Three Troubling Trajectories

Speech at Kyoto University, Economics Department, November 2007

Ladies and gentlemen,
I am honored to be invited to speak before you at the world renowned Kyoto University and it is a distinct personal pleasure to be here. I have been to Kyoto a number of times but have always treasured my first visit. It was in October 1975, just a little over 32 years ago. I was on business for SRI International and my then colleague and now dear friend, Takaoka-san, took time out to show me Kyoto. He was then the executive director of SRI’s office in Asia. He was obviously proud of Kyoto and proud to be an alumnus of Kyoto U. And his pride made my visit that much more memorable.

I really enjoy traveling around the world. Each time and each place affords so many opportunities to learn about history, culture and the diversity of the people that populate our world. For example, my wife and I just spend ten days in Sicily, our very first visit there. I learned from this trip that Sicily was probably one of the earliest beneficiaries of ethnic diversity. You see, Sicily has rich soil constantly added by active volcanoes, lots of sun shine and a warm climate—a California of the Mediterranean. Many people came to settle there, Phoenicians, Greeks, Romans, Byzantines, Moors, Normans and now young Chinese selling souvenirs at tourist attractions. Each brought their culture and values to enrich Sicily and added to the island’s rich heritage.

I will be coming back to Sicily later in my talk. But I am here today to talk about China, Japan and the U.S. Except for elementary school education in China, I was educated in the U.S. and grew up in America. I have been visiting China regularly on business consulting assignments since 1978. I write commentaries about the sometimes troubled U.S. China bilateral relations. I think I know the two countries pretty well. I have been to Japan less frequently and can not claim to be an expert on Japan. So forgive me, if my presentation today appears unbalanced.

Nonetheless, I would like to take this opportunity to present some personal views that may sound blunt and direct. I hope you will forgive me if some of my statements sound untactful. My American upbringing is urging me to “tell it like it is,” and I would be remiss to pass up this chance to share some very serious concerns with this distinguished audience by obscuring my remarks in polite but ambiguous language. I hope you’ll find my remarks provocative but not offensive.

Some might argue whether China, Japan and the U.S. are the three major powers in the world, but there can be no doubt that they are the most important nations around Asia Pacific. Each shares many common interests but also has important differences in values and priorities. Each faces some ominous dark clouds in the horizon that I would like to discuss with you. The peace and stability of the Asia Pacific region depends on the three countries getting along with each other and staying in good health.

First, let’s talk about China. When I first went to China on business trips, late ‘70s to early ‘80s, just trying to place a phone call to make an appointment was a frustrating experience. There were so few telephone lines in Beijing in those days that I would get the busy signal even before I finished dialing the number. Today there are 500 million cellphone users in China and no bottlenecks at the switch boards.

In 1985, one of my clients, a maker of automotive components, celebrated the formation of a JV in China. That same year, Germany’s VW JV in Shanghai started production. At the time China’s total yearly production of motor vehicles was less half of million, most of them trucks and buses. Only 5000 passenger sedans were produced that year. In 2006, 21 years later, China’s vehicle production exceeded 7 million of which about 4.5 million are passenger cars. So vehicle production has increased more than 14 fold over this period of time while passenger cars grew by a phenomenal 900 times. China is now the third largest auto producing country in the world, after Japan and the U.S.

Today, everybody knows that China’s economy has been doubling every 7 years for nearly the last three decades. For a long time, skeptics found it hard to believe that this kind of unprecedented growth was possible and doubted the official statistics. They would point out that 28 out of 29 reporting provinces report their annual GDP growth as higher than the national average—clearly a mathematical impossibility. It was discovered later that the central government’s calculation for the national average was too low and less precise than the regional reports.

How did China accomplish such phenomenal growth? The full explanation is much more complicated than I can present today but I would like to outline a few highlights that I think were key developments.

In the early 1980’s, China removed the commune system in the rural sector. Farmers were essentially free to plant what they want and to pursue other livelihoods. Many, especially those living south of the Yangtze River became wealthy and even had time and energy to start small businesses. This was the beginning of the township and village enterprises which played an important role in China’s early economic reform.

