Oil price will peak after it cross the $70 mark, and US has full control on oil price now

Click this link to look at the chart at EIA. Notice the pikes since 2004

• 67) OPEC delegates agree to lower the cartelÂ’s output ceiling by 1 million barrels per day, to 23.5 million barrels per day, effective April 2004.
• 68) OPEC agrees to raise its crude oil production target by 500,000 barrels (2% of current OPEC production) by August 1—in an effort to moderate high crude oil prices. Price onlfellened slightly but quickly shoot up (compare the quantitative adjustment of 68 with 67)
• 69) Hurricane Ivan causes lasting damage to the energy infrastructure in the Gulf of Mexico and interrupts oil and natural gas supplies to the United States. U.S. Secretary of Energy Spencer Abraham agrees to release 1.7 million barrels of oil in the form of a loan from the Strategic Petroleum Reserve. Price corrected briefly and shoot back right afterward

The above is for what happened from 2004 till Mar/2005. More recently (number labels added by me),

• 70) Aug/1/2005: King Fahd died, although Saudi has been effectively ruled byt he heir for about 10 years already, oil price continued to hike with this excuse
• 71) Aug/27/2005: Hurricane Katrina send oil price to $69, do we expect oil price to correct when production resumes in Gulf of Mexico?

You can see every single time when there is an event favorable for oil price to rise, it rises. Even if that temporal event has ceded, the price does not correct to its original value, as it should have (because it is unlikely the demand/supply scenario changed that much during a couple weeks). However, when there is an event indicating the other way, oil price did not adjust to the same scale. What am I getting at?

1. There is a fundamental trend of continuous rise in demand, no question about it, China and India, 2.3 bn people consuming oil. However, this rate of increase is not new in 2004. We had it coming since 1998, or may I say 1978?
2. The pikes seems to be pushing beyond a normal upward trendline (which can be plotted using x-day average), So it is very likely that someone is trying to manipulate the market (on top of reason 1 above), the speculators, the hedge funds

These are no news to any of us. After all, speculators are riding the general market expectation, and very often, helping market close in to the "equilibrium price". However, when we study the one-sided adjustments above, it is hard not to believe that oil price has already passed the "equilibrium point". Dong Tao of CSFB seems to agree. He said that "hedge fund are responsible for today's high oil price". (Via 东亚经济评论 East Asia Economic Review, in Chinese)

In CSFB, Tao has first hand contact with hedge fund managers, and commodity traders. His logics are: crude oil futures dictate spot price, and he knows that 20-30% of the future contracts are hedge fund bets, which are all highly leveraged bets. When leverages and stakes are so high, the underlying motivation is no longer driven by economic fundamentals (or the "expectation" of these fundamentals). Irrational bets are common. He quoted some examples ("educated rumors", I suppose):

• some hedge fund managers have been buying information from Mossad agents (Israel's secret agent, they are 100 times better than CIA) for first haninformationns in the Middle East
• some even tried to meddle with Venezuela politics (Tao did not say how, maybe sponsoring both sides so that the fight continues? or bribing the ministers?)

The implication: this is a metastable position and that it could collapse when the one-side bets are no longer sustainable (like LTCM in 1998) e.g., if there is a sudden increase in supply (e.g. Venezuela, Iraq stabilizing, Iran compromising, or US selling "strategic reserve") or a sudden drop in demand (a looming recession), triggering stop-loss order circles. Dong thinks it is now very risky to bet on oil price to rise further, and trouble is waiting the speculators.

Update: One more important point to add. Higher price will lead to higher supply, and eventually lead to the correction in supply (deep water drilling and oil sands) and demand (alternative energy). The price of silver in 1979-1981 is a good lesson.

Now, US announced it may use its strategic reserve. Government should not intervene on market activities. But since Katrina affects US, it gives a perfect reason.

"Obviously, the Strategic Petroleum Reserve is there for emergency situations, and that would include natural disasters," [White House Spokesman] McClellan said. "But it's just too early to know at this point."

It seems Bush administration is finally trying to act. Because the price hike is threatening the economy and more importantly, the financial risk for invention is very low now. What is better than invention while making huge profit at the same time (selling the "strategic reserve" high and buying low later)?

In the next few days, if the threat of dumping reserve will not stave off speculators, there may be real dumping of the reserve. If the Bush government does it right, it should dump more the amount it needs to. i.e. pushing oil price back to under $50 or even $45 per barrel, to tricking a chain reaction of stop-loss orders by hedge funds. Then it should buy back the reserve slowly again.

