In prior posts I touched on the notion of China having an industrial policy intended to foster the development and growth of world class technologies developed and produced by Chinese companies. The execution of this none-too-surprising strategy is founded, I believe, on a three step serial process of "import needed technology," "partner with western players and co-manufacturer" and ultimately "reinnovate" on wholely owned domestic platforms once necessary know-how and expertise is "in country."
Yesterday we had another hint of this policy in action. Having now established itself as a manufacturing base for composite components for the commercial airline industry, the head of aircraft development has now called for China to design and manufacture a homegrown jumbo jet. With an estimated 4,000 planes needed in the next 20 years, it appears China wishes to make sure the local players benefit rather than the western aircraft makers.
As China's economy continues to move upscale in the coming decades I expect to see additional examples of national innovation policy to play out in other basic manufactured goods markets, be it steam, wind or gas turbines or electricity grid infrastructure components or other basic building blocks of mass transportation systems, water purification or environmental control industries.
I suspect western players who keep "the secret sauce" in the west will find themselves under increasing pressure to "share" with their Chinese manufacturing partners. This will be an interesting dynamic to observe as the west works to protect western developed innovation from a "give it to us because we need it to grow" mindset. Rational and profitable sharing is one thing. Having western innovation subsidize accelerated development in China on non-economic terms is something complely different.
Several weeks ago the Chinese government thundered relentlessly about how the RMB was fairly valued and how the US financial problems have nothing to do with the RMB and everything to do with bad US trade policies. Listening to the Tiananmen noise machine is like listening to the Cheney Cabal – facts are rewritten, ignored and reinterpreted as necessary. So, with all the noise about how “China will not be told what to do…” it appears the central government has undertaken a financial stress test of industry to ascertain the impact of a revaluation. Surely such actions have been taken outside the public eye. Yet, in this case, it was published as news. If China is so insistent about not revaluing the RMB, why then make public a stress test in preparation for such an action? Certainly commentary from Congress about drafting legislation that will serve to force the Treasury to brand China as a currency manipulator might be causing some anxiety here. Ambassador Huntsman appears to think an improved understanding on RMB valuation will be forthcoming.One of the Chinese arguments against revaluing the RMB is that it will “hurt America” from the perspective of all our cheap stuff will no longer be so cheap. True. Further, many US companies with Chinese operations would experience adverse financial impact. Again, quite possible. What do western businesses do when “local” business climate becomes inhospitable? They move. “ Good morning Vietnam” and “Hello India!” are possible strategic responses. Now think about the SOE “squeeze out” or “national champion” problem I mentioned above combined with a (I think necessary) revalued RMB. Sure seems like China could end up loosing a lot of business activity to other emerging economies. In order to offset that reduced export oriented business, Tiananmen is going to have to pull quickly a lot of very harmonious rabbits out of their hats to shift a savings-oriented society into a rapidly consuming society. Do we see tax cuts/benefits and other incentives offered to manufacturers who might leave in response to a revalued RMB? Stay tuned.
Here in China, $$$ - Money and, of course, the attendant power and influence.
Regarding the quality of emerging cleantech companies (private and public), concern was expressed over maturity issues. Once one moves below the very top tier Chinese players., the vast majority of businesses are perceived as having one dimensional business models. This brings two points to mind. For private companies, any western partner (operational, technical or financial) will have to assess how capable the incumbent management can plan and orchestrate change. Here in China, a westerner will not have the lever of majority control to force change, thus careful assessment of management and their comfort with expanding the business models will be more challenging than in the west.
Now, on to more topical matters. The most disturbing matter that arose from the discussions relates to state owned enterprises and how they can destabilize the nascent cleantech sector for profit-oriented participants.
A state-owned enterprise (SOE) has the economic might of the government balance sheet behind it. These are the major electrical companies, grid operators and much of primary industry. Despite the word “enterprise” being in their name, as government funded entities, they do not manage to profit, but rather manage to policy and politics.