Shortly after, China began a small experimental step and established a handful of special economic zones, most notably Shenzhen right next to Hong Kong. Hong Kong business took almost immediate advantage and moved their factories from Hong Kong to next door to maintain their competitive cost advantages. The whooshing sound that Ross Perot predicted for the U.S when North America Free Trade Agreement was signed, actually took place in Hong Kong, leaving many multi-storied factory buildings empty.

Following the Hong Kong businesses were business people from Taiwan and Southeast Asia, virtually all of them ethnic Chinese, who began to locate their manufacturing inside China. During this time, there was still much internal debate in Beijing between those wishing to remain with the planned economic model and those wishing to pry the economy wide open. One of the senior leaders was Chen Yun（陈云）who famously coined the term, “bird cage” economics （鸟笼经济）. The nation’s economy, Chen said, must be kept in the cage. Sometime the cage can be loose and other times tight but the economy must never be allowed to fly away.

In 1992, Deng Xiaoping decided to break the debate in favor of the free market proponents. He made the now famous tour of Shenzhen and declared that “to get rich is glorious.” And thus, China opened its doors wide and began to attract foreign direct investments at a rapidly increasing rate, first $30 billion at year, then $40 billion, $50 and now over $60 billion annually. Today, China has become the most open of market economies in the world and the most attractive magnet for foreign direct investment.

In terms of economic policy, China’s approach from Zhao Ziyang to Zhu Rongji to Wen Jiabao has been cautious, step by step and trial and error. “Crossing the stream by groping the stones,” another of Deng’s saying, describes the approach. The policy makers saw what happened to Soviet Union when they quickly adopted the western capitalism without the controls and thus imploded. Beijing looked to Singapore as their template for development and gradually loosened their control as the economy expanded.

In the early 1980’s China approached the World Bank for development loans. Unlike many 3rd world countries, China did not just want the money but also wanted to work with World Bank on the terms and conditions for those loans. Those terms and conditions, Beijing saw as a necessary learning process to establishing rules for internal control and to instilling financial discipline. To transition from a totally planned economy to a market economy, China needed outside guidance on rules, financial process and implementation of controls and they recognized the need and were willing to learn from outside sources. An interesting historical footnote is that the person that led the Chinese team in working with the World Bank was Zhu Rongji.

Subsequently, Zhu Rongji as premier dragged China into WTO over considerable internal opposition. He believed the discipline imposed on WTO treaty nations would be good for China and raise its competitiveness. By having to meet world competition, China would raise the quality of Chinese manufacturing and force inefficient factories out of business. The transition would be painful, as some 30 million or more for the workforce became under employed or unemployed. But give China credit, they have been willing to undergo short term pain for the long term benefits.

Today, China has become or will soon become the world’s third largest economy, amassed a foreign exchange reserve well over $1 trillion dollars, raised hundreds of millions out of the poverty line, and has become skillful in the exercise of soft power and making its presence felt in such places as Africa, South America and of course, the rest of Asia. Unfortunately, this is not the whole picture, but before discussing the dark side of China’s rise, I would like to summarize briefly what I think China has done right.

When China began its reform in 1978, the country had been cut off from the rest of the world for nearly 30 years. I believe their go-slow, trial and error approach to policy changes turned out to be the right approach. One aspect where the Beijing government did not go slow was recognizing early the importance of infrastructure investments. Not only the World Bank financing went toward infrastructure but Beijing even went into deficit spending to improve port facilities, increase power plants, double tracking of rails and construction of a network of superhighways. No other country, certainly not India, has made such a commitment to economic growth.

China is blessed with over 60 million ethnic Chinese living outside of the mainland including Taiwan. Many of these overseas Chinese, even if they are born outside of China, never lost their sense of identity and cultural ties to their motherland. Both the governments of Taiwan and Beijing go out of their way to encourage this sense of affiliation and kinship to their ancestral home. In turn, overseas Chinese including those living in Hong Kong were the first to invest in China. At the beginning of China’s reform before Deng’s southern tour of 1992, overseas Chinese investments were the major source of FDI. Taiwan investments, whether officially approved by their government or not, played a major role not only in job creation but in introducing to the mainland the methodology and approach needed to make consistently good quality products. (Some of you may be thinking, what about the recent rash of faulty products coming from China? Unfortunately, the propensity to take short cuts （上有政策，下有对策）is part of the Chinese character. I have a partial solution to this problem which we can discuss during the Q&A if you the audience is interested.)

