The most recent issue of The Economist ran a wonderful survey of innovation in emerging markets (see Special Report on Innovation in Emerging Markets). The collection of articles discusses how innovation is helping developing countries catch up with their developed country counterparts, and how emerging market multinationals, through internal innovation and acquisition, are becoming formidable global competitors.

Developing countries are becoming hotbeds of business innovation in much the same way as Japan did from the 1950s onwards. They are coming up with new products and services that are dramatically cheaper than their Western equivalents: $3,000 cars, $300 computers and $30 mobile phones that provide nationwide service for just 2 cents a minute. They are reinventing systems of production and distribution, and they are experimenting with entirely new business models.

Emerging-market champions have not only proved highly competitive in their own backyards, they are also going global themselves.

The United Nations World Investment Report calculates that there are now around 21,500 multinationals based in the emerging world. The best of these…are as good as anybody in the world. The number of companies from Brazil, India, China or Russia on the Financial Times 500 list more than quadrupled in 2006-08, from 15 to 62. Brazilian top 20 multinationals more than doubled their foreign assets in a single year, 2006.

At the same time Western multinationals are investing ever bigger hopes in emerging markets. They regard them as sources of economic growth and high-quality brainpower, both of which they desperately need. Multinationals expect about 70% of the world’s growth over the next few years to come from emerging markets, with 40% coming from just two countries, China and India. They have also noted that China and to a lesser extent India have been pouring resources into education over the past couple of decades. China produces 75,000 people with higher degrees in engineering or computer science and India 60,000 every year.

The world’s biggest multinationals are becoming increasingly happy to do their research and development in emerging markets. Companies in the Fortune 500 list have 98 R&D facilities in China and 63 in India.

I agree that there are some truly exciting opportunities in developing markets, especially China, India, and Brazil. The potential those markets hold certainly make me hopeful for the prospects of long-term economic development.

That said however, frequent readers of this blog know where I stand with respect to the prospects for developing countries (and their firms) to quickly close the capabilities gap with the developed world. Despite the incredible potential these markets hold, my position has been that we ought not get too giddy thinking that developing countries will be able to catch up anytime soon (see China Attracting High-Tech Research or Doing Business in a Developing Country). They face some serious headwinds.

First, the US alone accounts for one third of worldwide R&D expenditure. Developed countries as a group account for around three quarters of worldwide R&D expenditure. Second, much of the R&D that developed country multinationals conduct in developing countries is skewed toward low value-added activities. Third, much of the “innovative” activity engaged in by local firms in developing countries centers on the simplification of existing technologies from developed countries for less sophisticated local consumers. Fourth, developing countries are still relatively economically and politically unstable. They are fraught with structural problems that in no way guarantees that their economic growth will continue unimpeded, and their political and economic institutions remain underdeveloped. Finally, it is true that emerging market multinationals have grown significantly over the past several years with an impressive number of entries on the Financial Times 500 list. However, much of that growth has been achieved through acquisition of developed market firms at the peak of the equity bubble. It will be interesting to see how those acquisitions fare over the next decade.

I hope that doesn’t come across as curmudgeonly because I do absolutely believe that there will be nothing more exciting than witnessing the growth and development (both the good and the bad) of the BRIC markets over the next 50-100 years (if only I could live long enough). I just think that the unbridled optimism with which many mainstream media pundits describe emerging markets needs to be put into context, and tempered with a dose of reality.

Nevertheless, each and every article in The Economist survey is well worth the read. I strongly encourage you to take a look for yourself (see Special Report on Innovation in Emerging Markets).

It’s been a whirlwind few weeks of travel for me – beginning in Holland, then on to Paris, followed by a trip to DC. But I am now back in New York, looking forward to getting back to a more regular, regimented schedule.

In the meantime, I thought I’d share some articles that I’ve enjoyed reading over the past few weeks.

