Reshaping China’s Government-Services Supply Chain

Andrew Sheng, Xiao Geng
12 November 2012

HONG KONGA supply chain links producers and consumers through a complex web of outsourcing contracts, with market leaders in any product category orchestrating activities to produce components profitably along its entire length. For example, an iPad is designed in California – with chips from Japan and parts from South Korea, Taiwan, and elsewhere – and finally assembled in China for global distribution. But the ecology of supply chains is not as straightforward as this depiction suggests.
Most studies of supply chains examine their operations, but take for granted governments’ critical enabling role. Because the non-delivery of government services would inhibit the proper functioning of business supply chains, understanding how the government-services supply chain works is vital.
For example, the Chinese economy’s transformation was enabled by the synchronized delivery of government services to support the logistics, finance, and manufacturing supply chains. This was a complex task that involved different levels of the Chinese government and many state agencies and ministries.
A supply chain is not only a network for production, but also a live feedback mechanism, continually adjusting itself to ensure that production is coordinated and aligned efficiently to meet changes in global consumers’ demand, tastes, and preferences. Technology has enabled faster, more efficientjust-in-timedelivery, taking full advantage of specialization and knowledge-sharing on a global scale. As Apple has discovered, the winner in orchestrating a supply chain emerges with the lowest global costs and the largest market share.
The iPad could not be produced at such high speed and low cost without the “made-in-the-worldsupply chain based in China. In addition to the macro and micro aspects of economics, understanding supply chains in private and public goods and services in China requires mezo (institutional) and meta (system-wide) analysis.
When China initiated its economic reforms in 1979, it inherited a centrally planned economy that lacked the institutional infrastructure for markets. Recognizing the need for systemic change, China allowed local governments in special economic zones and cities to experiment with modern legal, administrative, and logistical practices for export industries, including investments in utilities and transport.
Intense competition among local governments for foreign investment led to dramatic improvements in the business environment, featuring economic incentives in areas like land, labor, and taxation, as well as speedy issuance of permits and approvals. City leaders were given responsibility for mobilizing local resources to generate GDP and employment, and they were (and continue to be) rewarded with promotion for good performance.
The result was considerable innovation and institutionalization of local government services to support market activities, including outsourcing of expertise in infrastructure project design, administration, and operations to private and foreign consulting and design companies. To support China’s participation in global manufacturing supply chains, many local governments sold and dismantled their state-owned enterprises (SOEs), enabling many new private firms to provide the services needed for an export-oriented, market-based economy.
At the national level, the consolidation of SOEs and banks, and the modernization of their corporate governance via public listing on stock exchanges, enabled improved efficiency in regulated utilities, hard infrastructure, and resource sectors, complementing liberalization and market growth.
The Chinese government-services supply chain also benefited substantially from a meritocratic human-resources tradition. Officials with substantial and successful experience in local governments, ministries, or SOEs were deliberately promoted and cross-posted to less-developed regions to spread know-how, technology, and best practices and processes. Indeed, China’s economic success reflects the depth of administrative and market experience embedded in the Chinese bureaucracy. Chinese mayors are CEOs of their local economy, responsible not only for market development, but also for social stability.
The critical mechanism for orchestrating and implementing the complex web of contracts embodied in China’s government-services supply chain is the Five-Year Plan, which foresees vertical and horizontal integration of almost all Party and administrative agencies. The FYP uses broad objectives and targets for social and economic development, formed after extensive internal and public consultations. These mandates are translated by sub-national officials into projects and work plans, such as targets for reducing energy use per unit of GDP in order to address resource constraints and concern about climate change.
China’s success in developing from scratch a modern government-services delivery system explains why many foreign investors find it much easier to deal with Chinese governments than those in other developing countries.
The 12th FYP aims to shift China from an export-driven growth model toward a balanced economy that relies on domestic demand, while simultaneously addressing industrial transformation, social inequities, and environmental degradation. This implies more complex contracts that go beyond promoting markets, GDP growth, and employment to ensure inclusive, equitable, and high-quality government-services delivery. Implementation of these evolving social goals through local government agencies by specific officials is a daunting task that requires profound changes in roles and performance metrics.
No one doubts that Chinese local governments play a much more active and intrusive role than their counterparts in the West, which implies an additional complicating factor. Local governments now face not only growing demands from the emerging middle class for greater transparency, competition, fairness, and access to opportunities, but also deepening conflicts between local interests and global rules.
Orchestrating a complex government-services supply chain in a substantially open continental economy with 1.3 billion people and five levels of government is difficult enough using a simple GDP growth objective. Adapting the governance metric in a country of China’s size to an economy that is green, inclusive, and equitable presents a novel challenge in human history. The only precedent for such an achievement is China itself.
Copyright Project Syndicate - www.project-syndicate.org