For the last ten years, FDI has been coming from all over the world, Japan, S. Korea, the U.S. and Europe. Before then, it was mostly from overseas Chinese. No other country has this kind of diasporas to draw on with the possible exception of Israel. It was Beijing’s deliberate policy to risk letting a few Western flies in order to open its door wide open for foreign investment. Again, no other country has been as open or as successful.

Unfortunately, China followed the Western model of economic development without modification and failed to learn the price paid by all the predecessor nations that developed in that manner. Namely, it was economic growth without any regard to environmental consequences. Factories pollute, the society bears the cost and the common people paid the price in sickness and shortened life expectancy. Because of the size of China and the rapid rate of economic growth, the undesirable side effects are unfortunately magnified. The current generation of leaders is beginning to understand the grave consequences but have not found an effective way to deal with this problem. The more China’s economy expands, the darker is the air, dirtier the land and more toxic become the rivers and stream. The desertification of China has increased by 60% in 12 years. In 1994, 17.6% of China was desert. Now it is 27.5%. For those of us fortunate enough to enjoy fresh air, blue skies, clean water and green parks, this is a very depressing picture.

The reason this has become such a difficult problem for Beijing is their need to continue to expand their economy and create jobs to serve a huge population. The central government has made a deliberate policy to greatly increase college enrollment, an investment in human capital, but now they are faced with the need to find jobs that match with their training and aspirations, along with a range of new jobs over the entire economic spectrum. This drive to maintain economic growth is almost out of control. Local officials are still driven by how quickly their GDP is growing. Beijing has been trying to measure a “green” GDP by subtracting the environment damage and cost of remediation from the reported GDP, but so far they have not been able to find a way of calculating the down side of rampant economic growth and have not been able to convince the local officials to pay equal attention to environmental protection.

Today, any visitor to China, and one does not have to be an environmental scientist, can see the enormity of this problem and challenge. There is a real opportunity for Western technology to go into China and help restore the balance. Whether it’s the power plants or the motor vehicles, China is wasting a lot of energy and throwing off too many pollutants. China is already extremely water poor with only one quarter of the world average per capita and this problem will get worse. These are just a couple of areas where foreign technology can make a difference. Helping China remediate their environmental degradation not only can be profitable but is in our self interest. After all, the consequence of pollution respects no national boundaries.

Part of China’s problem is, of course, that it is not yet a rule based country. Too much latitude and inconsistency can take place when it is dependent on who has the authority. There is too much room for corrupt practices. China’s President Hu Jintao has again proclaimed a systematic crackdown on corruption at the recent People’s Congress. It remains to be seen how successful he will be. I think China is much too big for any central authority to be able to enforce anti-corrupt practices uniformly and effectively.

I do see help coming along in the form of the Internet and the cell phone. China recognized both as important communications tools and encouraged their growth while trying to control its use. I believe the flow of information will always outpace the authority’s attempt to monitor and restrict flow of information. Instead of control, I wish Beijing would find a way to channel the webpages, blogs, emails and sms in such a way as to bring more transparency to the country and allow the general population to shine the spotlight on the corrupt officials and wrong doers. Even if the central government does not encourage such practices, I think the use of these devices will inevitably increase, people’s voices will grow louder and the public will benefit.

Unlike the prevailing American sentiment, I do not believe a democratic form of government is necessarily the solution for China, certainly not the form of democracy that is being practiced in the United States today. In America, democracy is measured by the dollar sign. The likely success of a political candidate depends on the amount of money backing his/her candidacy. The first thing a candidate has to do, even running for the local dog catcher, is to raise money. Should the candidate be successful, the first thing after being elected is to raise more money, to ensure that as an incumbent, the candidate will not face a serious challenge for re-election.

