[Note: below is Chapter 17 from Great Wall of Numbers]
There are over 170 cities with a million people in China compared with nine in the US. By 2020 China’s urban population will reach 800 million, by 2025 there will be 221 cities with 1 million people and by 2030 there will be more than 1 billion people living in cities. While some of the build-outs may turn out to be unsustainable, McKinsey & Company estimates that 50,000 skyscrapers will be built in the next 20 years on the mainland, “the equivalent of 10 New Yorks.” In fact, one-third of all the 100 tallest buildings in the world are now on the mainland and one estimate suggests China will surpass the US in skyscrapers by 2017. And as China’s urbanization increases (crossing the 50% barrier in 2011, see Chapter 6), according to one argument – these people need to live somewhere. Thus numerous foreign architects, currently facing a soft labor market in the West have moved to the mainland, to design and construct a cornucopia of buildings including mian zi gong cheng (面子工程).
For example, it is a truism to note that nearly every country and political class around the world has erected shrines commemorating battles, people and events (e.g., monuments of grandeur, arches of prestige). In China, “face projects” are called mian zi gong cheng. While it could be argued that while the productive capacity of such projects range from practical to ‘hopeful’ (e.g., Three Gorges Dam versus the Great Wall itself), there are any number of modern day Pyramids continually being built in mainland China (and elsewhere). The reason it is arguably important to study these face projects is that they provide an insight to what Frédéric Bastiat called the “seen and unseen.” Or rather, what are the opportunity costs foregone in the construction of such edifices?
For example, the Pyramids in Giza offer a historical illustration of this principle in action. These Pyramids, while stunning cultural monuments, consumed vast quantities of economic activity that produced little in return. After a factory is built, it can be used to manufacture any number of products including consumer goods. Pyramids on the other hand, despite their timeless grandeur, are little more than a decorated tomb, a very large mausoleum. And while modern graves do provide positive sanitary spill-over effects (e.g., prevent the spread of diseases) it would be disingenuous to argue that the funeral industry is a productive long-term generator for any economy. Thus in an alternative timeline, what were other productive uses that the Pyramid materials and workers could have been used in?
And as Frank Shostak pointed out several years ago, while measured by some modern economic metrics constructing the Pyramids would have looked like a GDP boom (e.g., increased economic activity), the actual reality is that this kind of face project consumed several orders of capital without providing any in return. In short, it was a money pit with no tangible return-on-investment other than psychological feelings of “greatness.” And you cannot eat “greatness.”
What is the point of this history lesson? How does this apply to modern China? In Mark DeWeaver’s new book he discusses Fuyang airport located in Anhui:
Consider the city of Fuyang in Northeastern Anhui Province, for example. Located in a relatively remote location in one of China’s poorer interior provinces, the city originally had only a small landing field for flights to Hefei, the provincial capital. In the 1990s, the local government decided to “raise the city’s profile” by building an international airport. The original airport’s 400 meter runway was expanded to 2,400 meters (long enough for commercial flights to most Asian destinations) and a 7,200 square meter terminal and other amenities were built at a total cost of 320 million yuan.
In 2004, after being open only a year, the new facility had to be closed because there was not enough traffic to keep it operating. While it was finally reopened in 2008, as of the beginning of 2011 its website showed only three flights a day.
When I taught in Anhui I asked several students from the Fuyang area if they had ever used the airport. They said it was more practical to use the large train station because the airport only had flights to just a couple of cities (Beijing and Shanghai) during the day. While there is potential growth due to the population size (Fuyang itself is either the 1st or 2nd largest county in Anhui depending on which areas are included), this represents an unproductive asset that would probably not have been built in this location or time frame if left to market forces.
Is this an isolated incident or just a rare exception? Neither. According to the Financial Times, in 2010, three fourths of all airports in China lost money. In 2011, of the 180 civil airports in operation, more than 70% lost money. In fact based on research from Li Xiaojin, a professor at Civil Aviation University of China, an airport in China needs to handle 1 million passengers a year in order to turn a profit. Yet according to his estimates, 80% of airports do not hit this mark. And according to the Civil Aviation Administration of China (CAAC), these losses in 2011 amounted to more than $314 million.
How does any of this have to do with opportunities for foreigners?