November 12, 2012 7:53 pm

How the US can avoid falling off the fiscal cliff

I have fond memories of summer trips to Perkins Cove in Ogunquit, Maine – for lobster yes but also for the scenery along Marginal Way, a narrow path along a cliff by the beach. Getting down to the pleasant waters requires navigating a narrow path down the rocks.

And so it is, figuratively speaking, with tax policy and the fiscal cliff. A sensible approach can lead us to the water: less uncertainty and stronger growth. But we must first define the path, then find the way down.

US policy makers must begin by realising three points. First, raising revenue is about raising average tax rates, not marginal tax rates, as Barack Obama’s campaign suggested. Higher marginal tax rates distort behaviour and reduce activity.

There are ways to raise revenue without increasing marginal rates. Tax deductions should be scaled back, especially in the areas of mortgage interest, charitable giving and employer-provided health insurance.

Second, tax increases should form only a modest part of the approach to deficit reduction, given the urgent need to curb spending by the federal government. Since the financial crisis, federal spending as a share of gross domestic product has been elevated by as much as 4 percentage points relative to its long-term average.

The Congressional Budget Office long-term forecasts suggest this elevation will persist. Indeed, the CBO forecasts that spending on social security and Medicare could rise by 10 per cent of GDP over the next 25 years.

Third, fiscal consolidations are less detrimental to growth when they are overwhelmingly about tax reform and spending reductions, particularly cuts in transfer payments, according to academic research by Alberto Alesina and Silvia Ardagna.

So given these three points, what should those negotiating the fiscal cliff do? The first step is to raise average (not marginal) tax rates on upper-income taxpayers. Revenue increases should first come from these individuals. This means closing loopholes. For instance, the Bowles-Simpson commission, which Mr Obama established, has proposed limiting tax preference benefits for upper-income households. Also, Martin Feldstein of Harvard University and Maya MacGuineas of the Committee for a Responsible Federal Budget have suggested caps on the amount of deductions relative to a taxpayer’s income. These ideas are good places to begin.

The second step would be to agree to a package of expenditure reductions to occur over the next 10 years. These would include decreases in the growth of defence and non-defence discretionary spending. Gradual increases in the retirement age for social security benefits will also be important.

The third step is both fundamental and difficult: it is to realise that a strategy of “taxing the richcannot pay for the entitlement state. If we wanted a larger government as a share of GDP, we would have to raise taxes substantially on everyone.

The present tax system can raise at most about 20 per cent of GDP in a booming economy. A government of, say, 25 per cent of GDP cannot be paid for by changing rates in such a system. The distortions would be too great. Rather, as in most other advanced economies, a universal consumption tax would be required. (Such a tax would also enable reductions in individual and corporate income tax rates.)

An alternative routesuperior from the perspective of growth – would be to reduce benefit expenditure over time for the non-poor. This would allow for both a lower tax burden and for investments in education, research and development, and infrastructure. These are political choices and it is important that our leaders be candid. Mr Obama cannot argue that we can right the fiscal ship simply by taxing the rich.
Republicans cannot argue for low tax rates without being clear about where cuts must come from.

These steps are not dependent on a “grand bargain” by the lame duck Congress or on sweeping reform in early 2013. But they do represent a map for how the US can once again begin to find its fiscal way.

The writer, dean of Columbia Business School, was chairman of the Council of Economic Advisers under George W. Bush and an adviser to presidential candidate Mitt Romney

Copyright The Financial Times Limited 2012

Is Finance Too Competitive?