However, the obstacles are the oil interest group lobbyist, and the family business of Bush himself. So, oil price would peak but it might not retreat as it should. It is all up to the Republican government. Unlike a few months ago, when no one is very sure whether the equilibrium point has been passed. The question is, do they want to win the next election? Bush himself does not care. But there are other side of the market force, as mentioned (4 paragraphs) above, or some of the dark arts of hedge fund might turn into a scandal. Collapse of one single hedge fund will suffice to trigger the stop-loss circle due to its high leveraging.

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Updates:

Econbrowser has a great analysis , looking much deeper into the supply and demand of oil than I did here.

• "The Energy Information Administration also reported that global oil consumption fell 0.1 mbd in the first quarter of 2005 compared with the fourth quarter of 2004... Taken at face value, the difference between global production and global consumption growth would imply either a build-up of inventories or less inventory drawdown during the first quarter of this year, though it could also reflect inaccuracies in either or both of the underlying statistics."

Let's set aside any urge to relate to a conspiracy theory about hedge fund with refinery prompted by the rumors Dong Tao heard, the fact is demand in 2005 did not increase over that of 2004, and supply did not decease. So what has happened to the price?

How much would RMB/USD rate drift (ii)?

Talk Talk China made a great observation that SAFE charged the big banks in China a hedging preimium of 3% to cover RMB appreciation till 2007 (or 1% per year). He concluded that there will be around 6% adjustment between 1/2005 and 1/2007, or perhaps a little more.

This is in agreement with my earlier "speculation" that RMB will appreciate at a rate of around (not more than) 2.5% p.a. on average, at random timing, based on the need to discourage speculative activities.

However, one should also note that 2-3% is the typical premium any investment bank (MS, CSFB, GS) would charge for hedging, for a 12 month contract. What this means is that the 1% p.a. option premium SAFE charges the bank is ridiculously cheap, because the duration of this option is 3% for 36-48 months (Xie said it was 1% p.a.). We know the risk is much higher if the duration for an option is longer.

According to Xie Ping (via Talk Talk China), the options were signed in Jan/5/2005, Jan/12/2005and Apr/20/2005 for BOC, CCB, ICBC respectively, for an amount of $18bn,$22.5bn and $12bn. Another point to note is from the original text of Xie Ping in Chinese, he offered to interpret that "the risk is shared between SAFE and the banks" means that they are merely following what an option underwriter would do. It does not neccessarily mean that they share the cost mathematically, as TalkTalk has interpreted. (是商业银行和汇金公司用市场化方式共同承担了风险。商业银行支付了期权费，我们执行约定的买入价格。这是期权交易，其他投资者既然关心这个问题，我们就用市场化的方式解决掉这个问题。汇金公司这么做是很市场化的，投资者看到资本金汇率风险已经对冲，就不用担心此事了。) In fact, Xie alleged that SAFE has hedged the risk in the market already, although I do not understand how it did that, maybe through issuing RMB bonds?

Another minor point worth mentioning is that the strike price is RMB8.277/USD for these options. Therefore, whatever TalkTalk predicts, we need to subtract 2.1% from his number because the rate today is already around 8.11. i.e. SAFE's gross profit is 0.9% only today, assuming RMB does not depreciate or appreciate further, and neglecting interests earned/lost from the premium and hedging operations.

There are two possible ways to interpret this

1. SAFE is pricing the option at a huge discount, in a way subsidizing the banks
2. SAFE did not expect major changes, or as TalkTalkChina reasoned, the range will not be much larger than 6% (from 8.277)

Another way to look at this, is to plug the premium of 1% p.a. (more accurately 3% for 3 years)into Black-Scholes and calculate the implied volatilities. I do not know how much the NDF underwriters are charging now (was reported to be around 3% p.a. before July 21), but the implied volatitily they use must be a lot higher than that used by SAFE. (Black Scholes theory shows that the higher the premium, the higher the implied volatility, which is a measure for the expected fluctuation of the strike price) If SAFE is acting rationally, or it knows something we do not know, the NDF underwriters are making obscene profit. In other words, RMB will appreciate at a rate much slower than NDF market expectation, or SAFE is going to lose a lot of money. My "epiphany"? let's go into the NDF underwriting business.