Over the next five years an additional 82 new airports will open in part because policy makers see these losses as short-term pain. Yet this is not entirely without merit as this may just be a modern chicken and egg problem as airports are only useful if there are other airports that connect to them (i.e., the network effect). If recent trends hold, then the popularity of flying may make these projects more financially feasible. For example, over 270 million passengers flew domestic routes in China in 2011, up 70% from 2003 – and the International Air Transport Association projects “379 million will be flying domestically by 2014.” Furthermore, according to Reuters, in the last decade passenger air traffic has grown 14% a year, which is twice as fast as the growth in train travel. Thus despite the added competition from CRH (high speed rail lines) that have been seen as the main reason why domestic carriers have operated at losses for the last 3 months in a row (through January 2013), ultimately many of these airports may turn a profit. As a consequence, foreign airport designers may also find opportunities in China. For example, in building airports in western provinces like Tibet, foreign aviation consultants have been brought in to build transponder landing systems such as Automatic Dependent Surveillance-Broadcast (ADS-B).
Engines and cleantech
Another opportunity is avionics and engines. For example, the Aviation Industry Corporation of China (AVIC) is a large SOE with 400,000 employees which has set aside around $16 billion to build a new engine and may spend up to $49 billion on an even larger engine research effort in the next decade. And Commercial Aircraft Corporation of China (COMAC), another large aerospace SOE, recently announced that it has now had 380 orders for its domestically made C919 commercial jet. Yet because the nascent domestic aerospace industry has been unable to build and design a reliable jet engine to power the domestically made planes, foreign engine makers are expected to sell $100 billion in engines alone to China over the next 20 years. Domestic issues also present opportunities to foreign airplane manufacturers, who are expected to sell 5,000 airplanes worth more than $600 billion to Chinese airlines over the next 20 years, as well as to foreign pilots seeking flight time.
Because of retirement changes in their home countries that have extended the tenure of senior pilots, many junior foreign pilots have begun flying routes in China to accrue flight time. In fact, over the past several years, Chinese airlines have been actively recruiting pilots in the US, offering various perks and enticing several hundred so far. Thus, because of the growing pains on the mainland, there are numerous opportunities for foreign aerospace and aviation experts. In fact there are only about 6,000 pilots altogether on the mainland, half of whom are students or teaching in aviation schools. Yet more than 10,000 pilots are estimated to be needed in order to fill the demand as the industry expands. For comparison, in 2009 there were 594,285 active certified pilots in the US.
Again, as noted in Chapter 4, with more than 57 million inbound tourists in 2011, there is certainly potential for air-related services to cater to the growing tourism market. Yet how these domestic airports and airplanes are built, financed and maintained (public versus private) will have long-term consequences for the overall economy (as well as the local domiciles they are built in).
It is little wonder then that China produces and consumes more than half of all cement globally. It is also the largest producer and consumer of steel. And while the domestic market is fragmented, subsidized and unsustainable at local levels, one of the areas where foreign firms can find new opportunities is developing and selling “cleantech” to cement manufacturers. For example, as part of the 12th Five Year plan 10% of these cement facilities are set to use “cleantech” with a goal of reducing waste and emissions. As a consequence, Switzerland-based Holcim Group (one of the world’s largest cement producers) is beginning to sell its technology to mainland firms. According to Ian Riley, the head of Holcim Group in China, “[i]f you think about all those things that the Chinese government wants companies to do that require good technology and good management, there are a lot of excellent opportunities indeed for companies such as ours.”
Another example is Canadian-based Westport, a maker of heavy-duty truck engines that run on natural gas instead of diesel. While there may be some IT security issues that all firms should be aware of (e.g., see trade secrets in Chapter 13), Westport’s Q2 2012 sales increased 206% year over year, leading its CEO to note that, “I don’t think you can do anything but conclude that it’s very, very encouraging, and China is going to be a fabulous opportunity for natural gas over the next few years.” And based on an estimate from China Merchants Securities, the “cleantech” market in China is expected to be worth $473 billion by 2015. Furthermore, state owned oil majors and policy makers hope to replicate the natural gas boom in the US onto the mainland by investing heavily into fracking technologies to diminish the use of coal (see Chapter 19 on ‘air pollution’). Modern fracking is a method utilizing pressurized liquid to force and retrieve previously-hard-to-recover hydrocarbons (e.g. gas and oil) from rock and sand formations. In fact, one estimate by geologists is “the nation’s recoverable reserves at about 25 trillion cubic meters, on par with the United States.” Thus both foreign and domestic firms specializing in the natural gas segment (e.g., extraction, storage, transportation) may find new revenue streams in an industry that is expected to pump “6.5 billion cubic meters of natural gas from underground shale formations by 2015.”
