Remarks to the Summer Roundtable of the Pacific Pension Institute
Next year will mark the thirtieth anniversary of Deng Xiaoping’s liberation of the Chinese people. In 1978, he replaced bureaucratic central planning with the invisible hand of the market economy. This must be counted as one of the most momentous events in modern history. In terms of current prices, it has brought about a 58-fold increase in China’s gross domestic product (GDP). GDP per capita in China is now 40 times what it was in 1978. The country has been transformed by this, and so has the world. China is rapidly acquiring a first-class infrastructure that provides a credible basis for further progress toward affluence.
Deng’s revolution in economic affairs is now creating a lot of consumption as well as investment and industrial production. It seems much more likely that current trends will continue than that they will not, but there is nothing inevitable about this. Still, even if growth turns out to be much slower than most people now expect, the net effect will be to stretch out the impact of China’s reemergence into wealth and power, not to halt it, and to reduce but not eliminate the implications of a growing Chinese economy for global commodities supplies, prices, investment opportunities, and the environment. Most of what I will have to say about China and its global impact refers to current realities, not projections into the future.
Energy is very much part of this picture, but there has been a lot said about it elsewhere, and it’s not very relevant to private equity. I want to focus instead on other natural resource import requirements. Chinese industry is set to grow almost 17 percent this year and that generates a lot of demand for raw materials. Of course, much of what’s happening with respect to these raw materials applies equally to oil and gas and to the ships and pipelines by which it is being siphoned up by the Chinese market. We can talk about that later, if you wish.
Rapid growth in industrial demand is, however, far from the only cause of the rapid rise in China’s imports of commodities. In the first quarter of 2007, per person disposable income of urban Chinese rose by almost 17 per cent year-on-year in real terms, while average cash incomes in the countryside increased by more than 12 per cent. That’s a lot of demand for basic consumer goods, furniture, home electronics, foodstuffs, recreation, personal products, and you-name-it.
There is also the phenomenon of China’s emergence as the final assembly point in global supply chains and as a formidable processor of raw materials into products for export, like furniture. (The 50,000 furniture companies in China now have half the global market and, with logging having been banned in China, they are competing with each other to buy up the rest of the world’s wood.)
Industrial production and consumption by newly affluent people in China are the twin forces now tightening supplies and driving prices in global commodity markets upward — not just minerals, metals, wood, and petrochemicals, but feedgrains, meat, dairy products, and a host of other things. Retailers report that in newly rich cities, like Beijing, the average apartment owner now spends $30,000 on infill and decor. In China’s major metropolitan areas, 78 percent of the registered population own their own homes, up from zero two decades ago. (The comparable figure for home ownership in the United States is about 69 percent.)
Without many outsiders noticing, China has acquired a vast, property-owning middle class of around 300 million people — about as many as the total population of the United States. At nominal exchange rates — not converted for purchasing power parity, there are already about 50 million Chinese with incomes over $25,000 per year. (In China, that amount will buy five or six times what it will here, so these people are, by any standard, upper middle class.) By 2025, McKinsey projects that this Chinese upper middle class will have grown to about 520 million, even without appreciation of the Chinese currency in relation to the dollar — which seems virtually certain to occur. You don’t have to believe that projection of current trends — though I think it’s plausible — to grasp how China has become the fastest growing part of the global market served by North American business — and everyone else.
China’s growth is throwing up huge requirements for domestic infrastructure — highways, railways, housing, offices, factories, power plants, pipelines, ports, airports, and so forth. The Chinese are currently spending over 9 percent of their GDP on modernizing their own infrastructure, not counting what they’re spending on building infrastructure abroad with which to ship raw materials home. What China is building is big and it is efficient. It has a lot to do with the astonishing gains in productivity that the Chinese economy continues to register. (In the United States, we are spending less than one percent on developing or sustaining our infrastructure — and it shows.) Before I get to its long-term implications, let me cite a few examples of the speed with which development is unfolding in China.
China’s first expressway opened seventeen years ago. There are now about 30,000 miles of expressways, many of them privately financed, built, and operated. (They say the only robbers allowed on these highways are in the toll booths.) By 2020, China expects to have 53,000 miles of superhighways, a high-speed road network 15 percent larger than the interstate highway system in the United States. China will build and pave about half a million miles of ordinary highways over the next five years alone, including, of course, the controversial road it is now building for tourists determined to drive up Mt. Everest rather than hike it. All these roads will get heavy use.