In America, money has trumped all other aspects of the democratic process. The candidates themselves have to have a large war chest for TV ads but they are technically limited by the amount they can raise. Therefore, special interest groups compensate by raising unlimited amounts of money mostly for attack ads against candidates they do not like or issues they are against. These attack ads are unencumbered by facts and truths but deal with innuendos and outright lies. They can get away with lies with impunity, because they hide behind anonymous groups and storefront organizations.

In this environment, it is possible for a petty scam artist to make a lot of money for himself by posing as a big political donor. There is a case going on in America right now, a Norman Hsu who discovered that by giving investors’ money to cash hungry candidates in lieu of making legitimate investments, he became instantly respectable and have no trouble raising more money from others. There will always be con-artists but America’s current climate provides them the arena to make it big, albeit illegally. In short, the American democracy has drifted so far from the original ideals that the founding fathers would not recognize the country they founded.

The state of U.S. China bilateral relations is like a roller coaster riding on the rails of American domestic politics. Periodically, China becomes the convenient whipping boy for aspiring politicians who should know better but cannot resist the temptation to put the blame of American domestic problems on China. Trade deficit is just one example. In 1997, China accounted for 27% of America’s trade deficit while rest of East Asia, including Japan, accounted for another 47% for a total of 74%, almost ¾ of the overall U.S. deficit. In 2006, China accounted for 28% while rest of East Asia accounted for only 17% for a total of only 45%. A reasonable and objective observer would say that much of the manufacturing from East Asia has moved to China and that the ballooning trade deficit is due to fiscal policies of Washington and not because of any alleged predatory practices. However, the American propensity to spend beyond their earnings, the weak dollar, the barriers to export and other domestic causes are too difficult for politicians to tackle and it is just much easier to go on the podium and blame China for everything that is wrong.

For Washington (and for that matter for Tokyo) to feel threatened by China’s military expenditure is even more ludicrous. Former Secretary of Defense Rumsfeld made a fool of himself, when he, figuratively speaking, stood the deck of the American carrier off China’s coast line and accused China of aggressive intentions by daring to develop a navy with blue water capability. It will be years before China’s military firepower can match Japan’s technology and even longer to America. China has too much to do in their domestic agenda to entertain a confrontation with the U.S. However, one can understand China’s desire to continue their domestic agenda unmolested by foreign interference. Best assurance is to make sure they have a credible retaliatory strike capability. I would call it the porcupine defense.

I am absolutely convinced that the September 11 attack on the World Trade Center changed the course of world history. Just April of that year, the world was transfixed by the spy plane incident where a Chinese jet collided with an American air reconnaissance plane off Hainan Island. Thanks to the neoconservatives who had taken over Washington, China and the U.S. were on a collision course. After 9-11, Washington found a real enemy and China became a tenuous ally in the fight against terrorism instead of being the adversary of choice.

I don’t believe bin Laden in his wildest dream could have anticipated the success of 9-11 in unraveling America. Instead of finishing off the military task in Afghanistan, the Bush Administration allowed bin Laden to get away, charged into a war in Iraq and blundered the aftermath in the most appallingly incompetent manner. Thanks to Guantanamo and Abu Ghraib, the U.S. has lost all moral high grounds when it comes to human rights issues. The Bush Administration even invented a new terminology, “enemy combatant” in order to circumvent the Geneva Conventions—not being prisoners of war, the reasoning goes, means it was OK to deprive them of human rights and dignity. America’s message has become “do as I say, and not as I do.” American prestige world wide is at an all time low and Washington is finding out that even the world’s greatest military power cannot solve the world’s problems unilaterally and simply by relying on guns and bombs. Unless the next administration consists of capable, clear-eyed, non-ideologs willing to undo the damage of Iraq, I am afraid history will identify the Bush response to 9-11, not 9-11 itself but Bush response, to be the slippery slope of America’s decline. Of all the trajectories, this is the most troubling to me.

While visiting the city of Syracuse on Sicily, I learned an interesting history lesson. Syracuse was a powerful city state during the Greco period. In 413 BC, the invading Athenian navy was annihilated by Syracuse defenders which led to the decline of Athens and a relative peaceful period for Syracuse. For a brief while, Syracuse experimented with a form of democracy but then the people from Carthage came to invade Sicily. The people of Syracuse quickly elected Dionysius as their tyrant to lead them in the battle against the Carthaginians. Then as now, in times of war, people find comfort in relying on an authoritarian leader. I believe Bush’s advisors understood the psychology which is why he declared war on terror. Only difference is that Dionysius was a brilliant and effective leader.

