asset prices are currently overheated and will likely experience a near-term correction. But there is no question in my mind that China is on a long-term growth path toward prosperity, …provided it can avoid political calamity.

In the aftermath of Dubai World’s near default, The Economist magazine ran an interesting article that examines the so-called “Hybrid” organization (see The Rise of the Hybrid Company). According to the Economist:

The travails of Dubai Inc have left commentators struggling for the right phrase to describe Dubai World and its various siblings. They have come up with various formulations—state-controlled, state-supported, quasi-state, parastatal—without ever quite capturing what they are talking about. And Dubai is not the only place that is challenging the business vocabulary in this way.

Wherever you look you can see the proliferation of hybrid organisations that blur the line between the public and private sector. These are neither old-fashioned nationalised companies, designed to manage chunks of the economy, nor classic private-sector firms that sink or swim according to their own strength. Instead they are confusing entities that seem to flit between one world and another to suit their own purposes.

MY COMMENT: For examples from the U.S., see Fannie and Freddie, pre-nationalization. France, in the form of their national champions, also engages in the practice. So do many emerging economies: China (and their SOE’s), Russia, Malaysia, Vietnam, Brazil, etc.

What should we make of these hybrid organisations? Their supporters have long argued that they enjoy the best of both worlds: the security of the public sector and the derring-do of the private sector. They can use their global reach to provide their home countries with the pick of the world’s resources. They can borrow money at a favourable rate thanks to “implicit” government guarantees. They can use their political muscle to outperform their less well-connected rivals.

MY COMMENT: I have never been a fan of Publicly-Backed Private Companies (PBPC’s). Although they may be able to borrow at lower rates because they are “implicitly” backed by their home governments, they often grow too large, become too bureaucratic, and eventually crater under their own inefficiency (thereby costing home-country taxpayers dearly in the process). In addition, their objective function is not always clear. Are they meant to profit-maximize for shareholders/bondholders, or are they meant to serve a larger social purpose?

The most interesting part of the Dubai World saga (in contrast with Freddie and Fannie) is that the government of Dubai has seemingly repudiated Dubai World’s debt. So much for that “implicit” guarantee. If this becomes the norm rather than the exception, you can soon say goodbye to the last remaining benefit of Public-Private hybrid companies – the ability to borrow at favorable rates.

I have nothing, in principle, against government-backed companies. Although they are generally inefficient and often do not make sense, there are instances in which they might be appropriate — e.g., in instances of severe market failure. However, if there is severe market failure such that the government must become involved to prevent perverse societal outcomes, my intuition is that private companies operating in a system of more stringent governmental oversight and regulation perform better than a system comprised of public-private hybrids.

In this sense then, I agree with the conclusion of the Economist:

The clearer the line between the state and the private sector, the better it is for those on both sides.

I came across an interesting article yesterday that discussed the impact of the U.S. dollar weakness (and Canadian dollar strength) on the state of the National Hockey League (see Currency Rise Helps Canadian NHL Teams).

The decline of the American dollar has led to a trade imbalance north of the border, on the rinks of the National Hockey League

Over the past two decades, the Canadian teams in the N.H.L. were considered poor cousins of their colleagues in the United States. Some floundered financially, others packed up and moved south. The league even created the Canadian Assistance Program to subsidize the country’s struggling teams.

But the landscape in Canada has changed drastically, because of a rise of more than 50 percent in the Canadian dollar since 2002. A stronger currency has made it cheaper for the six Canadian teams to pay their players in United States dollars and to reduce debts. It has also inflated the revenue of the six Canadian franchises and, in turn, the league’s revenue.

…The rising Canadian dollar is nearing parity with its United States counterpart. The Canadian dollar, whose value against the United States dollar fell to a low of 62 cents in 2002, is worth about 96 cents today. As a result, the revenues for the six Canadian clubs helped the entire league earn its highest operating profit in more than a decade, according to Forbes magazine.

…added revenues have had the biggest impact for the Canadian teams with player salaries, which must be paid in American dollars under the collective bargaining agreement between the N.H.L. and the N.H.L. Players’ Association.

MY COMMENT: In hindsight, I bet that some players wished they had negotiated to be paid in Canadian dollars.

The Canadian teams’ relative wealth is quite a turnaround, given that the league initiated the Canadian Assistance Program at the start of the 1995-96 season to help small-market Canadian teams stay afloat.

The N.H.L. prefers exchange-rate stability, but recognizes that the rising Canadian dollar has helped revive some teams, which is good for the league.