Twenty-five years ago, there were a handful of private cars in China. The country still has only about seven cars for every thousand people — a level of market penetration for the automobile that we achieved in North America in 1915. But the car is fast becoming as Chinese as the sampan. By 2009, income levels are forecast to have risen enough to allow most middle income Chinese families to buy cars. Auto sales are projected at 10 million by 2010 and 20 million by 2020. China will then, by a considerable margin, be the world’s largest car market.
This has all sorts of implications beyond additional demand for petroleum products like asphalt, diesel, and gasoline, not to mention the output of exhaust fumes, used tires, and the like. China now accounts for only a tiny percentage of the world’s cars and trucks but no one who’s been there recently will be surprised to learn that it has over one-fifth of the world’s traffic accidents. You can bet that some entrepreneur is already thinking about the huge opportunities in both health care and funeral services as more Chinese compatriots take to the roads! McDonald’s has just partnered with Sinopec to add drive-in hamburger joints at filling stations throughout the country. Can the drive-in movie, backseat sexual acrobatics, and ambulance-chasing tort lawyers be far behind?
The economic boom has also generated soaring demand for rail transport. China has only 6 percent of the world’s railway mileage. But last year Chinese railways handled 25 percent of the world’s passengers and freight, carrying 662.2 billion passenger-kilometers — 2.7 times the figure for rail-dense Japan — and 2.87 billion tons of cargo, a billion tons more than the US, and 4.8 times as much as heavily rail-dependent India. China projects expansion of at least 35 percent in its rail network by 2020. It has just introduced the first intercity bullet trains, with more to come.
China’s economy is increasingly powered by its domestic market rather than foreign trade but it is becoming heavily dependent on imports for continued growth. Over the coming five years, Chinese ports will add 42 percent to their current handling capacity, which is already the largest in the world. China has built seven of the world’s twenty largest container ports, with major technological innovation and expansion underway to handle volumes of trade that could hardly have been imagined only a few years ago. The country is also the world’s fastest growing aviation market. Air passenger traffic has been going up by about 15 percent and air cargo by 19 percent each year. Over the coming five years, China will build fifty new airports and double its inventory of commercial aircraft.
All this development is occurring apace with urbanization at a rate and on a scale unprecedented in human history. Over the past quarter century, China’s urban population has doubled. Over the next twenty-five years, it is expected to double again as 500 million or more people move to China’s cities. There are now more than one hundred Chinese cities with populations over one million. Each year, urban areas must find room for 20 million new arrivals from the countryside. Not surprisingly, China accounts for over half of world construction by area. It is building about 8 billion square feet (800 million square meters) of new housing annually.
One result of this is huge new requirements for minerals and metals. China makes 44 percent of the world’s cement. More to the point, thanks to rapidly rising Chinese demand, the global mining industry has never been as hyperactive or as profitable as it is now. Mining revenue rose to $249 billion in 2006 from $181.5 billion in 2005. The industry’s net profits skyrocketed 64 percent. New mining companies are swarming forth like mosquitoes in the rainy season. There is no end to the boom in sight.
This year, China will make about 500 million tons of steel, over two-fifths of the global total. This is six times as much as the United States produces. It is more than the entire world made ten years ago, and 23.5 percent more than China itself produced last year. To make this steel, China will import about 400 million tons of iron ore, supplementing the rapidly rising output of mines on its own territory. Chinese buyers dominate worldwide scrap markets. Already the largest producer of stainless steel, China managed to increase production last year by another 45 percent, setting off a boom in nickel and ferrochrome. To the delight of countries like Australia, Brazil, and India as well as shipbuilders everywhere, Chinese iron ore imports are expected to rise to at least 600 million tons by 2010.
Similar trends are evident in other minerals and metals. Chinese demand is driving major expansion in mining in Australia, Bolivia, Brazil, Canada, Chile, Guyana, India, Indonesia, Laos, Peru, the Philippines, Russia, South Africa, and Tanzania, to name just a few of the countries where large China-connected projects are currently in progress. But China is not just an importer. It is the dominant factor in the production of many minerals and metals. It produces 96 percent of the world’s rare earths, 87 percent of its tungsten, 86 percent of its antimony, 75 percent of its magnesium, half of its fluorspar, one-third of its tin and lead, one-fourth of its aluminum and zinc, and one-fifth of its molybdenum. Chinese domestic consumption of all these commodities is rising apace with industrial production, so exports of rare-earth elements, tin, and tungsten are declining even as domestic consumption of these and other commodities continues its dizzy rise.
How long can such growth in Chinese production and consumption be sustained? The answer appears to be that it can go on for a very long time, providing that new sources of raw materials are discovered, that the huge investments necessary to develop and transport them are made, and that new strategies to increase recycling, remanufacturing, and reuse are elaborated.
