Part 1 - Understanding a Trade War Between Australia's Biggest Investor and Australia's Biggest Trade Partner

This is the first in a series of articles that will ultimately look to explore the potential impact, both short and long term, of a trade spat between Australia’s largest investor and Australia’s largest trade partner. This installment looks at the way business is done in China; an important dynamic to understand in order to truly examine the impact of a trade war on Australia and the broader global economy.

​After a big start to the year on all global share markets, we seem to be back to a sense of déjà vu with the headlines for past fortnight again dominated by escalating trade tensions between China and the USA. Although it is beyond the limits of our intellect to fully understand what is driving the latest bout of Trump tweets and the Chinese government's response to it, we thought it might be pertinent to revisit the topic given the far-reaching consequences this spat could have. This article will be the first in a series of articles that try to grapple with this evolving context and to elucidate what the follow through implications might be for both local and global markets. 

As the old Munger saying goes ‘show me the incentives and I will show you the outcome’ and so we shall use that adage as a foundation to understand just where this latest spat might lead. In doing so we will try and give our take of what exactly it is that is motivating the actors in this unfolding drama.

Business - Chinese Style

We begin our story not, as you might expect, in the power corridors of Beijing or Washington but in a little known town called Muscatine, Iowa. It is here that, in 1985, a little known but up-and-coming communist functionary by the name of Xi Jinping led a delegation of officials to look into farming technologies. Boarding with a local family, Xi spent his days keeping a relatively low profile and gaining a first-hand taste of America. Fast forward three decades, this little known town was at the forefront of Chinese largesse with officials showering the town and state at large with gifts, ranging from delegations, to skyrocketing Chinese student enrollment at the university to free shows from touring Chinese orchestra’s. Indeed the family home where he stayed was later turned into a museum and the owner of the room he stayed in who was at the time away in college now works as a consultant in Beijing helping listed American companies do business in China. The reason? Simple, the little known up-and-coming functionary is now the General Secretary of the Communist Party and perhaps the most powerful leader of China since the time of Chairman Mao. 

Chinese President Xi Jinping and Iowa Gov. Terry Branstad raise their glasses in a toast at a State Dinner at the state Capitol in February 15, 2012.

​The above story is an almost perfect illustration of day-to-day business ‘Chinese Style’. Where patronage is key and reciprocity is everything. From a business perspective consider the story of Chery Automobile, one of the largest Automobile manufacturers in China and its largest auto exporter. Its story tells the story of Chinese industriousness but also how and why the evolving trade tensions are unlikely to be short-lived. 

Chery Automobile - The China Way

We were first made aware of how Chery evolved from a speech by Professor Hsieh at the University of Chicago. In his speech he illustrates the point of how China defies all the logic of neo-liberal economics in the sense that it remains low on ease of doing business, red-tape remains high and market inefficiencies are rampant and yet despite this, the growth of the past few decades has been nothing short of miraculous. His contention is that their success was contingent on single-minded co-ordination the likes of which is hard to fathom the western context. 

The example he gives is of government within a local city where everyone from the Provincial Secretary of the Communist Party, the Mayor, the Vice-Mayors and down the hierarchy actively look for quality prospects in the form of foreign and domestic businesses. Each official then becomes effectively a political liaison. With a finite set of businesses allotted to each, they then ensure that said businesses have everything they require in order to do business. Think of it like an Amazon-like tax deal in the USA (where large corporations have states compete with each other in order to invest). In this complex hierarchy of patronage, various interests are arbitered by the seniority of the official that is providing the patronage. That is to say, if one company’s interests are at odds with another then the company with connections to a superior official would have primacy and so on and so forth until one reaches the very top of the food chain so to speak.

It is within this context that Chery started off from its infancy as a small manufacturer to become a behemoth in the automobile space. When car manufacturing became a priority for the party in the early 90’s, one of the very first companies to play within the space (in fact, only eight companies were allowed to manufacture at this time) was the Shanghai Automotive Industry Corporation (SAIC). Granted a virtual monopoly within its own city, SAIC which is majority owned by the local government embarked on a project with General Motors to manufacture and sell cars in the domestic market. GM, which up until then was a non-entity, saw a lucrative opportunity to not only enter into a virtually untapped market but also to do so with monopoly rights, which they were granted. In return, SAIC pinned its hopes of gaining manufacturing expertise and know-how. 

GM went on to take their least marketable cars such as the Buick New Century and dump them in the local Chinese market with exceptionally profitable results. However, in the early 2000s things turned sour when a local Chinese manufacturer by the name of Chery (a play on Chevy) quickly gained market share by replicating one of its models.

What had happened? It seems that a young entrepreneur previously working for a state-owned corporation had combined forces with the vice-mayor of another locality to create a local competitor. The city of Wuhu which up till then had been practically unknown was set to become a manufacturing hub thanks to these enterprising individuals. 

The young entrepreneur by the name of Yin had reached out to the Vice Mayor of Wuhu in the hope of building an automotive company. They, in conjunction with Volkswagen, which at the time (as part of their input) granted the rights to use one of their unused manufacturing plants in the mid-west of America, started initially building engines. Yin not only travelled to the plants in the US and Spain but dismantled them and replicated them in Wuhu where they had applied for permission from the government. 

When senior officials refused permission for the manufacture of cars given their strategic importance and the fact that agreements had already been made, the gentlemen decided to take a classic land and expand approach. They initially started with subcontracting for the manufacturing of engines and gradually applied for sales within the local city which they were granted. Eventually in order to make the enterprise viable they then made an agreement with SAIC in return for a 20% stake whereby they would circumvent the regulations by piggy-backing off SAIC production licenses. Eventually they had the ability to market and sell cars all over China with the exception, of course, of Shanghai! Though there are no regulations making it illegal to sell in Shanghai, the nature of local business means that JV partners of the local government tend to have an advantage. Just as Volkswagen does in Beijing and Toyota in Shenzhen (where the local governments have their own JV’s with those players). 

The story of Chery just about sums up the issues for American corporates in China. Though it presents a lucrative opportunity it is also filled with hurdles. Not the least of which is the patronage system itself. Where business is not external to the state but is expected to work towards the outcomes the state desires. Where local government officials try to prove themselves and stay upwardly mobile by deferring to their superiors and ensure that the companies they sponsor do well and achieve the goals that are set forth by their higher ups (whether GDP growth or employment numbers). Where bureaucrats try to vie for attention by seemingly impromptu demonstrations of deference like giving largesse to a town that resonates with their leader. 

It is important to understand this dynamic before one attempts to understand the broader implications of the external pressures currently being placed upon and threatened on the Chinese economy. As such, this was the logical starting point of a series of articles that will ultimately look to explore the potential impact, both short and long term, of a trade spat between Australia’s largest investor and Australia’s largest trade partner.