Andy Xie on G-20 in Seoul

The G-20 in Seoul was supposed to be a pressure cooker for China. Geithner coordinated a united front against China before the ministerial gathering by signaling that the euro and yen were high enough, emerging economies could restrict capital inflows and resource exporters would be exempt from the proposed 4 percent limit over GDP of the current account surplus ceilings. The coast was clear for everyone except China. The hope was for the G-20 to gang up on China at the Summit. Instead, it became a festival of global backlash against the Fed's QE 2. Some people are just too clever for their own good.

How are emerging economies curbing capital inflows?

A war of words is unfolding before the Summit and the battle lines have been clearly delineated. Germany is leading the charge against QE 2. China is more than willing to echo the sentiment. On the other side, the U.S. is leading the push for capping current account surpluses. It is backed by India's support for its QE 2. But an element of the absurd is at play here by targeting surpluses. Why isn't the onus on the largest deficit economies to rein in the deficits on their own?

The piling of sandbags against a deluge of hot money has begun. Taiwan is restoring restrictions on foreign holdings of local currency bonds. Korea is proposing a hefty tax on foreign holdings of its bonds. China is stepping up checks on sources of foreign capital inflows. Most of its foreign exchange reserves are not from trade surpluses, but from hot money. If the government is really serious, it could surely stop the inflows.

The fight against inflation is heating up too. Australia just raised interest rates again. China increased its deposit reserve ratio. The market is pricing in four rate hikes in the next 12 months. I think the rate hikes will continue. India's central bank just raised its interest rates too, in an effort to curb real estate loans.

When the U.S. is engaging in super loose monetary policy, emerging economies must curb capital inflows and increase interest rates to fight inflation and asset bubbles. It seems that the Fed's QE 2 has convinced everyone of this path. The measures may have come too late for some. Inflation in emerging economies may be already in double digit territory. It seems underreporting CPI has become fashionable, under the pretenses of prolonging an economic boom. The consequences could be severe.

Negative real interest rates and an increasingly large current account deficit are a lethal combination for emerging economies. History has shown repeatedly that it leads to crisis. Brazil and India are in that camp today. Brazil is running a surplus. But, it is too small to offset the Fed's impact on commodity prices. When commodity prices are so high, a country like Brazil should run a large surplus like Russia. India is running a huge deficit outright. Its real interest rate is severely negative by some measurement. Its boom continues because the Fed's policy encourages speculative capital to fund its deficit and support its currency value.

China and Russia have inflation too. But they have large current account surpluses and wouldn't have a liquidity crisis when the Fed is forced to abandon its policy. Brazil and India don't have the same cushion. Unless they tighten substantially in the coming year, they may feature big time in the looming 2012 crisis.

Can rich countries grow?

Germany is upset with the U.S.'s policy and for good reason. A decade ago, it was left for dead. Its economy was saddled with high cost commodity industries. As East Asian countries like China and Korea were charging into them, few thought Germany had a chance. The Germans didn't give up. They cut costs dramatically, even wines, to the Frenchmen's astonishment. In addition, they innovated and turned many commodity businesses into IPR-dependent ones. With low costs and pricing power, Germany is enjoying the fruits of an export boom. But, the Americans want to turn it into an exchange rate issue. It is facing many issues that Germany faced before. Instead of restructuring, it is looking for a quick way out through devaluation.

Even though Germany is very competitive, it's not growing rapidly like an emerging economy – and it shouldn't. High growth belongs to emerging economies. If rich economies try to grow fast, it will run huge deficits and lose wealth. The reason is globalization.

Information technology created the 21st century multinational corporation and made the current wave of globalization different from the previous ones. A multinational corporation is a company in name and substance. But it has the breadth of empire. It has transformed the world through investment and trade into one economy. Both demand and supply are global now. Cost arbitrage by multinational corporations have made it necessary for labor in developed economies not to compete against that in the developing economies. The wage difference is too big to be bridged in the foreseeable future. This force ensures that demand stimulus in developed economies will lead to widening trade deficit and limited impact on employment.

