This past week the United Nations Conference on Trade and Development (UNCTD) released its annual FDI report. One of the interesting things about the report is that all four BRIC countries are now solidly in the top 5 of FDI destinations. We are truly witnessing the rise of these powerful “emerging” economies, and the revolution is well under way. It is also interesting to note China now occupies both the top spot as the destination of FDI but also the #2 spot in outward FDI. Quite remarkable.

Related to this, yet another milestone of China's rise in economic power There are two issues I wanted to briefly write about here. 1) We dismiss the strong fundamentals of China's economic growth at our own peril; and 2) one of the fundamentals of China's growth as viewed through “the second-tier city phenomenon.”

First, China still has its doubters. Every year there seems to be a new group of writers and pundits predicting the collapse of this house of cards. This year it was James Chanos, the wealthy hedge fund investor who shorted Enron, who has been stumping his prediction of the “bust of the myth of the biggest conglomerate of all: China Inc.” His analyses of China's stability and structure could not be more facile. It's almost embarrassing. Then there are the jingoists like George Friedman. Recently, I had the joy of reading (airplane reading) of taking in his audacious “futurist” work, the NYT bestseller, The Next 100 Years: A Forecast for he 21st Century. Here again: embarrassingly simplistic. Friedman writes: “[China] is not only an Asian state that allocates money politically and manipulates economic data. It is also a state in which equity holders--demanding profits--are less important than bankers and government official, who demand cash... China has expanded extraordinarily for the last thirty years. The idea that such growth rates can be sustained indefinitely or permanently violates basic principles of economics. At some point the business cycle, culling weak business, must rear its ugly head--and it will. At some point a simple lack of skilled labor will halt continued growth. There are structural limits to growth, and China is reaching them.”

I don't even know where to begin with statements like these. It all sounds very erudite; maybe he even took an economics class or two. But seriously, does this guy understand anything about China at all? I have many acquaintances (and some friends) who are among the economic elite Friedman derides as the political allocators of money and the manipulators of economic data. Behind closed doors they relish the underestimation of their economic prowess. Their view: yes, yes, keep thinking of us as backwater, simplistic capitalists; we are going to continue taking you to the cleaners at the negotiating table and we are laughing all the way to the bank. Can we at least ask that our experts in international policy spend some time with the people they are writing about? If only so they don't sound foolish?

Second, I want to take a few minutes to write about Chinese economic development in its current state and why people like Chanos and Friedman get it so wrong. Chinese economic development is an incredibly decentralized process. There are many nuances to this (which I plan to write about in coming weeks), but suffice it to say that the process is a decentralized local state entrepreneurial process. The Central Government sets broad macroeconomic policies; meanwhile, local governments (provincial and municipal) take on their own initiatives to compete for economic development initiatives (the attraction of foreign capital being a big part of these initiatives). This has led, recently, to what I like to think of as the second-tier city phenomenon in China: Local municipal governments have been incredibly innovative in their institutional systems and also in their initiatives to attract foreign capital, to create niche markets for economic development, and yes, Mr. Friedman, to develop *skilled* labor in specific industries.

· The case of Suzhou: how did it happen that Suzhou suddenly supplanted Shanghai as the major destination of FDI in the mid-2000s? There is a long, winding story to this, but the basic issue is that, with the backing of the Jiangsu provincial government in coordination with the Singaporean government (and an investment of $BN), the Suzhou municipal govt built the China-Singapore Suzhou Industrial Park, which, for a brief time, became the #1 destination for FDI in China. It is an unbelievable place. If you have been to Shanghai, stood on the Bund and looked out over the urban development phenomenon that is Pudong, you were probably impressed. You should really get out to Suzhou, because, you ain't seen nothin' yet. And the foreign managers I have spent time with there, people who talk about institutional security, environmental regulations, skilled labor: they are amazed. Hearing these people and then reading the words of “experts” like Chanos and Friedman, who are bestselling authors and rockstar hedge fund manages, all I can think is: “we are in trouble; we have no clue what is going on behind the scenes in China and we buy books by and invest our money with people who have no clue either.”

· The case of Chengdu: how did Chengdu beat out Chongqing as the primary destination of FDI in the western part of China? Here again, the story is about an entrepreneurial second-tier city. Talk to the senior people of Intel in China... they will tell you a story about a flexible, entrepreneurial (and capitalist and opportunistic) government that believes in creating stable institutions, building a base of skilled labor, and winning in the global economic game. They are building the infrastructure of a dynamic, modern capitalist economy that is helping to position China for the future. And I am sure, if they took the time to read it, they would laugh at Friedman's characterization of China's economic weaknesses. They are probably saying, “Yes Mr. Friedman, keep beating that drum, keep underestimating us. Keep believing that we have no idea of what we are doing. We are just going to go about our business and become the most powerful economy in the world.”