MY COMMENT: Of course the league prefers relative exchange-rate stability (in a floating exchange-rate regime), as do most businesses that operate across multiple country markets. Exchange-rate stability makes predicting future states of the economies in which companies operate a much easier task. That said however, the larger question for the league is whether the strength in the Canadian dollar and the weakness in the U.S. dollar represents a temporary, transient effect or a more permanent, structural economic state (see Forces Impacting the Dollar).

I have enjoyed reading Thomas Friedman’s work over the years, but I have to say that I am not a big believer in the Flat World hypothesis. Although intellectually appealing in many ways, it is not supported by scientific evidence. Decades of international business research has demonstrated that companies that span national boundaries face enormous risks and challenges. Moreover, a casual glance at the popular press on just about any given day provides countless examples of companies whose international expansion efforts have foundered because they failed to account for the additional costs imposed by institutional distance (for background, see my posts So You Want to Do Business in  a Developing Country, Tata and Jaguar, Tesco’s Venture into the U.S.).

In fact, just this week I received an email from Mike Malone of ABC News calling my attention to a recent article addressing the Flat World debate (see Navigating a Flat and Bumpy World). Mike writes:

Despite the title of a best-selling book of a few years back, it turns out that the world isn’t flat. And, despite all of the leveling forces being unleashed by the Internet, global business and social networks, it won’t be getting any flatter in our lifetimes.

But don’t believe the growing legions of naysayers to Tom Friedman’s book either, because nearly all of them begin by accepting his underlying premise … and then set out to debunk it by showing how pockets of entrenched cultural differences won’t succumb to Twitter and the iPhone.

As many recent stories have shown, if your business follows Friedman’s advice you are very likely to get blindsided by markets with rules that are alien — even antithetical — to our own.

Although Mike writes mostly about how technology impacts globalization and tries to find common ground between those who adhere to a Flat World view and those who subscribe to a Spiky World view, I thought his opening salvo (quoted above) was spot on.

Another good example of how the world is not so flat can be found in Qantas’s latest trouble in Vietnam (see Jetstar Creates a Jet Stir in Vietnam, ht Steve). According to Crikey:

The $US50 million ($A53.9 million) Qantas investment in Jetstar Pacific has flown into an ideological chasm in the ranks of the Communist Party and government in Vietnam and it isn’t clear how it can escape.

…ideologues in the [Vietnamese Communist] party are waging a glorious struggle against the oppression of the people and their cultural identity from the subversive forces of global capitalism, or words to that effect.

And if that weren’t enough evidence, last week BA and Iberia formally announced that they will merge (see Uniting in the Sky). What strikes me as interesting is not the deal itself, as I actually think that this deal makes a fair bit of operational sense. The potential for synergies are enormous. However, what struck me as odd is that BA and Iberia will be maintaining separate corporate offices and operations (one in Spain and one in the UK):

…while the pair will combine their businesses they will maintain separate corporate operations. This will allow both to maintain their roles as the national flag-carriers while keeping valuable bilateral international landing rights that go along with that status.

That may be; however, maintaining separate operations will also keep their costs elevated and reduce their competitiveness in a market that is often characterized as global. If companies can’t find a way to benefit from economies of scale in a global, homogeneous goods market like the airline industry (or even the automobile industry), …how flat is the world, really??

The Economist posted a nice chart this week of the number of mentions of the word “Globalization” in their magazine since 1979 (see Going Global).

It seems that the number of mentions grew briskly through the dawning of the new millennium, with a drop off after the dotcom bust. The number of mentions picked up once again from 2005-2007, but has tailed off since the start of the financial crisis.

In order to see if these numbers were consistent with mentions of the term “Globalization” at large, I checked the number of mentions in Google Trends.

Although the Google Trends data go back only to 2004, somewhat interestingly, it seems that Globalization as a search term has been decreasing steadily from 2004-2009.

I wonder if the differences across charts speak to the differences in interests between the readership of a specialized economics magazine and the general populous, …or if The Economist is missing the boat, dedicating more time and attention to topics that readers are increasingly uninterested in?

Personally, I think Globalization is not only an interesting phenomenon in its own right, but given the global nature of the financial crisis, an especially timely topic for debate. It should not be a surprise where I stand on that debate. I have long been a proponent of Globalization (see Globalization and its Discontents, Globalization Revisited, or Interview in the Effective Executive).

Oops, I may have just answered my own question.