Europe and Japan have accepted this reality and have gone into the wealth preservation mode: focusing on pricing power, not volume in exports, targeting low growth rates and cushioning displaced workers with benefits. The U.S. is in so much trouble because it wants to grow out of its problems. When labor costs ten times that in developing countries and, adding to this is the fact that the other side has ten times as many people, this sort of thinking seems irrational. Yes, technology and quality can improve exports. But, this will barely affect trade volume. When the U.S.'s best product idea – the iPhone – doesn't lead to a rise in production at home, one should be wary of optimistic sound bites.

The U.S. government wants to change the global reality by rearranging the exchange rates. If this idea works, one must lift the standard of living in countries like China and India instantaneously to that in developed economies or lower the U.S.'s living standard to that of China and India's. Neither is possible. The political atmosphere in the U.S.'s requires solutions that generate instantaneous effects. The world can't offer that. As long as the U.S. continues to search for the impossible, the world will be a dangerous place.

Where are the real fault lines?

Rising incomes and widening wealth gaps are a global phenomenon. The top 1 percent of the U.S.'s population takes one fourth of the national income and 40 percent of the wealth. China's household income is below 40 percent of GDP, probably the lowest in the world.

The process of globalization should lead to increasing gaps in wealth. It is demonstrated in the strong balance sheets and good earnings of the top global companies, even as major economies struggle with low growth rates and high unemployment rates. But, globalization is not the only reason, and may not be the most important one in explaining highly concentrated wealth.

Financial bubbles, created by loose monetary policy from people like Alan Greenspan, are the most important factor for the rising inequality. The bubbles mislead low income people to borrow and spend on fictitious paper wealth. Their debt becomes the profits for a few. When the bubble bursts, the lower income groups spend less and cut the labor demand for themselves. Lower income demand usually produces lower income employment.

China's low consumption is due to excessive government power, not from low exchange rates. The force that pushes the economy forward is the government's desire and plans for big investment. It then raises money through taxes, property sales or state monopolies overcharging. Under such a system, consumption can't possibly play a leading role. Focusing on the exchange rate won't solve anything and may make the situation worse.

How will the U.S. treasury market fare?

The U.S. is obsessed with manipulating demand, through lowering or increasing debt cost, to manage its economy. It doesn't recognize that supply side management is the key in an era of multinational corporation-led globalization, because the latter doesn't provide instant gratification. Under political pressure to bring down unemployment rates quickly, it will continue to muck around with the money supply and the dollar's value in search of a quick fix. It will stop only when it can't do so anymore. Only a collapse of the treasury market can play that role.

The U.S. government is running a budget deficit close to 10 percent of GDP. The U.S. runs a current account deficit of nearly 5 percent of GDP. The dollar is so weak that inflation is likely to run above average. But, the treasury yields are close to historical lows. Investors justify their holdings by assuming that they can sell to the Fed at higher prices. This perceived Bernanke "put option" is similar to the Greenspan "put option." Investors bought crazy financial instruments, because they counted on Greenspan to bail them out in a crisis. But these maneuvers only work on the market's faith. But the Fed cannot buy all the treasuries out there. It will cause hyperinflation.

The trigger for the crisis will be something that panics treasury holders. It could be the worry over another maxi-dollar devaluation or inflation. Most American policy thinkers don't believe that inflation will come. Otherwise, they would have to pull back the dollar printing presses. But, when one looks at food and oil prices, it seems it's only a matter of time before inflation hits the U.S. via emerging economies and commodities.

Brace yourself for turbulence ahead. Unfortunately, it will likely end with another crisis. Hopefully, the world will be better off after 2012.

(Ref. Group Study Questions, for 20, Nov 12, 2010)

Reject the Consensus: 'V' Means Vulnerable

by Andy Xie, May 10, 2010

Behind all that upbeat data and macroeconomic noise are pricing and inflation facts pointing to another crisis in 2012
Major economies reported strong growth for the first quarter. In the United States, for example, GDP grew 3.2 percent from the fourth-quarter level. Year-on-year growth rates were not far behind.