Take steel as an indicator. Steel is a capital good that, once produced, is constantly recycled. To date, China has produced a cumulative total of about 4 billion tons of steel, four-fifths the total produced by Japan and half that of the United States. The Chinese are well aware that to reach U.S. levels of per capita capital accumulation, they will have to make another 32 or 33 billion tons of steel. At current production rates, high as these already are, that will take another 65 or so years. For China to match Japan will take over a century. It is much more likely that Chinese production will speed up its rise than that it will slow down or decline.
That, plus the impact of other emerging economic great powers like India, will keep mineral supplies tight and prices high. It will make recycling more profitable and encourage the use of substitute materials. It will also keep profits in the global mining industry robust and stimulate major new investment in the economies of Africa, Latin America, Australia, Southeast and Central Asia, and Russia. China is already very aggressively seeking new natural resource supplies in all these regions.
In Africa, Chinese companies are now, by a wide margin, the largest foreign investors. They have strong financial backing from their government, which thinks the business of business is business, not the moral transformation of those with whom Chinese companies are doing it. This is, of course, intensely annoying to Western nongovernmental organizations (NGOs), who had become accustomed to having Africa to themselves as a sort of humanitarian theme park in which capitalists and their business interests seldom intruded.
In this connection, environmentalists are very concerned, and rightly so, by the implications for African rainforests of China’s apparently insatiable demand for tropical hardwoods. The most farsighted NGOs are looking for ways to work with the Chinese government and to help it guide its companies toward environmentally responsible behavior. There is reason to hope this can may work. China was sufficiently concerned about the environment to double its own forest cover over the past fifty years — to 18 percent. It has recently put forward a “sustainable forests” initiative to govern its purchases of wood from abroad.
More to the point, there is no feasible alternative to working with China. The emergence of the Chinese economy as a driving factor in the global commodities trade has ended the West’s ability to determine international policy with respect to global extractive industries, even as it has put an end to the efficacy of coercive sanctions not endorsed by the United Nations on behalf of the entire international community. The arrival of India as another huge consumer of imported resources will give the coup de grâce to the age of American and European tutelage of the Third World. 250 years ago the West began to dominate the globe. As the 21st Century proceeds, that dominance is fading away. To cite the example of energy: not so long ago, the 20 largest energy firms, ranked by market cap, were in the United States or Europe. Today, 35 percent originate in China, Brazil, Russia, and India. A similar pattern is rapidly emerging in the mining sector.
Chinese companies are not prepared to take on a “mission civilisatrice” — the task of implanting their or other foreign norms on African soil so as to transform it. They promise to make Africa and other places in which they invest or do business richer. Whether or not these places also become better is — in their view — for the people who live there, not outsiders, to work out. For their part, Africans want to do business on their own terms, not to depend on handouts dispensed on terms set by others claiming to be wiser and more moral than they. Now that Africans finally have a choice of international partners, they — not foreigners and certainly not Chinese — will decide how natural resources are exploited in Africa and by whom. Blaming China or India or someone else for this global paradigm shift is not just futile. It is counterproductive.
Quite aside from the politics of Sino-African relations, their new financial aspects are impressive. The loans China offered Africa in 2006 were three times total development aid from the rich countries that make up the Organization for Economic Co-operation and Development (OECD). Since 2000 China has canceled more than $10 billion in debt for 31 African countries and given $5.5 billion in development aid, with a promise of a further $2.6 billion in 2007-08. In 2005, China committed $8 billion in lending to Nigeria, Angola, and Mozambique alone. In that same year the World Bank spent $2.3 billion in all of Africa. In 2007, lending by China’s Import-Export Bank to Africa is expected to be about $17.5 billion. And so it goes.
In Latin America, some of the same trends are evident. Trade with China has grown from a couple of hundred million dollars in 1978 to over $70 billion last year. It is expected to rise to at least $100 billion by 2010. Argentina and Brazil have emerged as major suppliers of soybeans and other agricultural commodities to the China market. Unlike Africa, however — where Chinese direct investment is opening mines and building the roads, railroads, and ports necessary to export their output — in Latin America most of the investment in new production for export to China is locally chartered and financed or conducted by joint ventures with Chinese companies.
This pattern of interaction is one reason that direct investment from China in Latin America has appeared to be much lower than Chinese and Latin American officials had forecast. Frankly, Latin Americans — like North Americans — continue to misunderstand both the nature of the current Chinese economy and its relationship to the Chinese government. They imagine that China’s economy consists of a few large state-owned corporations that officials can direct to invest where the Chinese state would like them for strategic reasons to invest. By and large, however, Chinese industry is much, much more highly fractured than in the West. It consists of hundreds or even thousands of companies that compete with each other for trade and investment opportunities and resources. Business has to be done with these companies, not Chinese ministries and their personnel.