Despite the gloomy future I see for America because of the self-inflicted injury by the Bush Administration, there are some inherent strengths that America possess that others can only envy. Thanks to a university system that continues to offer quality education, America remains the most desired destination for the best and brightest from all over the world. Right now, we are undergoing some back lash against immigrants, but by and large, America has had its welcome mat out for the best minds of the world. This is very important to America’s future because America’s school system below the college level is failing. Too many of the children born in America are not properly trained to face a future of high technology and globalization, instead they are getting an equal dose of pseudo sciences such as creationism and intelligent design along with biology and evolution.

Silicon Valley remains a beacon of strength for America. Silicon Valley continues to be the center of innovation because it continues to attract the world’s most entrepreneurial and talented people. As you may know, the two founders of Google are from Russia. One of the two founders of Yahoo is born in Taiwan. One of the original founders of Sun Microsystems who has become a high profile venture capitalist is from India. A Chinese who grew up in Vietnam then Hong Kong founded Lam Research a major semiconductor equipment company. A Chinese from Beijing who immigrated to South America, came to the U.S. for education founded Qume, a major printer company in its days. Silicon Valley is unlike any other parts of the United States. About 2% of the U.S. population resides in Silicon Valley and yet every year, around 30% of the all the venture capital is invested there. Why? Because this is where anybody with a bright idea has a chance to form a team and get financing, where failure in starting a venture is tolerated and counted as valuable experience. This tolerance for failure encourages people to take risks and think out of the box because they know that if they fail, it would not be the end of the world.

Can you see how my remarks so far is leading to what I am about to say about Japan? Historically, China and Japan have had a complicated relationship. For a long time, China was the teacher and Japan the student. Then in the 19th century, China became the student as the country began to send many of their brightest minds to Japan for further education and to learn how Japan was able to catch up to the Western powers so quickly. Many of these students such as Chiang Kai-shek became leaders of the revolution that overthrew the Manchu dynasty and led China into the republic form of government.

Then when economic reform began during the Deng Xiaoping era, Japan again became an important partner for China, not only for the loans on friendly terms but the opportunity to learn from Japan’s management style, particularly the just-in-time and continuous improvement manufacturing processes. Japanese trading companies were among the earliest to establish offices in China, not just in Beijing or Shanghai but quickly spread their presence to lower tiered cities. Matsushita established a manufacturing joint venture in Beijing even before China began the special economic zones. Nissan began a long relationship with Dongfeng Motors, at the time China’s largest automotive operation, and eventually formed a 50/50 joint venture. These are just some of the examples of the close economic and business cooperation between China and Japan and Japanese presence in China was generally earlier than the Americans or Western Europeans.

However, tensions between the two countries, and for that matter with rest of Asia, will persist until Japan rid itself of national amnesia concerning what happened in World War II. People of Japan have forgotten about the role of Imperial troops as brutal aggressors and only Hiroshima to remind them of being victims of the war. But other people especially in Asia have not forgotten about the war and will not sympathize with Japan’s self image. I believe it is in Japan’s national interest to face history forthrightly. Only then can other people forgive and begin to forget. Only then can future generations of Japanese travel around world and not be puzzled by the undertone of resentment. Japan has been the most generous nation in dispensing of foreign aid around the world, even more generous than the U.S., not counting American aid in weapons and arms. Surely Japan deserves to be a leading nation in the world and take a seat on the Security Council but I am very pessimistic that this will happen any time soon, not until Japan comes to terms with World War II.

Because of its single child policy to bring the population under control, China is facing a demographic challenge in a few decades when there will be fewer able bodied workforce to support an increasing population of retirees. Japan has a similar but more immediate problem. Japan’s population is already getting older and is the first developed nation to be shrinking. I am not a professional economist or a demographer and have no expertise in this subject area but I do have a remedy that might help reverse the trend. This remedy will be very difficult because it would require a drastic change in Japan’s national character. Here’s what I mean.

