China, the Hollow Dragon

It is widely assumed that manufacturing (a.k.a. the world’s workshop) is the source of China’s wealth. But how can this be true, given that manufacturing profit margins are razor-thin in China, and have been since the early 2000s?

Given that as little as $10 of the value of every iPhone or iPad actually ends up in the Chinese economy, how can anyone claim manufacturing has generated enormous profits?

(Mis)leading Indicators:

Analysts differ over how much of the final price of an iPhone or an iPad should be assigned to what country, but no one disputes that the largest slice should go not to China but to the United States. That intellectual property, along with the marketing, is the largest source of the iPhone’s value.

Taking these facts into account would leave China, the supposed country of origin, with a paltry piece of the pie. Analysts estimate that as little as $10 of the value of every iPhone or iPad actually ends up in the Chinese economy, in the form of income paid directly to Foxconn or other contractors.

Foreign funded enterprises (FFEs–typically joint ventures between a foreign firm and a domestic Chinese company) dominate Chinese manufacturing. In the 2000s, the share of industrial machinery exports produced by FFEs grew from 35 percent to 79 percent. In computer equipment, FFEs’ share rose from 74 percent to 92 percent.

In the late 1990s, China allowed wholly owned foreign enterprises (WOFEs) to operate, essentially cutting out domestic ownership of production.

Meanwhile, the state-owned enterprises (SOEs) that have long dominated China’s economy remain inefficient, unprofitable and dependent on government-subsidized loans for their survival.

Correspondent Mark G. puts China’s remarkably unprofitable manufacturing sector in the proper historical context:

It may be the Chinese copied the old British Empire system without ever fully understanding it. As AJP Taylor pointed out back in 1965, the British direct trading account of exporting finished products only showed a surplus over food and raw materials imports one year in the course of a century from the 1820s – 1920s.

The deficits were always made up by profits from shipping services, banking and trade finance, insurance and overseas investment dividends. In other words, The City of London was always the profit center of the British Empire. These activities are what produced the huge current account surpluses of the British Empire’s heyday. Export manufacturing was a loss leader of sorts.

“A loss leader is a pricing strategy where a product is sold at a price below its market cost to stimulate other sales of more profitable goods or services.”

Unfortunately for China, it is generally not to be found in these really profitable sectors internationally. China used nearly free labor to make itself the dominating competitor in what was always the least profitable sector of the British Empire. China is now left with just loss leaders.

In effect, China has been running a loss leader manufacturing economy without developing global profit centers in shipping, insurance, banking and trade finance–the source of big profits in every modern trading empire.

The U.S. runs a trade deficit of goods and services of around $40 billion a month (roughly $500 billion annually): June exports were $188.6 billion. June imports were $232.4 billion.

As I have explained here before, trading paper money for tangible goods and commodities is not only a good deal for those able to trade essentially worthless currency for real goods, it is also necessary if you’re issuing the world’s reserve currency.

Understanding the “Exorbitant Privilege” of the U.S. Dollar (November 19, 2012)

I think we can safely say that creating money out of thin air and “exporting” that is much easier than actually mining, extracting or manufacturing real goods. This astonishing exchange of conjured money for real goods is the heart of the “exorbitant privilege” that accrues to the issuer of the global reserve currency (U.S. dollar).

In other words, the U.S. doesn’t need to run a trade surplus to skim the wealth of the world; all it has to do is issue a risk-free asset (Treasury bonds and U.S. dollars) that effectively vacuums up the wealth of the world, one trade at a time.

The only way the U.S. can botch this skimming operation is if it allows its risk-free assets to become inordinately risky. In a $17 trillion economy with $84 trillion in net private wealth, issuing $500 billion annually in exchange for tangible goods and commodities is not about to threaten the entire edifice.

The same cannot be said of China’s renminbi (RMB), a.k.a. the yuan, which is just starting the long descent of devaluation–a devaluation that is already roiling markets and crunching profit margins in China by raising the cost of imported raw materials.