East Asian export-oriented countries reported even stronger data than those in the West. As a group, they probably grew twice as fast as the United States. And their second-quarter reports are likely to reflect similar strength. Meanwhile, the International Monetary Fund has upgraded its global, 2010 GDP growth forecast to 4 percent.

All these positive statistics raise an important question: Are we in the midst of a V-shaped recovery following the economic collapse that began in the second half 2008?

The answer is no. I think the current recovery is merely based on government stimulus and low-base effect. And given the amount of stimulus spending, this is not a strong recovery. More importantly, structural problems exposed by the financial crisis were merely covered up, not resolved, by stimulus spending. This is why the recovery is not sustainable.

Since stimulus will eventually lead to inflation, interest rates will have to be raised. That will lead to another dip in the global economy. I expect this second dip in 2012, which means we are en route to a W-shaped economic phenomenon, not a V-shaped recovery.

When so many people are bullish about an economic outlook – and offer lots of data to support their optimism – it is easy for little people like you and I to be persuaded. But one should always question the consensus. You don't have to poke too deep to find holes in the latest recovery story. One year ago, the consensus was that the financial crisis was the most serious in 60 years. Now, the doomsayers have changed their tune. How can things change so dramatically in just a year?

In early 2009, I predicted the people who were panicking at that time would declare everything fine by the end of the year. I also thought that, in the middle of the crisis, policymakers around the world had decided to err on the side of too much stimulus rather than too little. These predictions have come true. So the latest growth rates should be analyzed in that context.

Here's what's really happening: Major economies such as the United States and Britain are running fiscal budget deficits exceeding 10 percent GDP. Deficits in Europe and Japan are half that amount. Interest rates around the world are close to zero. When viewed in this context, 4 percent global growth is not impressive. Actually, we should be asking why the global economy isn't growing faster.

But can individuals like you and I make sense of what's happening in our huge global economy, with its roughly US$ 60 trillion in gross output and more than 6 billion people? More importantly, can we identify unsustainable trends and make the right decisions to avoid collective or personal losses?

In fact, it's impossible for an individual to gather and analyze all the data needed to reach meaningful conclusions. We have to rely instead on government agencies. But bureaucrats are slow, and they're usually too late in delivering data and analysis. In addition, some agencies massage data to achieve desired financial market reactions. As a result, a lot of little people have been force-fed misinformation. They've been left to search for answers in the dark before being led to the slaughterhouse.

Look at Prices

Yet we can improve our odds of success while navigating the vast global economy and avoid being fooled by consensus views. This is possible if we always remember that the economy is guided by a price system. Multinational companies have arbitraged away production cost differences over the past two decades, so price information about a company or a product can shed light on macroeconomic trends.

Let's look at China's auto industry to prove the point. Everyone says the industry is booming. Meanwhile, automakers are depressed everywhere else around the world. How should we read the difference? What facts are true and sustainable, true but not sustainable, or false?

It's true that auto demand is booming in China. This is line with the global industry's trend. Whenever a country's per capita income rises above US$ 6,000, auto demand tends to take off. And that income level has been surpassed in many Chinese cities.

But is this growth rate sustainable? It is not. China's auto market is new, which means many consumers are buying their first car, creating a spike in demand. Demand for replacement vehicles will be the market's next development, and that will be a long time coming.

On the supply side, which includes auto dealers and manufacturers, China's auto sector seems highly profitable. One can be easily enticed to think this profitability is due to strong demand. But it is not. Autos are a globally traded product, so supply and demand sides in any single country don't have to reflect each other. China-based auto producers and distributors are profitable due to trade barriers that keep global competition out. The telltale sign is that prices are higher in China than elsewhere.

What's the significance of this story? From an investment perspective, one should be cautious about China's auto sector. Most analysts pushing auto stocks cite strong demand growth and high profitability. But this profitability is due to trade barriers.