(also note: this may, in part, explain why the reval on July 21st was adjusted from pbc proposed (reportedly)5% to 2.1%, as SAFE might have joined force with Ministry of Commerce, unless they did hedge it by issuing RMB bonds)

Price control in Chinese hospitals

FT on China's price control (Aug22, also Chinese translation if you don't have subscription): other than the widely publicized price control on gasoline, it is probably about time to lift the hands on hospital diagnosis, and that on utilities

"When Gao Qiang, China's health minister, responded to scathing criticism of his country's health system this month he turned his ire on local hospitals, saying they had put profits ahead patients. Mr Gao raged that patients were being billed for drugs to cover the cost of everything from wages to building maintenance, leaving an increasing number of citizens unable to afford to see a doctor.

From the hospital's perspective, however, the picture is very different. A squeeze on government funding and strict price controls on most services mean they are forced to rely on drug sales for up to 70 per cent of their budgets.

"The problem with hospitals centres on the draconian capping of doctors' fees and in-patient beds," said a foreign pharmaceuticals executive. "The result is that they run these services at a loss and have to make up the money elsewhere." The cost of a bed in China's hospitals, even in large cities, can be as little as Dollars 1 a day. Prices are kept low in the name of maintaining what the government calls "social stability".

China has extensively deregulated price controls since it abandoned the command economy in 1979, with the prices of nearly all consumer goods now determined by the market. But the prices of a host of other services - including water, oil, power and cable TV fees - remain under the command of the National Development Reform Commission, the chief economic planning body.The NDRC even controls parking fees for cars and bicycles, the latter because it is a staple cost for many workers.The controls are designed as a political tool, to ensure that ordinary citizens are not driven to protest against spikes in prices for daily necessities, and also as an economic measure to cool inflation."

What Gao tried to avoid was the fact that diagnostic charges are under strict price control, which has forced hospital to find profit from drug prescription and charging for using imported diagnostic equipments. I have visited many Chinese hospitals in the past 10 years, while consulting for pharmaceutical clients, when you enter any hospital in China, there is a price board (like the timetable in a train station, as in the picture, via Bingfeng), specifying how much each consultation cost, how much it costs for using gastroscope (imported gastroscope can charge a higher price tham domestic equipments), etc. Usually a typical visit you will have to pay RMB 5-20 for diagnosis and 50-100 for drugs. Physicians will ask about your insurance before deciding what drug to sell you. In other words, what you get might not be what you need. Furthermore, some patients are subsidizing others, while pharmaceutical companies act as the "tax agent". Plenty of opportunities arise also for corruption among physicians and wardens, via drug rebate. I am also pretty sure the new building in this picture is funded, in part, by pharmaco "donation"

This is hospital's answer to price control, although not as visible as that of the oil's companies.

Until the price control on diagnosis charges is lifted, and competition opened, it is unlikely to see this problem solved. (As to Gao Qiang, I despise anyone among the leadership of MoPH before Apr 20, 2003. Gao got "promoted" only because no one was clean and he was seen as an outsider in the clan, though he was not. I still remember Gao defended Zhang even 2 weeks after Zhang was fired. They were on the same boat. Gao was as guilty as Zhang Wenkang. I do not expect bureaucrats like Gao would be willing to solve the problem.)

Fair enough, price control should only be lifted gradually. Following the wisdom of Dengs' gradualism, I do not believe it should be changed over-night. However, there needs to be a plan and a schedule for reform, where clear milestones are set. An example is, to first use foreign insurers' reimbursement limit as an index, slowly enlarge the price cap to 10%, 20%, and finally maybe 50% or 100% of that index (or benchmarking foreign insurers, e.g. Singapore's, then adjust to RMB using PPP). The problem for MoPH under the leadership of Zhang and Gao is, they have all talked the talk without walking the walk for the past 10 years.

Efficient ride-sharing - Inspired by Chinese taxi-driver innovation

This is in continuation of my previous discussion on Sromi (Ride-Share on 3G/GPS). This one concerns the picking up and dropping off of your friends or relatives over medium distance (ideally 50-200 miles, or 80 to 350 km, or longer range). The problem we try to solve is how to utilize the wasted return leg of the journey. The inspiration comes from the innovation of Chinese taxi drivers on routes between nearby cities, in particular, between Shenyang/Changchun/Harbin, which I learned about a couple years ago.