Raghuram Rajan

12 November 2012

NEW DELHI Many economists are advocating for regulation that would make bankingboring” and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition. During the Great Depression, the head of the United States National Recovery Administration argued that employers were being forced to lay off workers as a result of “the murderous doctrine of savage and wolfish competition, [of] dog-eat-dog and devil take the hindmost.” He appealed for a more collusive business environment, with the profits made from consumers to be shared between employers and workers.

Concerns about the deleterious effects of competition have always existed, even among those who are not persuaded that government diktat can replace markets, or that intrinsic human goodness is a more powerful motivator than monetary reward and punishment. Where the debate has been most heated, however, concerns the effects of competition on incentives to innovate.

The great Austrian economist Joseph Schumpeter believed that innovation was a much more powerful force for human betterment than was ordinary price competition between firms. As a young man, Schumpeter seemed to believe that monopolies deaden the incentive to innovate – especially to innovate radically. Simply put, a monopolist does not like to lose his existing monopoly profits by undertaking innovation that would cannibalize his existing business.

By contrast, if the industry were open to new players, potential entrants, with everything to gain and little to lose, would have a strong incentive to unleash the waves of “creative destruction” that Schumpeter thought so essential to human progress. In a competitive industry, only paranoid incumbentsthose constantly striving for bettermenthave any hope of surviving.

As an older man, Schumpeter qualified his views to argue that some degree of monopoly might be preferable to competition in creating stronger incentives for companies to innovate. The rationale is simple: If patent protection were limited, or if it were easy for competitors to innovate around intellectual property, a firm in a competitive market would have very little incentive to invest in pathbreaking research and development. After all, the firm would gain only a temporary advantage at best. If, instead, it withheld spending, and simply copied or worked around others’ R&D, it could survive perfectly well – and might be better off. Knowing this, no one would innovate.

But if the firm enjoyed a monopoly, it would have the incentive to undertake innovations that improved its profitability (so calledprocess innovations), because it would be able to capture the resulting profits, rather than see them be competed away. A “boring bank, shielded from competition and knowing that it “owns” its customers, would want to go the extra mile to help them, because it would get its pound of flesh from their future business. Customers can be happy even when faced by a monopoly, though they would grumble far more if they knew how much they were paying for good service!

An analogy may be useful. A monopoly is like running on firm ground. Nothing compels you to move, but if you do, you move forward. The faster you run, the more scenery you see – so you have some incentive to run fast.

Competition is like a treadmill. If you stand still, you get swept off. But when you run, you can never really get ahead of the treadmill and cover new terrain – so you never run faster than the speed that is set.

So which industrial structure is better for encouraging you to run? As economists are prone to say, it depends.

Perhaps one can have the best of both worlds if one starts on a treadmill, but can jump off if one runs particularly fast – the system is competitive, but those who are particularly innovative secure some monopoly rents for a while. This is what a strong system of patent protection does.

But patents are ineffective in some industries, like finance. The overwhelming evidence, though, is that financial competition promotes innovation. Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980’s – that is, after it stopped being boring.

The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter’screative destruction,” bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management). Former US Federal Reserve Board Chairman Paul Volcker has argued, somewhat tongue-in-cheek, that the only useful financial innovation in recent years has been the ATM. Hence, the critics are calling for limits on competition to discourage innovation.

Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial, allowing a variety of firms to emerge and obtain finance in a way that simply was not possible before.

Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses in spreading home and auto ownership. The problem was not with the innovation, but with how it was usedthat is, with financiers’ incentives.

And competition does play a role here. Competition makes it harder to make money, and thus depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.

Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the chief economic adviser to the government of India, served as the International Monetary Fund’s youngest-ever chief economist and was Chairman of India’s Committee on Financial Sector Reforms. He is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

November 11, 2012 1:47 pm

Latin America a gold mine for Europeans

It is a culmination of the so-called reconquest”, which in the 1990s saw European companies invest heavily in Latin America. What then seemed risky bets are now proving to be an El Dorado.

