Playing Chicken with China
Posted: October 1, 2010
Everyone with a normal childhood is familiar with the game of chicken – racing on a bicycle (with baseball cards now worth thousands flipping the spokes, probably) headlong toward another rider to see who flinches first – to see who is “chicken”.
Western industrials are playing chicken with China and the Asians hold a distinct advantage. Like a child bike rider wearing body armor, China protects their best interests with a near-impenetrable industrial policy tightly controlled by their political class, focused with precision on long term needs of the nation.
Recent announcements from Beijing foretell the next battlefield – vehicles powered by batteries and alternative energy. Advising Western automotive companies that the price to play in the China market is to yield controlling interest and control over supporting intellectual property for batteries, powertrain, and vehicle operating systems to Chinese companies, China expects similar gains to those in other industries.
We’ve been on this road awhile now. The wind-turbine industry started this way and six years later, Western industry leaders (particularly GE) have seen their market share and earnings decline nearly 80%. This pattern, almost precisely, followed feeble efforts by the West to invest in (and profit from) solar power initiatives which resulted in no profit but tremendous volumes of technology transfer to now-dominant Chinese state companies.
Similarly, Western heavy vehicle manufacturing IP has circuitously landed in China via a decade of exporting to Russia’s Gaz Group. From there, as of September, Gaz plans to transfer their gift to China’s FAW Group Corp. to complete the circle of give-aways partnered with no profit for the developers of these technologies. Oddly, no one seems to notice that much of this technology is exceptionally adaptable for both Russian and Chinese military applications.
China consistently takes advantage of two global facts: they have an industrial policy while the West has no plan beyond short term profit. China uses their policy, like credit cards with teaser rates, to lure Western firms into high cost structural investment across their nation then sucks the intellectual wealth they bring to benefit State owned firms, their military and their political elite.
The great advantage Western firms have over Chinese is innovation. Structurally and culturally, China is not an innovative country (as recently admitted by China’s Minister of Technology Li Yizhong in a rare moment of public truth). In a recent talk with top MBA candidates at a leading Midwest university, Unicorn challenged the class of thirty bright people to name one, just one, manufacturing or scientific innovation originating in China; the most recent one named was gunpowder. In return for exceptional control over their population, systems, and thinking, China sacrifices any capability for cutting edge technical jumps.
The West (including Japan, Korea and Taiwan) is incredibly innovative, driven by profit, high tolerances for risk and failure and an unquenchable entrepreneurial drive. These character traits have and will continue to be why China has to coerce, bribe and steal technological advances from the West if they are to advance society materially to a level sufficient to keep their people from unrest and rebellion. It is also why Western firms are willing to gamble their exceptional brainpower on returns that prove illusionary.
For retail investors, playing chicken with China offers several directional leads to follow. First, know that Western firms will be led down this road (again) by the huge potential of the China market. Several years of modest gains will follow that seem to validate this strategy, followed by a GE-like erosion of market share and disappearing earnings with only billions in cost to show for their collective myopia. With those evaporated earnings will go evaporated share price, reduced dividends and corporate retrenching.
Yet slices of opportunity do exist, born of China’s industrial-corporate marriage. Rare earth metals is one example where recent Chinese decisions to limit sales and Western investment in mining, refining and exporting these critical elements creates an opening for Western investors to gain.
Rare earth metals are, well, rare. The largest reserves are currently mined in western China with 95% of world supply coming from there. Japan, dependent completely on Chinese supply, as well as the US and UK are increasingly concerned about quiet reductions in Chinese deliveries, despite denials by Beijing of any policy change. Availability of these metals alarms Washington and London because they are essential to most modern weaponry and communication systems. Most often used in smart phones and consumer electronics, rare earth metals are also indispensable to stealth bombers, unmanned drone flyers and command-and-control military systems.
Well informed retail investors can benefit here as Western (primarily US) firms begin to ramp up mining. Several companies in the industry have announced large new commitments to tap known resources in the western US and in eastern Germany. Money for identifying new sources globally has also increased markedly.
Anticipating new, sole-source contracts from the Pentagon, Whitehall and Berlin for Western-sourced rare earth supplies, the promise of long-term, high margin profits for these firms is very bright.
The promise for Western firms thinking they can win playing chicken with China? Well, not so bright.
©Unicorn Equity Analysts, 2010. All Rights Reserved.
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