1. Canadian Pension Organization to Buy UK Lottery – Details how a Canadian Teacher’s Pension organization is trying to acquire a British lottery operator. Can someone please explain to me the logic of a pension fund running a lottery company, …in a foreign country no less? This defies just about all corporate strategy logic regarding M&A activity. What do pension funds know about running lottery companies?? And if they’re simply a financial buyer, what business discipline will they be able to impose, especially since the owners get only a small portion of the profit? Also, I can’t help but wonder how Canadian teachers will feel about owning a gambling operation.
2. The Celebrity Effect – Details research on the financial impact of appointing celebrities to a company’s Board of Directors (e.g., Evander Holyfield at Coca Cola; Michael Jordan at Oakley; Billie Jean King at Philip Morris; Gerald Ford at American Express). Although the research suggests that firms benefit from announcing celebrity directors, I remain skeptical. I have brought board members from various large public corporations to speak in my class, and they have expressed disappointment with the celebrity members of their boards, sharing stories about celebrities who typically do not pull their weight. I can understand if a celebrity has a particular expertise that lends itself to the business or if a former politician joins the board of a firm that operates in the government sector and/or for which political connections are especially important. However, by and large, I think that many of these appointments are ceremonial, and likely do not create value.
3. The Panda has Two Faces – A story from the Economist on the perils of doing business in China. They stress the political, economic, and cultural quandary facing foreign entrants (see also So You Want to Do Business in a Developing Country). A choice quote from the Economist article, “[China] regards foreign investment as a mechanism for acquiring foreign know-how rather than just jobs and capital; hence the insistence on joint ventures…political difficulties are piled on top of cultural difficulties. The Chinese emphasis on personal connections (guanxi) makes it hard to distinguish between business-as-usual and corruption. And the weakness of the legal system means that companies operate in a confusing half-light. Transparency International’s most recent Corruption Perceptions Index ranks China 79th out of 180 countries…”
4. Relax, We’re Fine – The future of the US economy according to David Brooks. Although the title of the article might be viewed as insensitive to the plight of the millions of Americans who are currently unemployed, I think that David is rightly optimistic about the long-term prospects of the US economy. And it’s nice to remind ourselves of that sometimes, …especially when things don’t feel so great at the moment. A choice quote, “…the U.S. remains a magnet for immigrants…the U.S. is among the best at assimilating them (while China is exceptionally poor). As a result, half the world’s skilled immigrants come to the U.S. As Kotkin notes, between 1990 and 2005, immigrants started a quarter of the new venture-backed public companies. The United States already measures at the top or close to the top of nearly every global measure of economic competitiveness. A comprehensive 2008 Rand Corporation study found that the U.S. leads the world in scientific and technological development. The U.S. now accounts for a third of the world’s research-and-development spending. Partly as a result, the average American worker is nearly 10 times more productive than the average Chinese worker, a gap that will close but not go away in our lifetimes.” This is exactly why I find it hard to believe some of the predictions that China will soon overtake the US as a technological super-power (see also China Attracting High-Tech Research).
5. The Return of History – A David Brooks two-fer. This Op-Ed is his critique of the field of economics. These are not necessarily new arguments (see Future of Financial Economics, Future of Financial Economics Part Deux, and Krugman on the Future of Economics). Moreover, I am not so sure I agree with David’s prediction with respect to Act V. Nevertheless, it was thought-provoking and provided an entertaining read.

Anyhow, I hope you find these articles well worth your time to read. Enjoy!

Don’t know how many of you caught the recent news, but a new Nano (Tata’s ultra-cheap car) spontaneously burst into flames last week soon after its owner drove it off the lot (see Car Fire Raises Safety Concerns for details and a FIERY photo).

When it was launched less than a year ago, the $2,500 Tata Nano was promoted as a safe, ultra-cheap car for poor Indians, an alternative to the motorbikes that zoom precariously around the country.

New questions about the safety of the pint-sized auto are being raised, however, after one of them burst into flames Sunday as it was being driven home from the showroom.

I have no doubt that Tata is trying its level best to develop a car that’s at once affordable and reliable. However, in light of this incident, I can’t help but be reminded of the folly that was the Yugo. The Yugo debuted in the U.S. in the 1980′s with great fanfare, only to disappoint in just about every imaginable way. In fact, a recent book details its ignominious history and goes so far as to label it the worst car in history (see Yugo: The Rise and Fall of the Worst Car in History).

If Tata plans to sell the Nano in developed markets (it has stated that it will), it best make sure that it overcome the quality issues that currently dog it – not only the perceptions, but now, the reality. In fact, after digging a bit deeper into the Nano, I discovered that this was not the first problem of its kind. There have been four similar occurrences. That may not sound like many, but when you’ve only sold 30,000 units, it is more than a minor issue.

