Rule by Law

At first impressions, Australians and Japanese are very different, but once you understand the language and spend some time in Japan you realize that we share some very important fundamental values.  In spite of the occasional scandal and the odd incidence of corruption of public officials, there is a high level of trust in public institutions.  There is awareness of rights and a certain level of respect and consideration for other people.  In short there is some sort of unspoken social contract that impels people to behave well, without the need for immediate legal sanctions.   Things work because people generally see the value in cooperation.  Even strangers tend trust each other to some extent if there is no immediate reason not to do so.

When I arrived in China as a long-time Japanese speaker I was struck by a superficial resemblance to Japan.  The people were not affluent or as fashionably dressed, but they looked much the same.  Signage was largely legible to a Japanese speaker and there was some similarity in language due to the use of characters, although not in structure.   There were at a deep historical level a lot of shared traditions.

China however is not like Japan in many important ways and this quickly becomes very obvious to anyone doing business.  These differences stem from a lack of trust in the system and in each other.  I hear from friends that this was the same in Eastern Europe and the Soviet Union before the 1990s and even to some extent today as a result of the Communist legacy.  I suspect it goes back further than that and that the differences are as much related to the emergence of democracy in our parts of the world versus the lack of it in some less-developed countries.  Unchecked power is at the root of the problem.

But paradoxically it is not a police state as one might imagine prior to living here.  In some ways there is more freedom than in the West. Essentially in China, if Big Brother is not looking, do whatever the hell you like. And Big Brother doesn’t really care much what you do as long as you don’t challenge him in any way. The result is that today’s China is like the Wild West; a largely lawless place.  More correctly, there is plenty of law, probably too much, but there is no rule of law. There is “rule by law” and that is different.  The law is a weapon to be used to keep people in line when officials so choose.  The law is not applied universally, and certainly not without fear or favour.  If you do anything to rock the boat, or cause any kind of disruption, the law will come crashing down on your head.   One boss said to me the other day that every boss in China operates with one foot in gaol.  Local companies cannot operate within the law because to do so would mean going bust.  For example, how can you obey an edict that says “from tomorrow you cannot use any electricity for 20 days”? That happened yesterday in the village where I have my warehouse.  The choice is easy, if stark: Obey and go broke, disobey and hope they will not call your bluff.

Of course, as a foreign enterprise we are different.  We are more closely scrutinized and are unable to flagrantly flout the law.  However in this case it is different because we too have no choice, but we will wait a day or two and see what the locals do.  I think I know the answer.   And what is the reason for this new edict?  The local officials have been told that they need to reduce power consumption (from coal-fired power stations) if they want to get promoted.  Great policy objective, lousy execution.

So what is the point of this ramble?   I have only touched on one or two implications of this systemic dysfunction, but once you recognize the problem you can see its consequences everywhere.   

Five-year Milestone

We have just celebrated our first five years of operations here.  I just submitted an article to an industry publication with a view to getting some free publicity.  I copy it below for those of you who may have been wondering exactly what we have been doing here, but were afraid to ask.  I apologise for the self-promoting tone, but that is what publicity is.

An Australian owned and operated flooring factory in China has just celebrated five years of successful operations.  Located in the regional city of Huzhou, two hours to the west of Shanghai, Ecquality Timber Products has about 40 employees and is run by its owners, Terry Newman and Sonoe Mishima.  Terry and Sonoe, a husband-and-wife team, are well known in the timber industry, especially to the Cypress mills of Queensland, where they have been sourcing timber and flooring for about 15 years for export to Japan.

The move to China was prompted by the rising Australian dollar and increased manufacturing costs that have accompanied the mining boom.   Terry explains that initially the plan was not to set up a manufacturing operation at all; “We came to China to outsource production, not to make things ourselves, but we quickly learned that China is not a place where you can simply write a contract with a manufacturer, go home and expect things to run smoothly”.  After finding that he was spending more time on factory floors in China making things work than in Australia, Terry and Sonoe decided to move to China to start their own operation.  “We knew it would be hard, but so was running around China trying to stay on top what was happening in our sub-contract factories.  We tried many factories and none of them could consistently produce what we needed”. 

On the personal side it was a huge change too.  “We brought our daughter, about to turn 14, with us, but our 16 year old son elected to board at his school and complete his last two years there, rather start in an international school at that late stage.  For them it was no doubt a big challenge too, but they both adapted quickly to their respective new circumstances and there were no major issues”.

The challenges for the family and the business were just beginning, however, because after soon after registration of the company, but before operations commenced, Lehman Brothers collapsed and what Terry calls “the great train wreck” began.  “We just got started with things went bad.  We had enough cash to carry us through a slow year or so, but this went from slow to zero at the beginning and took about three years to get back on track, so it was nerve-wracking on top of all the other challenges of operating here”.   Terry says that there is a book in these “other challenges”, but he is now clearly on top of things and is confident of growth.    “Our challenge now is to stay on top of orders and to manage growth.  Last year was 20% up year-on-year and I expect that will now continue”. 

The factory still produces Australian Cypress for Japan, but also does other Australian hardwoods and German Oak.  “Solid German Oak wide boards to the Australian market are now one of our biggest items”, Terry explains.   “We are also supplying some engineered products from nearby factories that we work with closely.  Trading is now about 20% of our sales, but we still do all the QC”.

Terry is first to admit that times are very uncertain, but says, “There are never any guarantees in life.  You just have to get on with it and give it your very best shot”.  It is pretty clear that this hard-working couple is giving it their best shot and that it is working.   Good luck Terry and Sonoe in the next five years!