In December 2012 I spoke William Song, a software engineer at TravelSky (中国航信). TravelSky is a state-owned enterprise based in Beijing that manages a computer reservation system that handles all of the airline travel data and increasingly others such as hotel and railways (similar to Sabre and Amadeus in functionality); or in industry vernacular they develop a global distribution system (GDS). According to him “we have a monopoly in the sense that we are the sole provider of information technology related to booking, reservations, pricing and ticket settlements on the mainland which we aggregate from airlines; we generate revenue every time an e-ticket is issued with partner airlines. Consequently, consumers using domestic online travel agencies (OTAs) such as eLong and Ctrip (the equivalent of Priceline) and Qunar (similar to Kayak) indirectly utilize our system in booking their air travel.” In 2011 TravelSky generated $589 million in revenue compared with Sabre and Amadeus who together generated more than $6 billion in revenue during the same period.
The way GDS systems like TravelSky work is, “basically for each passenger that boards a flight, the airlines pay a ‘booking fee’ to our company (like a commission). In return the airlines use our system to distribute flight information and ticket prices to travel agencies and airports that can use this information to provide services to passengers. In other words, when you buy a ticket and use it, all of the flight logistics information systems behind it are managed by our company. From a technical standpoint these databases are huge considering the size of the current industry in China and that it includes the data for all procedures of the whole journey. Yet because we were originally a department of CAAC (Civil Aviation Administration of China) we still maintain close ties to the indigenously made software stacks. Thus one of the challenges for both domestic and foreign companies that have experience making this kind of software is that in the short-run there will not be a second or third company like us, so there are not many opportunities for their expertise. In fact, all of the SOEs which have monopolies over their respective industries such as rail, gas and telecom have other SOE companies like us to help them develop and restore the data.” And this is where ancillary services and business models can be built for, such as fulfilling the needs of travel agency owners.
In March 2013 I spoke with David Tang the owner of a travel agency in Guangdong. According to Tang, “one of the challenges created by TravelSky’s monopoly is that their interface is very dated – it uses a command-line style system reminiscent to DOS. As a consequence, travel agencies around the country hire outside vendors to develop easier-to-use front end software packages that hook into TravelSky’s system. My company has been around for more than five years and we have spent at least 100,000 RMB ($15,000) this past year to work with a vendor in Shenzhen to develop a customized interface. Ctrip and other agencies have also built their own systems. Thus one of the business opportunities is to provide the hundreds of travel agencies around the country with customized interfaces to work with TravelSky’s databases. In addition, foreign GDS systems like Amadeus have begun to be used on the mainland as a way to book hotels and I predict that at some point the government will allow foreign competition to take place in the GDS field with airline bookings as well due to the fact that foreign technology is probably 10 years more advanced than the domestic GDS capabilities.” Ctrip is publicly listed on NASDAQ and is the largest OTA in China, with 36 million hotel bookings and 30 million flight tickets handled through their system annually.
While Tang’s last point is speculation, William Song suggested one future business opportunity may come from opening this up as well. Song noted that, “I think that OTA aggregation services which are easy to use and can eventually utilize our data can make a small fortune. For example, apps for smartphones which can aggregate destination times and prices no matter where you are. Both incumbent and start-up travel agencies will be able to use AI robots (or ‘spiders,’ a program that can collect data) to recalculate information and provide services and metrics to the end customers. For example Qunar is one such domestic start-up, whose founding team came from Kayak. Even though the real time flight information is stored in our database, direct access to this is usually unneeded today because we continuously distribute the flight information directly to airlines and OTA’s who in the future can be scanned by the AI robots for use by other services such as smartphone apps. Or in other words, eventually 3rd parties can use robots to crawl through our databases or our partners’ databases to collect information. Thus there are opportunities for new competitors in this segment.”
Rails and a paddle
As I mentioned in Chapter 9, when I first arrived on the mainland four years ago, I spent time sight-seeing in Shanghai before moving to Bengbu. And as I mentioned in Chapter 4, my initial encounter with proficient English speakers colored my view of the populace (e.g., selection bias, see Chapter 9 about EFL). Similarly, the trip to Bengbu itself skewed my view on economic developments on the mainland because the trip was done on a new high-speed train traveling at 300 kilometers/hour. It took approximately 3 hours, a journey that just 10 years ago would have taken half a day on older rolling stock. At the time I wondered if other travelers on the mainland had similar access. The short answer is yes, the longer answer however dovetails into mian zi gong cheng and opportunities therein.
Two years ago a broker friend at Morgan Stanley similarly asked me what my perception of the high-speed rail network was, “Have you ever been on one? Are they packed and profitable?”