Ravaged by the eurozone recession, such companies are increasingly using their Latin American operations to repair troubled balance sheets at home. This is especially true for Spanish and Portuguese companies, for which Latin America accounts for 15 per cent and a third of revenues respectively, according to Morgan Stanley.

“The expansion of Spanish companies into Latin America was their first step to become global. Now it has become their way to survive,” said José Antonio Ocampo, a Columbia University economics professor and former Colombian finance minister.

Santander, Spain’s biggest bank, has been among the most opportunistic. It raised $7bn in 2009 when it listed its local subsidiary in Brazil. Last month, it raised a further $4bn when it did the same in Mexico. Both operations helped boost capital levels in Madrid.

Telefónica, Spain’s third-largest company by market capitalisation, is also considering spinning off all or part of its Latin American operations. Worth an estimated €40bn, Madrid may park more of Telefónica’s €57bn debt pile there. BBVA, Spain’s second-biggest bank, said last month that it could consider listing its Mexican operation, Bancomer, which accounted for half of group profits last year.

Such capital releases have thrown a financial lifeline to Europe, and also given a fillip to Latin American capital markets.

“After the privatisations of the 1990s, many local companies were bought by foreigners, and their listings disappeared. Now this trend is reversing, partly thanks to the eurozone crisis,” said Luis Oganes, head of Latin American research at JPMorgan.

The capital extraction is a mirror image of emigration flows. Last year, 20,000 Spaniards emigrated to Latin America to seek their fortune, nearly seven times the amount in 2005. Meanwhile, five of the region’s 10 biggest M&A deals last year were the sale of local assets by retreating Europeans.

Top of the list was Dutch bancassurer ING, which sold its Latin pension operations to Colombian banking group Grupo Sura for $3.6bn. This October, French retailer Carrefour sold its Colombian business for $2.6bn to Chilean retailer Cencosud.

Relative valuations can make such trades appealing. Santander Mexico was valued at two times book value at the listing, while the holding group’s stock trades at less than one.

It can also be cheaper for subsidiaries to fund themselves locally than for the parent company to do so.

Top-tier Mexican corporate issues are issuing at a substantial discount to top-tier Spanish names,” said Damian Fraser, head of Latin American equities at UBS.

That is even true of sovereigns. On Wednesday, Santander Mexico issued $1bn of 10-year bonds at a yield of 4.2 per cent; by contrast, Spanish government 10-year euro-denominated bonds currently yield 5.8 per cent.

However, repatriating capital from fast-growing emerging markets has its drawbacks and difficulties.
A survey by the IE Business School in Madrid found that, by 2015, most of the 30 largest Spanish companies with operations in Latin America expect revenues from the region to exceed those from home.

On Wednesday, Telefónica reported that was already so in its case. Cutting investment now, therefore, jeopardises future profits.

That is why Italian utility Enel says funds raised from plans to consolidate its Latin operations within Chilean subsidiary Enersis, which would then launch an $8bn capital raising, will be used to invest in local operations.

There are also limits on the amount of profits that can be repatriated, especially in Argentina and Venezuela due to currency controls. Elsewhere, there are no signs yet that local regulators are worried about rising levels of repatriated profits – although it has become a talking point among European bank analysts.

BBVA has historically repatriated about 70 per cent of its profits from Mexico, according to analysis by Espírito Santo, with Santander managing about 50 per cent.

However, it is not just in Latin America where troubled companies are looking to raise money: Telefónica this week raised €1.5bn after listing its German unit.

Nor is it only troubled European corporates that are using Latin America as an ATM machine. Cemex, the Mexican cement company that almost bankrupted itself after a string of global acquisitions, is expected to raise $1bn from a listing of its South American assets on the Colombian bourse.

Still, it is mostly an Iberian phenomenon, “driven by hard-pressed Spanish firms who, in earlier expansionary mode, eschewed other parts of the emerging world given their special niche in Latin America,” said David Lubin, head of emerging economics at Citi.

Indeed, larger Spanish companies are now realising the need to be in other fast-growing economies aside from Latin America, although their presence there is serving them well, with the two big banks examining expansion in Asia.

Copyright The Financial Times Limited 2012.