So what happens when an enormous player enters a market and does not care if they make or lose money? Bad things happen. Profit-oriented capital is driven out as returns plummet once the SOE’s flood the sectors with significant amounts of poorly invested capital. In fact, one seasoned project developer in the biomass area noted that returns in regions where some SOE’s have decided to bid for waste streams (eg, inputs into biomass projects) have already eroded to 8-10% levels – hardly worth the risk!
Many of the biomass projects are still developed bilaterally between project developer, waste stream supplier and power customer. If the development of biomass moves toward an open bid procurement process, one developer with 1GW scheduled for completion in the next 18 months, noted they will exit the China market once those projects are online. The parallel to the semiconductor industry was drawn in describing the economic scorched earth that might arise from an SOE acting non-economically. When a semiconductor fab finds excess supply in the market, pricing for product rapidly falls to marginal cash costs and in some cases, lower, simply to cash depreciation expenses. With an open bidding process where the fat SOE wallet can wreck the biomass supply chain economics (eg, paying too much for garbage, agricultural waste etc.) will ensure that profit-motivated capital will flee.
The wind sector was pointed to as another example of this problem of non-economic development behavior by some local investors. The wind story is a bit more complex, though, because national incentive policies are poorly crafted: while a developer is incented to build a project, those ever clever lads in Zhong Nan Hai forgot to make sure the incentives were only paid when wind assets were connected to the grid. No solar power PV or solar thermal observations were offered on this topic. With solar deployment a tiny fraction compared to wind deployment, perhaps we have not yet reached the scale for SOE’s polluting the pool.
So how does real estate fit into this story? Note well that the SOE’s are primary actors in orchestrating national economic policy. Further, much of the huge stimulus spending the central punch bowl tenders poured last year ended up on the ledgers of the SOE’s. I have commented before on the bubble-like trajectory of real estate prices. This past week, the central government noted that perhaps the SOE’s had overdone it in the real estate sector, paying silly prices for land and buildings. Recall that much of the land bought for development (by the SOE’s and other players) is purchased from….. the provincial or city governments! The political “sellers” are happily enjoying rich sales prices paid by silly buyer-developers. Once the buildings are completed and flogged to investors, everyone stands around bemoaning high prices. Thus, it appears the state-owned enterprises’ real estate ambitions appeared to have mucked up that market. The central government notes that of the 94 state owned enterprises, only 16 of them have business models where “real estate” development is a core business. In other words, 78 SOEs (83%) appear to have been “investing” in real estate. The central government has said these 78 must now restructure and exit the market as one step needed to quench the speculative fires in the real estate sector.
“Will they or won’t they restructure?” or “how long will it take?” are questions I cannot answer, but let me offer a few interesting thoughts. While the SOE’s are powerful, they are also organs of the state and thus, I think, will generally drift in the direction Zhong Nan Hai directs. I suspect many of these businesses will turn to their core operations and figure out how to invest. This is likely, I believe, to result in the SOE’s becoming more visible in greentech development at both the manufacturing and project levels. If this plays out, venture and project investors should be concerned. If the SOE’s are investing without regard to return, the sectors could prove to be rather frustrating.The reason I worry about this possible situation is because there is a greater awareness that China is actively pursuing a “national champion” strategy for technology development. This is a country that is very sensitive to being dependent on any external party. Planning here appears to include making sure there are as few levers as possible in the hands of western players or governments that can be used against national policy or “the Party.” While an SOE may increase investments into developing businesses closer to core operations, it may also form partnerships with foreign enterprises where either technology or know-how is needed. These partnerships may appear as quite attractive given the political clout of the SOE. Yet conference participants shared general observations that “partnerships” are temporary things from the Chinese perspective and that once the Chinese feel the minority western partner can be forcibly “bought out,” such exits will happen quickly. I believe the Chinese will seek to develop their own alternatives to “necessary” IP a partner may bring and that “local content” in both technology and project development will always be treated favorably as a matter of national policy. These nationalistic tendencies, if they unfold as many fear, could put quite a chill on greentech sector investment and development here in China.