For centuries, Japan’s culture is insular, what I would call an island mentality. Only some people living on the islands qualify as Japanese—not the Ainu, for instance, and not ethnic Koreans who have been here for many generations. Even a Japanese national, say a trading company executive who has been posted overseas for a few years, when he returns, his family is often treated as gaijins (外人) by neighbors and schoolmates. In Japan, it seems to be very easy to be gaijins and very difficult to be accepted as Nihonjin. Yet at this juncture in history, Japan’s economy is in need of new blood, new people that can bring new ideas and new vigor. Japan needs to open up and welcome other nationalities to live and work in Japan, needs to create an environment that make these foreigners feel welcome and not feel like gaijins. China actively recruits overseas Chinese to return to China and has programs that invite foreign experts of any ethnicity to teach and work in China. The U.S. and especially Silicon Valley does not have any organized program, just an appealing, multi-ethnic and diverse environment where anybody from anywhere in the world could come and feel at home. In my humble opinion, it would be in Japan’s interest to review whether a systemic change in national attitude is possible and would be in the best interest of Japan. In just the recent memory, Japan transformed from a country that makes shoddy products to one known for the Deming Prize and famous all over the world for high quality, high precision products. Perhaps it’s time for another dramatic transformation.

Before concluding my talk, I have been asked to specifically comment on possible impact of the three trajectories on the tri-lateral economic relationships. To do so, we should first consider where China is heading in the coming decades. The anticipation is that China will:

• Develop a greater consumer oriented economy
• Concentrate on higher valued manufacturing
• Reduce pollution and restore the damaged environment
• Place special emphasis on increasing availability of clean water
• Encourage more inland investments
• Increase regulatory transparency in banking and in securities market
• Improve the enforcement of intellectual property rights
• Improve efficient use of energy in cars, power plants, and others and develop alternative energy and coal gasification

One does not have to be a professional economist to see that each of the above represents opportunities for western technology and businesses and profitable participation while helping China accomplish its objectives. However, compared to the U.S., Japan enjoys certain comparative advantages that are difficult to overlook.

Japan is closer to China than America by about 10 hours in flight time. Common similarities in culture and language are leverage-able for Japan companies in China. I personally believe that many of consumer products developed for the Japanese market enjoy inside track in getting acceptance in China’s consumer markets.

There is a form of “reverse” outsourcing that Japanese companies may have not considered. Japanese companies are already outsourcing some IT related work to China but have they considered outsourcing call center work to young Japanese living in China? Some American companies are already hiring your Americans, Brits and Aussies living in Shanghai or Beijing to handle customer service calls. The advantage of this arrangement is that the expat in China get paid wages considered generous by local standards but still no where near an expat package of compensation. The irate customer gets to complain to someone that sounds right next door and not far away from India. The employer gets a good deal.

In my view, the biggest comparative advantage Japan has over American competition in China is Japan’s lack of a political agenda in dealing with China. Japan does not share America’s invasive zeal to judge how other countries honor human rights. Ordinary business transactions are not subjected to restrictive export control in such a way that it no longer becomes a transaction of equals but between adversaries.

Lastly, Japan is host to a large number of students from China. These students represent a significant resource to the future development of Japan if only Japan can figure out a way to recruit and keep them and let them know that they will be welcome to stay, and not as gaijins.

Since all of you in this audience are professional economists, I am sure you are aware that globalization leads to open markets. In trade, there is a buyer and a seller and the transaction has to be a fair deal for both. In other words, it has to be a win-win deal and such win-win arrangements have no impact and are not impacted by trade surpluses or deficits. There is nothing that says that each country must maintain a balanced trade with each bi-lateral trading partner. In fact, it is downright impossible to do so.

Ladies and Gentlemen, I apologize for prattling on like this. I touch on just some of the challenges of the three troubling trajectories but alas, I don’t have any sure fire solutions to offer. I do feel that these trajectories will keep China, Japan and the U.S. fully occupied for years to come without having to create artificial confrontations. Again I thank you for this opportunity to speak and I look forward to your questions and exchanging ideas with you. Thank you very much.