Ford revealed today that Geely, the Chinese automobile manufacturer, has emerged as the most likely suitor for its Volvo unit (see Geely Behind Ford’s Plan to Sell Volvo). According to Motor Trend, the price tag will be somewhere in the $2 Billion range.

Holding aside the sale price, if this deal goes through it would become the third high-profile purchase of a Western automobile manufacturer by a Chinese firm this year (Geely’s purchase of Volvo, Beijing Automotive’s participation in the Saab deal, and Sichuan Tengzhong’s acquisition of Hummer from GM).

Chinese firms are acquiring Western automobile manufacturers in an attempt to upgrade capabilities. They lag far behind the leading Japanese, US, European, and Korean auto manufacturers in technological capabilities, and the acquisition of Western firms represents an attempt to close that gap in R&D, design, styling, sales, marketing, and production.

However, as I noted in a recent interview in the Effective Executive magazine, this acquisitive behavior is not unique to the automobile industry. Chinese companies have increasingly been acquiring Western companies in a variety of industries (e.g., Lenovo’s acquisition of IBM’s PC division and TCL’s acquisition of Thomson’s TV division), all in an effort to close a still significant capabilities gap with developed country firms.

As I mentioned in that interview (see Interview in the Effective Executive):

When I think about China, Japan, and South Korea, certainly some similarities can be drawn. All three followed an export-led growth path to prosperity. However, once a certain level of prosperity had been achieved through trade, the three countries diverged with respect to international investment. South Korean firms have generally followed a more organic growth strategy – eschewing acquisitions of foreign targets in favor of building businesses from scratch. Japanese firms followed a similar strategy up to a point…Insofar as China is concerned, although we are in the early stages of China’s international expansion, it seems so far that Chinese firms are following a more growth-through-acquisition type of strategy…

My sense is that this has a lot to do with the capabilities of the firms from these countries. That is, by the time Japanese and South Korean firms began to expand, they did so from a position of technological strength. For this reason, they were able to organically extend existing advantages to other countries. China, by contrast, is expanding from a relatively weak technological position not only vis-à-vis Japan and South Korea, but also vis-à-vis the rest of the developed world. In this sense then, Chinese firms are embarking on a strategy of acquisition in order to acquire the technological capabilities their firms currently lack.

Seen through that lens, it is obvious why Chinese automobile manufacturers are interested in acquiring Volvo, Saab, and Hummer. However, the fact remains that they are purchasing extremely troubled operations in an industry plagued with overcapacity (even in China) at a time when when the demand for automobiles (certainly in the developed world) looks increasingly uncertain (see Auto Industry’s Big Little Problem).

As a proponent of free trade and globalization, I view the acquisition of Western companies by Chinese companies as a welcome development. However, given the auto industry’s ills, I wonder whether these Chinese acquirers will be able to derive value from their tired, beaten, and battered Western subsidiaries, …irrespective of the price.

Time will tell.

I have written some about developing markets and the difficulties that firms face navigating such markets (see So You Want to Do Business in a Developing Country? and The Birth of Plenty).

As a Corporate Strategy scholar, I am generally more interested in how foreign firms make decisions to enter developing markets and how they manage their operations in those markets than the economic development path of any of the individual economies. However, it goes without saying that economic development (or the lack thereof) impacts the calculus of firms considering doing business in foreign markets. I was therefore interested to read a recent Op Ed about Russia in the Globe and Mail written by my colleague Nouriel Roubini (see BRICkbats for the Russian Bear).

In that article, Roubini questions the soundness of the Russian economy:

One powerhouse in the BRIC group is just hanging in there. Hint: It isn’t Brazil, India or China

One piece of bubble wisdom that has escaped relatively unscathed…is the assumption that the BRIC countries – Brazil, Russia, India and China – will increasingly call the economic tune in years to come.

Yet, the economic crisis that began in 2008 exposed one of the four as an imposter.

The weakness of the Russian economy and its highly leveraged banks and corporations, in particular, which was masked in recent years by the windfall brought by spiking oil and gas prices, burst into full view as the global economy tumbled. Saddled with a rustbelt infrastructure, Russia further disqualifies itself with dysfunctional and revanchist politics and a demographic trend in near-terminal decline.

While Russia retains the world’s largest (if somewhat aging) arsenal of nuclear weapons, as well as a permanent seat with veto power on the UN Security Council, it is more sick than BRIC.

Roubini’s conclusion is that the Russian economy is facing an inexorable decline, and as a result, it no longer deserves to be considered in the same class with the other fast-growing, dynamic BIC economies. He suggests that it is time to find a replacement.