Hence, one must consider the sustainability of the barriers. If they come down one day, Chinese automaker profits will reach the levels of counterparts elsewhere. Further, demand growth will surely slow due to market saturation. We don't know where the high-water mark lies, but we're certain only a limited number of people in China can afford cars. And skyrocketing auto production capacity will likely lead to overcapacity.

What can be taken away from this story is that the profitability of China's auto industry is highly vulnerable. The practical implication is that auto company stocks should trade with heavy discounts to market averages. For example, if the market PE ratio is 20, auto stocks may need to trade at half that level.

Macro Mystery

Yet the auto industry story is relatively easy to tie together because it's all about microeconomics. Macroeconomic stories are a different sort of animal. Unless an analyst has special and significant insight, a macro forecast is all about extrapolation. This is why there are so many views of the future, and why the macro thinking noise level is so much greater than what's heard at the micro level.

But listening to most analysts who predict the future can be a waste of time. Indeed, economics itself says economic prediction is useless. If it were not, the predictors would use their insight to make money rather than share information with you for free.

Nevertheless, from time to time, macro trends don't make sense. This is when predictions can become meaningful. For example, almost everyone thought U.S. property prices could only go up. That prompted many people to act on a belief in borrowing money to increase property holdings. Thus, it was reasonable to bet that the opposite would happen. Predicting the turning point would have been hard, but insight into the errors of consensus reactions could have helped at least some investors think before chasing market momentum and suffering the consequences later.

So here's my attempt to make sense of the latest economic data and paint a picture that differs from the consensus, while concluding that the current recovery is unsustainable and another dip in 2012 is likely.

The U.S. economy has been rising on consumption, which means its growth is more dependent on a declining savings rate than income growth. This is exactly what happened before the burst of the real estate bubble. The U.S. property market is still in the doldrums, and there aren't asset gains ahead to support the declining savings rate. Furthermore, the nation's income growth is quite small compared to the rising government deficit.

In fact, the data is hiding weaknesses in the economy. These weak spots can best be found buried in household balance sheets and home foreclosure data. The U.S. household sector lost about US$ 10 trillion in net worth in recent years. A recent rise in the stock market prevented additional declines, but the market bounce is predicated on an optimistic economic outlook that depends on government stimulus. It's unclear whether this stock market momentum can be maintained.

The U.S. economy's main trouble is painfully evident in home foreclosure data. The foreclosure rate this year is on course to surpass the historic high 2.8 million, or 2.2 percent of all households, reached last year. Soon more blood may be shed.

Housing prices have fallen 30 percent, but they're still high relative to wages and GDP. If historical patterns hold, U.S. housing prices could fall another 30 percent. This has not happened so far because the Federal Reserve has kept interest rates near zero and has held down mortgage rates by buying one-tenth of the country's mortgages. Essentially, mean reversion or normalization is being prevented through policy action.

The question is, will such actions change the long-term norm? I suspect not. What they could do is increase inflation and thus push wages higher so that they more closely match property prices. Yet if the Fed allows a rise in inflation, people may panic and trigger another financial crisis.

Almost all East Asian economies attribute their latest growth to a recovery for exports, U.S. consumption, and China's investment drive. Standout GDP growth figures for the first quarter include South Korea's 7.8 percent increase from last year, Singapore's 7.2 percent, Australia's 2.7 percent and China's double-digit rate jump.

This trend is no different than what we've seen in the past. And it's sustainability is questionable. One major detour from the past course is that China's property market's infrastructure is now larger than the nation's investment composition. However, this fact only makes the story more fragile.

As East Asian governments are concerned about the recovery's staying power, they have been extremely reluctant to increase interest rates from the super-low levels set while dealing with the financial crisis. But inflation is pushing against this strategy. Inflation seems to be accelerating everywhere, even though most governments emphasize relatively low inflation levels and say current economic activity levels are not high enough for an accelerated round of inflation.