Let’s not also forget that Tata is the owner of Jaguar and Rover (see Buyer’s Remorse). Although I am not privy to financial performance data for Jaguar or Rover, my understanding is that the two brands have been underperforming (see Jaguar/Rover Revisited or Indian Firms’ Foreign Purchases). Of additional concern for Tata is that the fallout from Nano spillover to consumer perceptions of Jaguar and Rover.

Add that to Tata’s growing list of headaches…

I am currently out of the country, spending time visiting Tilburg University in the Netherlands. I am working with co-authors on faculty at the School of Economics and Business Administration, and giving a research seminar. My schedule keeps me in Holland for a total of 10 days, moving on to Paris from here. I will be making a brief visit to HEC Paris for a seminar and some meetings, followed by a few days of vacation with my family.

A couple of thoughts/observations about the Netherlands in the few days that I’ve been here:

1. civilized
2. modern
3. architecture
4. bicycles
5. bicycles
6. bicycles
7. rain

OK, I’ll leave you with that.

In the meantime, until I post more regularly,  I’ll share a few things that I’ve been reading of late:

• How will and RMB Revaluation affect China, the U.S., and the World? – Michael Pettis nails this one, going further than many of the analyses that I’ve read about revaluation of the Yuan. His post echoes many of the sentiments that I expressed in previous posts about a sudden revaluation of the Yuan (see China and the Yuan Again and China and the Revaluation of the Yuan). He, like I, advocates for a measured revaluation of the Yuan, but he cautions against inciting a trade war with China. It’s quite a long read, but well worth it.
• Is China the Next Building Bubble? – An interesting compilation of arguments on both sides of the China Bubble debate. Although I was not so much interested in the investment advice (although some might be), I thought the review of existing arguments was very well done. The article is similar to a recent post that appeared on this blog (see Is China a Bubble Economy?), but goes further by providing more detailed data.
• America’s Real Dream Team – Exactly why I see that China (and by extension, developing countries) is still years away from closing the technological capability gap with the United States (see my comments in China Attracting High-Tech Research). I should, however, also point out one thing that struck me about Friedman’s Op-Ed. For those of you who have read Thomas Friedman’s book, The World is Flat: If Friedman is correct in the Op Ed that immigrants help drive America’s relative innovativeness vis-a-vis the rest of the world, then he may be refuting the same convergence effects for which he advocates in his book.
• Enormous Adviser Fees Spark Warning – An article from the Financial Times about how interested parties to M&A deals (namely, investment banks) and their fee structures can create perverse outcomes. The article suggests that “[bankers] fees [are] a “deadweight cost” on shareholders that could swallow a significant part of savings derived from mergers and acquisitions.” Well worth the read. I’ve written a bit about this myself (see A Great Shareholder Ripoff and Why M&A Deals Go Bad).

If you believe everything you read in the New York Times, you’d think that China is about to wrestle away the technological leadership position from Western firms (see China Drawing High-Tech Research from U.S.). There is no doubt that foreign firms are increasingly conducting research in China. But that stylized fact does not tell us anything about the kind of research activities that Western firms are undertaking in China, or its likely impact on the technological dominance of Western firms.

According the Times article:

For years, many of China’s best and brightest left for the United States, where high-tech industry was more cutting-edge. But Mark R. Pinto is moving in the opposite direction.

Mr. Pinto is the first chief technology officer of a major American tech company to move to China. The company, Applied Materials, is one of Silicon Valley’s most prominent firms. It supplied equipment used to perfect the first computer chips. Today, it is the world’s biggest supplier of the equipment used to make semiconductors, solar panels and flat-panel displays.

In addition to moving Mr. Pinto and his family to Beijing in January, Applied Materials, whose headquarters are in Santa Clara, Calif., has just built its newest and largest research labs here.

OK, solid reporting of the facts. The article then continues:

It is hardly alone. Companies — and their engineers — are being drawn here more and more as China develops a high-tech economy that increasingly competes directly with the United States.

Competes with the United States in what exactly?

Jobs? OK, I get that. These are research jobs that might otherwise be located in the U.S. But the fact remains that they could just as easily be located in other countries if not China – Malaysia, Indonesia, or India for example. So just because the facility is located in China doesn’t mean that it’s a zero-sum job competition with the U.S. This is acknowledged in the article:

Mr. Pinto said that the company was readjusting its work force as manufacturing shifted to Asia, but that the Xi’an facility involved a new approach to researching the design of an entire assembly line and was not replacing laboratories elsewhere.