Like many public projects, the high-speed railway system (CRH) began with objectively good intentions: build a state-of-the art transportation network capable of connecting and bringing commerce to all corners of the mainland. Yet as Ludwig von Mises showed, such centrally managed plans cannot efficiently achieve the stated goals. Similarly, the Railway Ministry is now massively indebted in part because in its push to build a 20,000 kilometer nationwide high-speed rail network, subpar materials were used in certain sections and billions have been siphoned from the budgets via corruption.
As I mentioned in Chapter 10, in their bid to build rolling stock for the CRH project a Japanese consortium of locomotive and rolling stock designers (the same ones that built the Shinkansen) were edged out of the mainland market by the very technology they had designed and transferred to CSR, a domestic SOE that now builds half of the rolling stock. While it might be assumed that with this “free technology lunch” that the CRH project now gained would have resulted in fewer long-term costs, the reality is that building a rail network – as in any country – requires significant capital expenses for land, labor, tracks, ties, signal boxes and electrical conduits. Similarly, because the state effectively still owns all land (e.g., private individuals can lease land from the state for 50-70 years, after which time it reverts back to the state), it might be assumed that property costs would reduce the bottom line. Yet again, the assumption is incorrect.
In February 2011, Liu Zhijun, the railway minister was fired amidst a probe that alleged a variety of bribery and kickback charges. Upon investigation, one case mentioned by the National Audit Office noted $28 million that “was misappropriated by individuals or companies involved in building the Beijing-Shanghai high-speed railway.” And as Evan Osnos, a reporter for The New Yorker, recently described this was not an isolated case. For example, another account from the National Audit Office found on the accounting books of a SOE a “sixteen-million-dollar “commission” to an intermediary in return for contracts on the high-speed rail.”
This was only the tip of the iceberg as Osnos’s research found that this public-works project eventually encompassed payouts and bribes that are still being uncovered; amounts that dwarf those listed above:
Like many others, Ding knew something that government auditors uncovered only later: China’s most famous public-works project [the Railway] was an ecosystem almost perfectly hospitable to corruption—opaque, unsupervised, and overflowing with cash, especially after the government announced a stimulus to mitigate the effects of the 2008 global financial crisis. It boosted funding for railway projects to more than a hundred billion dollars in 2010. In some cases, the bidding period was truncated from five days to thirteen hours. In others, the bids were mere theatre, because construction had already begun. Cash was known to vanish: in one instance, seventy-eight million dollars that had been set aside to compensate people whose homes had been demolished to make way for railroad tracks disappeared. Middlemen expected cuts of between one and six per cent. “If a project is four and a half billion, the middleman is taking home two hundred million,” Wang said. “And, of course, nobody says a word.”
While the investigations are still ongoing, by one account former Railway minister Liu had taken a “4% kickback on railway deals,” another estimate suggests he netted $152 million. Zhang Shuguang, former deputy general engineer of the Railway ministry reportedly embezzled $2.8 billion into US and Swiss banks. All told the Railway Ministry is in debt by at least $330 billion and posted a loss of $1.4 billion in the first half of 2012.
How did it get to be this size? The Rail Ministry in China was essentially an autonomous entity – with its own schools, hospitals and until recently even its own judicial system – that only had to answer to itself. And as a consequence and as part of a major revamp implemented by the new Xi administration, the Rail Ministry is now being split up, with the Ministry of Transport taking over the railway construction and network planning. The operational units of the Rail Ministry will be spun off and separated into a new state-owned enterprise managed by the State-owned Assets Supervision and Admission Commission (SASAC).
This is not to say that corruption, bribery and kickbacks do not occur in other countries, nor am I suggesting that this scandal will doom the Chinese growth story or that the high-speed railway network will never be completed. Rather, I am citing this to be even handed, to show that just because planners come up with “big hairy audacious goals” this does not automatically translate into instant successes.
In fact, Mark DeWeaver’s book cites dozens of such stories including several others like the Loudi “White House” and a half dozen amusement parks built by local governments which gone bankrupt. Many Olympic venues alone from the 2008 Beijing Summer games have gone into disuse and several have been demolished.