Bubble, Bubble, Toil and Trouble

This week the bank came: not to us as we do not borrow, but to a big factory nearby. They took the bosses Benz, an Audi and a BMW.  The factory closed on the 30th of September, which is the end of the quarter and the day of reckoning in this case. This area is almost totally dependent on the timber industry. If you are not in the timber business, or servicing the timber business, you are probably not in business at all, so the closure of this factory and another large one on the same day, means serious trouble.

This little town has about 20,000 permanent residents and around 8,000 workers from poorer parts of China who come here to work in the timber factories. These outsiders hear of the work opportunities from friends and relatives and make their way here on trains and buses without pre-arranged work. They just lob here and walk around checking out the chalk boards at every factory gate until they find themselves a job.  It used to be easy, but not now. They are gradually drifting back to the inland provinces and to penury.

All the talk now is of tough times. The collapse of these factories is no surprise, it has has been coming for a long time and in some ways is a continuation of the Lehman Brothers train crash, but it would have happened eventually. The industry was booming up until the the start of the Great Recession. All you had to do was start producing and wait for the customers to come. And they did come, from all over the world and from all over China. This area supplied 60% off all the solid wood flooring sold in China.  (Just think about that for a second!)  Cash was easy to come by. If you had land, the banks were willing to lend, and if you didn't have land the gray lenders would lend on a promise - at a price.  Every boss had a big Audi and a young girlfriend or two.  Nights were spent in tea shops and bars. It was party time.  

Decoration in the home of a minor timber boss.

A marquetry castle built on borrowed money

But the crash did not come immediately after Lehman as it did in the West.  There was plenty of momentum left in the Chinese economy and so the domestic market rolled on. In part that was because people here are not so economically literate and certainly not so well informed. I remember thinking at the time that this was a very good thing.  Imagine what would have happened if China also stopped when the music stopped in 2008. Luckily they also had the Olympics to think about and then the Shanghai Expo in 2010. Of course, they also had the Szechuan earthquake in 2008 and that was far bigger news than the collapse of some unheard of bank in the US.  

The Chinese banks were by 2009, of course, aware of the implications and so they responded by tightening credit to SMEs, but all that did was to boost the gray lending market.  The buckets of cash held by all these bosses were still sloshing about and the sharks were happy to pay them 20% because they could re-lend at 30% - and more for short-term money. These local timber factories should have been reining in spending at this time, but many of them went aggressively after domestic market share, opening their own retail networks across China. And to make matters worse, firms were still able to expand their lending from banks if they had guarantees from other strong firms. This could happen, I think, because of the absence of a sophisticated title registry for land and also because banks did not have a central database where they could check what loans were already made against what property. I am not sure if I am right about this, but if there is such a system, the fact that multiple loans and guarantees could be made without substance shows that it does not work. The fact is that corruption subverts whatever system is put in place anyway.

So the house of cards continued to be stacked higher.  All that was necessary to bring it all down was a tiny gust. The slowdown in the construction market here has not been sharp, but that is another complicated story so I won't talk about that now, but there has been a deep slump in the "decoration market".  What that means is that, even if apartments are being built and even if some of them are sold, they are not being fitted out. If no one is doing fit outs, then there is no demand for flooring. This has naturally led to cash flow issues for many factories in the last two years or so.

One weekend in late 2011 some fool-son of a factory boss blew a few million in the casinos of Macao. That caused the collapse of the business because no one was in a position to come to the rescue. This was just one of many money-losing scenarios that occur when money comes easily.  Another boss I know bought the family's first brand new car at about the same time. His son soon ran someone down causing serious injuries resulting in bills of several hundred thousand RMB. Soon after he managed to get the money together to settle this, his wife hit someone resulting in another bunch of huge bills. The factory bosses no longer had the cash to make further loans, indeed they were now calling in their money.  

At the end of 2011 a loan shark with a basement full of luxury cars in an office tower here in the city jut a few blocks from where I live woke up one morning knowing that the game was over.  I don't know all the details, but he was only in his 30s and the story goes that he had a few years earlier conspired with his mate who was managing a local bank branch. He borrowed a million with no collateral and immediately put it into another local bank, obtaining a gold credit card in the process. From these humble beginnings and an overdose of self-confidence he was able to leverage his cash and that of his young factory-owning friends into a multi-billion Yuan loan business.  On that day in late 2011 the police arrested him and his bank manager mate as well as a bunch of officials who had turned a blind eye in return for certain incentives. The collapse of this illegal lender wrought havoc the village where I have my factory.  There was a whole bunch of reciprocal loan guarantees that were being called in.  Many businesses went to the wall and those that survived were now crippled by debt including the two factories that limped on until last week. 

In the two years since that first collapse the banks have continued to withdraw their support. That was easier said than done because they were in up to their necks and they did not want to precipitate a crisis, so they trod softly while cajoling these companies with threats of foreclosure. The local informal-lending network based on family and business connections was in overdrive trying to keep the banks at bay, but the underlying businesses were no longer viable. It was an endless cycle of good money following bad and so the other day, two years after the first loan shark went down, the second wave crashed. People are saying that this wave is going to take out up to one third of the businesses in the village. I cannot say, but I know that it is not a pretty picture. The combined debt of these two firms was about US$25 million and I would estimate their assets at less than $10 million at best.  Another factory I deal with has debts of about US$8 million and their annual profits are only about $1.5 million and they have no cash.  Half of these debts are from loan guarantees to others.  

My sense living here is that this situation is a microcosm of what is going on all over China. I may be wrong and I really hope that other places are faring better than my area, but from what I hear there is not a lot of good news.  What we need is for the global economy to pick up quickly so that these business can step back from the brink. What I can say for sure is that the appetite for debt and high living among my timber colleagues has certainly been curbed. The hangover is painful and those that do survive will be a lot more economically literate then they were in the heady days before 2008.