So if it not a direct competition for U.S. jobs, is the article then suggesting that China is increasingly competing with the U.S. in the technological knowledge race? I think that is part of the implication. However, I am likewise skeptical about this conclusion, …and several key nuggets from the article itself discredit such an inference. Allow me to elaborate:

1. The fact remains, an American firm (Applied Materials, Nasdaq: AMAT) is making the investment. The shareholders of AMAT own the rights to the residuals of the local subsidiary. So the profits belong to the American investor. Not only that, but theoretically (although I realize it does not always work this way in practice), any productive knowledge that is developed at that facility likewise belongs to the American parent. AMAT has the right to use that knowledge however it wants and wherever it wishes. The counter-argument has been that knowledge invariably spills over to local firms, the local economy, and even AMAT’s Chinese employees. However, research is increasingly calling those knowledge transmission mechanisms into question. The host country does not benefit nearly as much as some have suggested, precisely because foreign firms are very careful about the types of knowledge they are willing to bring to the foreign country and are keen to protect their most valuable knowledge (not allowing it to leak).
2. Speaking of the types of activities (even if R&D activities) that foreign firms conduct in host countries like China, Western firms often bring low value-added activities to their foreign research facilities. The most valuable knowledge remains in the domestic research facilities (see Globalization Discontents and Globalization Revisited). Even the author of the New York Times article recognizes this: “Applied Materials continues to develop the electronic guts of its complex machines at laboratories in the United States and Europe. But putting all the machines together and figuring out processes to make them work in unison will be done in Xi’an.” So the assembly (low value-added activity) will be performed and researched in China. The design (high value-added activity) will be done in the West. This is consistent with the theory of comparative advantage.
3. The Chinese government is subsidizing the investment. According to the Times, “Locally, the Xi’an city government sold a 75-year land lease to Applied Materials at a deep discount and is reimbursing the company for roughly a quarter of the lab complex’s operating costs for five years, said Gang Zou, the site’s general manager.” You certainly can cry foul and argue that buying (artificially subsidizing) foreign investment is tantamount to unfair competition; but  again, at the end of the day, who is appropriating the value of the investment, China or AMAT (and by extension, it’s mostly U.S. shareholders)? I vote for the latter, as research is increasingly demonstrating that countries that buy foreign investment often do not receive the hoped-for benefits.

So while this article provided a nice read and some interesting factual nuggets about Western firms making R&D investments in China, I am not so sure I agree with the conclusion that, “Of course, China will lead everything.” No doubt, China is a country with a tremendous amount of potential and an increasingly skilled labor force; however, the fact remains that it is many, many years away from closing the technological capability gap with the West.

Paul Krugman echoed the sentiment expressed by Simon Johnson in arguing that the U.S. needs to quit pussyfooting around and finally label China a currency manipulator (see Taking on China).

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

And it’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

Twice a year, by law, Treasury must issue a report identifying nations that “manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” The law’s intent is clear: the report should be a factual determination, not a policy statement. In practice, however, Treasury has been both unwilling to take action on the renminbi and unwilling to do what the law requires, namely explain to Congress why it isn’t taking action. Instead, it has spent the past six or seven years pretending not to see the obvious.

I agree with Krugman and with Johnson (see China and the Revaluation of the Yuan) that labeling China a currency manipulator is likely without repercussion. There is little that China can do but continue to purchase dollar-denominated assets. Dumping its dollar-denominated holdings seems far-fetched, and runs counter to its own self interest.

That said however, and as I’ve argued on this blog before, we must be careful what we wish for when it comes to a yuan revaluation.

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).

I certainly agree that it is in the long-term interests of the U.S. for China to address its imbalances via some kind of yuan remediation. It is also in China’s best interest. However, the near term economic adjustments associated with a significant rise in the value of the yuan could be painful, not just for China, but for the rest of the world as well. In addition, a sudden rise of the Yuan could be socially destabilizing for China. Given China’s already tenuous political and social situation, it is therefore difficult from a policy standpoint for Chinese politicians to justify decisions that might not be in their own near-term interests (and swallow the pill so to speak), …even though they recognize the problem.

But I agree that it likely won’t hurt to call China out.

Nevertheless, when China does finally revalue their currency, my recommendation is that it proceed with caution. A gradual revaluation to competitive levels over a number of years is probably the best outcome for the global economy.

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.