Despite $141 billion in investments and another $134 billion approved for future expansions, none of the nearly two dozen subway metro systems on the mainland is profitable. This is not to say that these subway systems do not generate substantial revenue. Rather they do not generate enough revenue to cover their expenses (i.e., they are operating at a loss). And because some projects may not provide enough return on investment to maintain the capital stock some party or multiple parties are subsidizing these activities. For example, only one of Shanghai’s lines is profitable. Beijing’s metro will post a loss of about $150 million in 2012. And Shenzhen’s metro charges an average of 2.8 yuan per trip yet the actual costs are 5.9 yuan per trip. According to The Atlantic one of the reasons it is costly is that “[a]t 500 million yuan per kilometer, or about $80 million, their pricetags are not that much cheaper than they are in Seoul, where wages are much higher.”
Similarly last year the Los Angeles Times detailed a number of other face projects built by local governments, that while creative and innovative – such as a $44 million hotel designed to look like a ping pong paddle – ultimately produce little in terms of sustainable economic activity. The one silver-lining for foreigners is that the demand for Western educated architects can be high in certain provinces, especially for those willing to work on mian zi gong cheng. In fact, according to industrial designer Michael Young, “China will produce as many world-class designers as Japan within 20 years.” Notable examples include Wang Shu, who won the 2012 Pritzker Prize, the world’s top prize in architecture. Thus foreign architects may find new opportunities in training and working with domestic firms on a variety of projects over the coming decades.
In an era of a closed capital account and relatively cheap public capital (as discussed in Chapter 5 and Chapter 10), both of which incentivize capital consumption and fixed asset investment, these types of cases will probably continue into the foreseeable future. All told these projects and other local government financing vehicles (LGFVs) that received stimulus funds since 2009 account for approximately $5.4 trillion in loans. Despite the ban on municipal bonds (see Chapter 10), these LGFVs issue bonds called chengtou which are traded in secondary markets. Andin 2012, 942 billion RMB ($150 billion) of chengtou bonds were issued by these LGFVs. Thus experts in debt restructuring may be able to do consulting for local banks when publicly traded bond markets become a reality. And one advantage of having a publicly accessible bond market is as Shawn Mesaros mentioned to me, “domestic banks could then become facilitators. They could offload debt and focus on value added services, creating new investment vehicles which allow for diversification.” Another advantage is that a bond market would allow for liquidating non-performing loans and spread and distribute risk away from “too big to fail” financial institutions.
And as mentioned in Chapter 5, foreign experts in debt structuring may find new opportunities on the mainland due to this ongoing business cycle. For instance, foreign firms specializing in managing distressed loans such as those used to finance the construction of tech parks, have already capitalized on opportunities on the mainland (with mixed results), including Shoreline Capital Management who raised $300 million for a new fund last year specifically to invest in distressed Chinese debt.
Another opportunity, although probably out of the reach of most SMEs and entrepreneurs is what Siemens has provided to several mainland subway systems: propulsion systems. Under several different agreements, Siemens has sold equipment packages that include gearboxes, auxiliary converter units, traction motors, traction converters and train control systems. In fact, as of 2010 Siemens maintained 90 operating companies and 61 regional offices in China alone across all of its divisions (including healthcare and energy). It has 30,000 employees on the mainland, generated $8.4 billion in revenue from China in 2012 and “nearly 90% of its raw materials and semi-manufactured goods are purchased from the Chinese local market.” This is part of an effort to develop and install their mobility technology which is used and deployed in nearly a dozen mainland metros and railways. Thus irrespective of the long-term financial sustainability of metro expansion plans, there may still be opportunities in the short-term for foreign component manufacturers in this sector.
Yet a word of warning. During California’s requests for bids in 2011 for a proposed high-speed rail project (HSR), Chinese firms offered to help build it. However the technology that Chinese firms were planning to build the HSR infrastructure (cars, signals, gearboxes) are all based on technology transfers from Siemens, Kawasaki and Bombardier. Thus the foreign firms found themselves competing with their very own technology as China now tries to build HSRs in other countries. This turn of events resulted in a series of press releases and some protests, yet subsequently both Siemens and Bombardier continue to transfer technology and sell equipment to Chinese firms. Be sure to speak with an attorney (see Chapter 10) before transferring any technology.
Takeaway: There are some opportunities for foreign firms and individuals that want to participate in the airline and aerospace industry as well as a number of opportunities for foreign architects. However, while it is impossible to predict what the exact opportunities forgone in the construction of these face projects are, we do know that ceteris parebus, that there are other productive choices that market forces would have gravitated towards instead (e.g., allowing capital to accumulate instead of being consumed). And as a consequence, the countless face projects dotting the mainland arguably act little more than a weight, a drag on overall growth. What other productive uses could both the skilled and unskilled laborers that built these uneconomic airports, railways, amusement parks and stadiums been used in instead? The answer to that is left to the imagination of the reader.