Chinese companies do not believe that they are in the charity business; nor are they inclined to serve as disbursement agencies for altruistic Chinese government donations, which are — in any event — as hard to quantify as the Sasquatch population of British Columbia and the State of Washington. The Chinese government can, as it has in Africa, publicize opportunities and create financial incentives that favor the development of investment by Chinese companies but it cannot substitute its business judgment for theirs and, by and large, does not attempt to do so. A lot of credit arrangements proffered by Beijing for business development in Latin America remain underutilized.
Let me conclude with a cowardly act of preemptive capitulation. I completely agree that the phenomena I have described pose serious challenges on multiple fronts. Global commodity prices are more likely to climb than to decline, as they did for the past 200 years. There will be a premium on reusing some materials and substitutes will have to be found for still others we have taken for granted. There will be large environmental problems as Chinese and Indian demand for forest products and agricultural commodities rises and mining activities get under way in virgin areas. Western countries are indeed losing the privileged position of monopoly control they had over global extractive industries throughout the 20th century. There is a major shift in the global balance of economic power going on; it is already evident in American and European friction with China and other non Western countries over policies toward places like Iran, Myanmar, Sudan, Venezuela, and Zimbabwe. Non Western countries, not surprisingly, feel no obligation to impose Western values or policy objectives they do not share on their trading partners. Our frustration with their unwillingness to do what we say — even if it isn’t what we ourselves had been up to for the past 120 years — will lead to still greater friction.
With these admissions out of the way, I’d like to spend a final few minutes looking at the opportunities the changes I have been describing present. How can outsiders profit from the rising appetite for natural resources of the Chinese dragon — or the Indian lion that is coming up behind it?
There are many ways that come to mind, but they break down into a few categories:
• Investors can invest in companies that have the potential and intention to supply China with the energy, industrial minerals, metals, forestry, and agricultural products it needs. This suggests a hard look at natural resource companies operating in currently underdeveloped areas of Africa, Australia, Brazil, Canada, India, Indonesia, Papua-New Guinea, Russia, southern Africa, and the southern cone of South America — Argentina, Bolivia, and Chile — or at the many new companies being organized to do this for the Chinese and Indian markets.
• Financiers can help Chinese investors leverage their capital with that of others to create companies and acquire properties at home or abroad. China has a very strong domestic mining industry but it has yet to develop the capability to structure its mining investments to maximum financial advantage. That’s where Western financial expertise can come in. There is a lot more capital in China — and, for that matter, among overseas Chinese and in the Arab world — than there are people who know how to make it work most profitably for them.
• Private equity investors can help new companies or pull together currently unrelated Chinese natural resource-related operations with a view to taking the resulting new companies public in Hong Kong, now the site of the largest number of IPOs in the world, or elsewhere — and eventually in equity markets in China itself. In the last six months, with not many people noticing, the price-earnings ratios of companies in the extractive industries have doubled on the Hong Kong exchange. Someone needs to help new companies establish themselves and existing companies to consolidate. Why not do these things in the most profitable way possible?
• Fund managers can invest in the creation of new infrastructure in China: for example roads, logistics management facilities like port, airport, warehouse operations, and real estate. Investors in funds of funds can invest in some of the four hundred or so venture capital and private equity funds that have been established in China.
• Individuals and groups of investors can buy shares in Chinese companies that extract oil, gas, minerals, or metals. Not a few such companies are strong performers with rich dividends. Many are listed in equity markets outside China. New companies are being formed constantly. They can be good investments in their own right but have the added advantage that, with their underlying assets denominated in Chinese yuan, their book value will rise along with the yuan exchange rate. Some will need help making IPOs.
And,
• Entrepreneurs can invest in companies that are focused on improving energy and materials efficiency or the profitable recycling, remanufacturing, and reuse of industrial materials. As supplies tighten and prices rise, companies in this business will prosper proportionately.
A lot of these approaches are very well suited to private equity. Some may not be. But I trust I have made my point. Not so very long ago, Deng Xiaoping declared that “to get rich is glorious.” His countrymen have taken him seriously. That’s causing some problems. But China’s demand for natural resources seems to me to represent some real opportunities for those in private equity who agree with the Chinese people that Deng knew what he was talking about and are prepared, like them, to take a risk or two to achieve the kind of glory he foresaw.
Ambassador Chas W. Freeman, Jr., USFS (Ret.)
Victoria, British Columbia