I have argued many times that this line of thinking is wrong. Keeping interest rates low is a mistake and will have negative consequences down the road.

Australia is probably the only country doing the right thing on monetary policy. Its central bank raised its policy rate to 4.5 percent – twice China's. Australia's unemployment rate is higher than China's and its growth rate is only one-fourth as high. But inflation rates are about the same in each country.

Even though Australia's central bank cites economic strength as a reason for an interest rate hike, there is little doubt that it's actually based on concerns about overheating in the property market. When the property market rolls over, Australia's economy will soften. The central bank knows that if it doesn't act now, at a time when commodity prices are high, the property market may crash if prices for the nation's exported natural resources fall. Australia is clearly thinking ahead.

Negative news out of Europe is centered on the Greek debt crisis. The market is worried about Greece's solvency and a bailout package that would require a spending cuts equal to 10 percent of GDP. But the social backlash could trigger a political change. So Greece is better off defaulting.

More important than Greece's crisis is Britain's economic weakness. Its fiscal budget deficit exceeds 10 percent of GDP and its economy stagnated, showing just 0.2 percent GDP growth in the first quarter. Britain is not benefiting from the global trade recovery because it hollowed out its industries during the financial boom and grew a massive property bubble that's since deflated. Now, its economy depends on government spending to stay afloat. It could face a debt crisis like Greece's, prompting the central bank to print money to pay government bills, which could lead to a crash for the pound that may feature prominently in the next global crisis.

One factor is common globally: the central role of stimulus. Most governments have been counting on stimulus to resuscitate their economies. As I have argued many times before, an economy tends to have a major misalignment of supply and demand after a big bubble phase. An adjustment takes time.

Trying to regenerate high growth through stimulus, rather than patiently waiting for a market realignment, leads to rising inflation rates. When inflation sparks panic, rapid tightening becomes inevitable. And that triggers another crisis. I'm afraid this is exactly what's in store for 2012.

Dismantling Factories in a Dreamweaver Nation

by Andy Xie, June 6, 2010

A decade ago, I took a group of fund managers to an assembly line at an electronics manufacturing contractor in China. We saw rows and rows of young women hunkered down, concentrating on putting together tiny parts. They had few toilet breaks, and during rest periods they had to sit at their benches.

"They're all 18," the line manager told me. "We need nimble fingers. In a few years, we will replace them with another batch of 18-year-olds."

I wrote a story after that visit. I didn't judge the situation but stated that a compliant labor force willing to be pushed to the extreme was the fuel for China's economic miracle. The engine was the mutually beneficial relationship between western companies with technologies, brands and distribution channels, and China-based manufacturing outsourcing companies that specialized in taking advantage of China's vast, cheap labor force. These included Taiwanese companies, which have been by far the most successful in the original equipment manufacturer (OEM) business.

The fund managers with me on the visit wanted to determine sustainability and profitability before deciding whether to buy the company's shares. They thought an endless supply of labor would ensure the model's profitability, and they were bullish about the company. What's happened in the years since has proven them right.

But will they be right indefinitely? To answer that question, we can glance back to the days of silent film star Charlie Chaplin. In his movies, Chaplin parodied the inhumane nature of the modern factory system, especially monotonous human movement on assembly lines. What he portrayed vanished a long time ago in developed countries, driven out by rising labor costs. Factory owners invested in automation, such as robots that now dominate modern auto assembly plants.

When multinational companies outsourced production to China, though, their business became less capital intensive. They took advantage of low labor costs and abundant supply. Some businesses, such as battery makers, started substituting machines with people. But no one could have predicted how far the outsourcing model, particularly in the electronics sector, would go while companies scaled up and maximized economies of scale by using cheap labor.

Scaling Higher

Economies of scale are typically associated with capital intensive industries. When a business requires a lump-sum fixed investment, it requires a certain scale to make the investment pay. Outsourcing businesses in China are labor intensive but have scaled up massively. Some businesses employ hundreds of thousands, often at a single location. So where do they get the economies of scale?