In terms of profitability and trade-generated wealth, China is a hollow dragon.Its gains have come on the coattails of the yuan’s peg to the U.S. dollar and an unprecedented four-fold expansion of debt from $9 trillion in 2008 to $28 trillion today.

Shadow banking boom pushes China to edge of debt sustainability Alarm raised over the country’s deteriorating credit quality as leverage tops 280% of GDP

Both have reached the point of diminishing return, and the consequences of this hollowness are becoming painfully apparent.

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  • diogenes

    Having reached the age of reading glasses I went to the two “chain” “drug” stores that each have several locations in my town — thus preventing competition and siphoning money to NYC — and find that each has a rack of the “styles” one brand — the same brand! — for the same prices! Ah, the Free Market. These are cheapo-plastic, made in China at a cost of, at most, under $2.00 a pair, and sell — at “both” chain stores — for $25 a pair — and — best of all – with super cheapo plastic frames that break — all by themselves, without encouragement — in a matter of months — but guaranteed long enough that the NYC slave “manager” of the NYC “chain” regards a request for replacement as the sheerest effrontery. How much of the $23 sheer gravy extracted from a captive market for these pieces of crap stays in China — how much goes direct to the same schmoes in the same schmo capital of capital? How many hundreds of similar hustles can you name? Is this how NYC “builds America’s economy” or how it “builds China’s economy” or is it how the pirate island of Manhattan pillages all humanity for the sake of its religion of predatory greed?

  • Jim G

    I think what you are saying is that the US and Britain, who gave Singapore to China with their British banking system there, invested a whole lot of money in China. Many of the smaller companies listed on US exchanges were shell US companies that were relabeled as Chinese companies in entirely different markets, and were essentially frauds. The president of one such company claimed dozens of internet contracts, but had none. Sold me, then moved to a different company. But I don’t blame the Chinese – these were American shells sold on American exchanges who thought China was easy money. The Chinese did buy back all the shares of two divisions of their largest petro-chemical corporation. I think these hybrid state / private equity companies still have value.

    About a year ago, I bought a package of information from an ex-CIA guy who wanted to get into Finance, and he said that China was one leg of the four legged stool that held up the American financial system. That is, if China collapses, the US financial system collapses. And I think that is what is currently happening – Financiers around the world are collapsing the world economy hoping their (ours?) will e the last to go. Or perhaps 9/22-23 will be the big global Financial re-set. Southern Europe has been in a depression for what – about five years now, Eastern Europe is dying because of our protectionist war to take Russian markets, Japan is entering another recession, economies in South and Latin America are crumbling because of low oil prices, and as you note, the Chinese financial markets are collapsing. I think it is because the US and Brits are taking their money out via Singapore.

  • Brockland A.T.

    I can’t verify correspondent Mark G. to read the entire article in context.

    The first article link is to a Foreign Affairs piece, which some commentators pointed out is infiltrated by the CIA.

    So… I’m not sure what to make of this.

    The “Hollow Dragon” is busy constructing the News Silk Road:

    and founded the Asian Infrastructure Investment Bank:

    and inaugurated the BRICS bank:

    Looks a lot like financial sophistication, which the article’s theses rests on China not having. Plus China is doing all this without inflicting any parallels of the mass bloodshed that marked the rise of the British and U.S. empires (and the ongoing bloodshed in their preservation).

    Mr. Hugh Smith seems better at highlighting Americas flaws than China’s.

    Normally this would be no big deal; prosperity benefits everyone. Yet if the U.S. feels justified in undermining an indigenous-ruled Eurasia, this can only mean threatening more of the same interventions; war, terrorism, and economic chaos – and blaming this on ‘the other’ just for existing.

  • berger friedrich-wolfgang

    Seems , “Our HOLLOWNESS” & Their “BLIND” “All – Seeing – EYE” , Are the SAME !!!