Institutional Innovation and Careful Planning in China (Part I)

Recently, the Agricultural Bank of China announced that it completed the largest IPO in history, following in a line of several Chinese hybrid state-owned entities that have made such historic offerings. It is amazing that, after more than three decades of astonishing economic growth, many still dismiss feats like the AG Bank of China’s IPO as a cynical story of state-market manipulation. But the truth is much more sobering: China actually understands the nuances of how to build a successful and powerful economic juggernaut than we in the US do. The reality is that we have much to learn from China these days. The irony of our times is that the largest (nominally) communist society in the world is also the most dynamic (and intelligently run) capitalist economy in the world.

As I wrote in a recent article on this topic (Guthrie and Slocum, “Through the Looking Glass: Inefficient Deregulation in the United States and Efficient Regulation in China,” in Markets on Trial: The Economic Sociology of the US Financial Crisis, Michael Loundsbury and Paul Hirsch, eds): “Since the early 1980s, most of the capitalist world has converged around the consensus that state-owned enterprises are fundamentally inefficient. With the privatization of national energy conglomerates from Britain to Italy to the privatization of tobacco and salt corporations in Japan to Mexico, Turkey, Zaire, the general consensus is that state involvement is fundamentally antithetical to the type of efficiency that comes with private ownership. The assessment of the inefficiencies of state planned economies in the Soviet Bloc and China seemed to confirm this view. Dating from the scholarship of famous economists like Janos Kornai and Jeffrey Sachs, the basic position has been that state ownership simply could not provide the right incentives for efficient market behavior. This notion is a mainstay of US economic and political discussions—any state involvement must be less efficient than private ownership. The core concept of the efficiency of a deregulated market system is often contrasted to the notion of the fundamental inefficiency of state ownership.

“The success of China’s economy and many state-owned firms within it has caused us to revisit some of the key assumptions upon which those arguments are based. The reality that China has revealed is that the issue is not ownership per se (state versus private) but, instead, the ability to create the right incentive structures that lead to efficient market behavior. In reform-era China, there has been a tremendous amount of institutional innovation that has allowed for a reform of incentives—leading to greater efficiency—while at the same time allowing the state to continue to watch over and guide the economy.

“While we typically conceive of private ownership as leading to efficiency and innovation and state-ownership as leading to inefficiency and complacency, this caricature simply does not match reality. In some cases, private firms like General Motors and Citigroup can be woefully inefficient, while state-owned firms like PetroChina and the AG Bank can be extremely efficient. The issue is not public versus private ownership per se; rather it is how effectively incentives are aligned to create dynamism and innovation in the marketplace. Further, state ownership has the added role of forcing firms to think long term and align themselves with national interests.

“Our own policy makers should be less fearful of and think more innovatively about public-private partnerships. In China, the government is deeply engaged in the economy—not only as regulator but also as economic agent. And, contrary to the common portrayal of SOEs as inefficient and complacent organizations, China has been able to align the incentives of senior executives in the SOEs; the government has also done an effective job of aligning the incentives of local officials. The key policy lesson here is that government agencies can be quite effective in guiding economic organizations: they are in a position to consider national (or local) strategic policy issues and broader issues of systemic risk; and contrary to popular belief, they can also think about economic action in creative and institutionally innovative ways.”

In short, there are so many ways that the US economy is lagging behind today (innovation, education, systemic risk analysis), and if we are not careful, we are going to fall further behind. Today, we are locked into a simplistic debate about the efficiency of the private market and the inefficiency of state “meddling” in the economy. First, there is no clear argument that private ownership is better. General Motors and Chrysler have been every bit as lethargic and inward looking as the worst caricature of the classic State-Owned organization might be; yet PetroChina is by almost every statistic the most efficient oil company in the world. But innovation is better in the private economy you might say; perhaps in some cases. But China is killing us in the development of clean tech right now. Why? Because the state has deemed it important, and it invests in it. The best we can do is tax credits to stimulate private sector development. The bottom line is that we need to get out of our simplistic mindset of a laissez-fair market economy. And we need to wake up and learn from the careful way in which the Chinese economy is being planned.