I know of two factors that can be scaled up in such businesses: customer relations, and what I call labor squeeze.

Good relations with big buyers such as Apple and HP are not easily obtained. Years of interaction are needed to build necessary trust. Suppliers that prove better than others are retained, while the rest are dumped. As time goes by, the number of suppliers shrinks and the survivors expand.

Thus, economies of scale are improved through good management of customer relations. Apple, for example, demands total secrecy in the production of its products. This goal cannot be met if it uses many suppliers, so when it signs with a trustworthy supplier a virtuous cycle is created.

An even more important factor is labor management. What I observed during my visit 10 years ago was actually the key to economies of scale. To put it bluntly, the key competence of a successful OEM in China is to squeeze labor to the maximum extent possible. That skill is developed within an organization. When a company employs hundreds of thousands from all over China, it needs a massive machine that involves recruiting, housing, training, and worker management on the factory floor.

For example, the factory I visited derives its economies of scale from 1) knowing where to find all the 18-year-old girls, 2) convincing them to stay in factory dormitories, 3) training them to put the parts together, and 4) ensuring that no one takes too many toilet breaks. This is all part of a huge system that can derive considerable economies of scale by processing hundreds of thousands of workers.

Labor management as a core competitive advantage in East Asia began in Japan. After the Meiji Reforms, Japan wanted to industrialize quickly but faced the challenge of turning agricultural labor into industrial labor. It looked to the military for a role model. The military faced a similar challenge: It had to turn farm boys into soldiers. The answer was maximum pressure and total regimentation. Factory uniforms, morning exercises, company loyalty indoctrination, etc., thus became unique characteristics of Japanese factories.

This model becomes less relevant as the transition from rural to urban labor force winds down and labor costs rise. Nowadays, Japanese factories have few workers and lots of robots on factory floors.

The Japanese military factory management system spread to other parts of East Asia, especially Taiwan. It was a Japanese colony for a half-century and receptive to Japanese management skills. When the yen's value rose in the 1970s, Taiwan got its first opportunity to take away Japanese market share by adopting the Japanese factory management system.

And when the Taiwanese took their businesses to the mainland, they found a place for applying their skill with 50 times as many people. Because they combine the Japanese system and knowledge of China's labor force, they are better than Japanese in managing factories in China.

The magnitude of scaling up by Taiwanese businesses is beyond what the Japanese could have imagined. Indeed, no other businesses have done what Taiwanese businessmen have with hundreds of thousands of workers in labor intensive operations.

This Taiwanese success drove an economic restructuring in the United States. It allowed multinational companies to focus on research and development, branding and distribution. Today, a U.S. brand company can dream up a product and order it from a Taiwanese company with factories in China as easily as ordering a pizza from Pizza Hut. Without Taiwanese factories in China, it is hard to believe that Wal-Mart and Apple, the era's quintessential creatures, could have become as successful as they are.

This sustainability of this profitable relationship between U.S. brand and distribution companies and Taiwanese factories is based on a Chinese labor force that continues to be plentiful and willing to accept working conditions.

How Much Longer?

In early 1990s, when I was working in Latin America, I became bullish on China's future. I saw Chinese workers would go much farther than elsewhere to earn a little money for two reasons: a cultural acceptance of "eating bitterness" in life; and familial obligations.

The girls at the factory I visited were earning US$ 100 a month, which was not a bad wage. That money could be used to pay for a younger brother's tuition, a mother's medical bill and, if circumstance permitted, building a house for the whole family. Each worker was willing to sacrifice herself for the family; she was not living for herself. Essentially, she accepted hardship.

These factors have changed. Today's young adults are less willing to eat bitterness. They are the first generation to grow up during prosperity, without worrying about food and shelter. Many were pampered by parents sensitive to the one-child policy. They are more like counterparts in other countries, which is good for China's international relations.

Moreover, rural families are not desperate as they were a decade ago. Siblings are few, and the government pays much more for rural education. Health insurance is decreasing the numbers of families facing financial crises due to sickness. Most rural families have built houses. And familial obligations for today's rural youth are not as urgent as in the past.

Meanwhile, inflation has severely eroded income value. Today's rural youth aspire to live in big cities, yet property prices in cities have grown twice as fast as wages. Dreams of owning a house in a comfortable city are becoming more distant.

Recent events at Foxconn and Honda factories are symbols of this new China. The labor force isn't as plentiful or compliant as before, and the ways that governments and businesses are handling the situations expose their ignorance of a new reality. They still think these are isolated incidents and, through pressure and bribery (such as a little wage increase for all and then firing rebel leaders) can bring the situation back to normal.

They think this way because of a generation gap, and the unusual relationship between local governments and businesses in China. The economy has raced three times faster than western economies did a century ago, and the generation gap seems three times larger as well. Today's young adults and their parents may as well be from different centuries. But government and business leaders are all from the parental generation, handling labor crises from this old perspective.

The governing class judges everything on short-term, marginal economic improvement rather than according to dreams and long-term goals. Today's young people are more concerned about what will happen to them in the future. They want to settle down in big cities and have interesting, well-paying jobs – just like their counterparts in other countries. This vast generation gap in perception is the force behind social tension over China's property bubble as well as factory working conditions.

The current factory system is unable to realize the dreams of today's young people. China's factories are often in isolated locations and self-contained. Youths who leave villages for these jobs find themselves more isolated than at home, with little hope of integration into urban communities. Indeed, they are neither in city or village. It's the most isolated life possible.

The compensation system makes their lives extremely difficult as well. Base pay is low, and only with massive overtime can they expect close to 2,000 yuan a month. They have no time for self improvement or integrating into modern urban life. In a few years, they will lose their youth and jobs, but they still will not have the ability or financial resources to live in cities.

Business leaders and government officials, of course, are asking why these workers aren't willing to accept these conditions, like the workers of a decade ago. They grew up in poverty and rule the country with a view that marginal economic improvement is the purpose of life. They don't appreciate, however, that times have changed: The previous generation focused on economic benefits for relatives in villages, not their own futures.

The unusual relationship between factory owners and local governments makes it difficult to resolve or prevent labor problems. Most coastal factories have workers from interior provinces. The governments have few ties to workers, but they are very connected to factory owners through tax revenues and other benefits. Local governments, therefore, side with the businesses when dealing with workers.

To improve the situation, the central government should limit these major, isolated factory sites. In the future, they should be located close to cities. As in other countries, workers should be encouraged to rent housing rather than live in factory dormitories. They should have a chance to integrate into urban life.

For example, future factories should locate close to provincial capitals such as Changsha, Chengdu, Hefei and Nanchang, which until now have been supplying workers for coastal regions. As a general rule, these cities should discourage factory dormitories but instead build public transportation systems to link factories and residential areas.

For many, these sorts of solutions to China's labor challenges may be apparent. But government and business leaders may not understand them at all. They are blinded by the urge to continue operating within the confines of the old model while protecting businesses from potential buyers in the West. So, when dealing with crises such as those at Foxconn and Honda, they try temporary fixes.

I'm afraid similar yet greater problems will eventually surface. Ultimately, market force will bring down the current system. Workers don't have to show up for factory jobs. They can join the urban service sector instead, where wages may be a bit lower but lifestyles are much better, and have a chance to integrate into urban life.

Rising labor costs will ultimately force factories closer to labor sources, and working conditions will turn more humane. The biggest losers will be coastal governments that side with the factories to protect their revenues. If they refuse to change, they will lose the factories and all those nimble fingers.

Andy Xie Discusses Chinese Economy

Andy Xie, an independent economist, talks with Bloomberg's Rishaad Salamat about China's economy and central bank monetary policy. Xie, speaking in Hong Kong, also discusses China's real estate market and the yuan.

(excerpt from the full Bloomberg interview, June 9, 2010)