The Chinese Taxi Model: Background

• China has many cities of over 2M population, typically provincial capitals, separated by 1-3 hour drives. Examples are, Ningbo-Hangzhou-Shanghai, Nanjing-Wuxi-Suzhou-Shanghai, Harbin-Changchun-Shenyang, Shenzhen-Guangzhou, Beijing-Tianjin -- think NY-Philly-Baltimore-DC in US)
• There are bus and train services linking these medium sized (2M+ population) cities, but often the schedules are not as good and tickets hard to get during long weekend or breaks (situation probably worse for US)
• So taxi services are quite popular, costing RMB300-600 per one-way trip. In addition, there are also taxi-pooling to fill the market between taxi and bus services. These are loosely organized among drivers themselves, or sometimes with agents specializing in luring customers who couldn't get a train or bus ticket

The Chinese Taxi Model: The innovation is to ask the passenger to switch to a car coming from the opposite direction around the mid-point of the path, so that both vehicles only have to drive half the distance and can return with full load of passenger as well. This way both vehicles can save fuel costs, time, depreciation and even toll by halving the mileage, and part of the savings given back to the passenger via a price discount

• The passengers are typically charged at a discount (maybe 30%) to the full-trip taxis, but are told about that there will be a switch of vehicle -- (they are very confident that theywill find a car to switch with in long weekends, which means there is already a cirtical mass and scale in the network)
• In the case of China, the drivers usually skip the divided highway and instead drive on the undivided highways which usually run parallel to the toll highways. so that when he sees a likely counterpart approaching, they will flash the high-beam and there is mutual understand to stop by the road-side. The problem is that it is almost impossible to swap passenger on a divided highway, but as we will discuss later, with mobile internet and better planning, we can make it work in divided inter-states as well
• The passengers then switch car and neither driver owes the other any money, so that each takes what his original passengers paid
• There have been "return taxi pools" in almost every cities, (in many airports as well, e.g. taxi's at Shanghai going to Suzhou) where drivers try to fill passenger in their return trip, at a small discount. But the uncertainty is high and drivers usually have to line up and wait for half a day

Mobile internet can greatly enhance the efficiency of this model

While this is a great innovation, and proven in practice (according to passengers and drivers I have talked to), especially between cities with undivided highways where traffic is light (esp in Northeast China), the match-making is not as easy elsewhere. But mobile internet (Sromi) can change all that. Moreover, it can be applied to everybody, not just taxi drivers, e.g. parents who are driving their children to school after long holiday, or even shorter range lifts.

There are two types of match-making

1. Pre-trip arrangement: look for people who travels the reverse direction and make appointment on a gas station (or rest area) near the mid-point in a specific time. Good certainly, but potentially some waiting time if there is traffic delay or unexpected event from either side
2. Mid-trip ad-hoc arrangement: when unexpected event happens in method 1, or for those whose schedules are more unpredictable. Arrangement can be made instantaneously at rest areas (e.g. those on Inter-states-95 between Philly and DC where N and S bound share the same rest area), or when one driving and is about 20-30 minutes before the "mid-point".

The technology and the match-making process (customer experience) is almost exactly the same as that I described previously in "Hitchhikers of America - a business concept". In fact, google has some beta service called ride-finder already, mainly for taxi drivers, though they haven't yet combines this with eBay style match-making.

Unlike the previous case for ride-share or carpooling, the inter-user relationship is a lot simpler. This time both sides are both drivers and passengers, and there is likely to be no cash transaction involved and hence less complexity due to pricing. (except a match-making fee of $0.50-1.00 charged by the match-maker who keep track of user-reputation-rank/etc, and even this fee could be sponsored in part by government who encourages energy saving and reduce global warming). Also note in this application of Sromi, locational service such as GPS or Mobile Basestation Triangulation plays a bigger role, esp for ad-hoc match-making.

An enhancement of this model is that it can apply for longer distance hitchhiking, if rest area becomes a car switching hotspot. It can also increase the feasible lifting distance, i.e. now that a 4 hour drive will only take up 2 hour to complete for the driver.

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p.s. Digression of why we see innovation from developing countries like China, I think it is a direct result of the different economics in these markets

• Labour cost and time is cheap, compared to fuel and equipment (car). People are willing to make small trade-off of cost over convenience (switching cars in this case -- see also previous discussion on de-aumotation in China). As oil price reaching $67/barrel, there is more similarity to the relative economics in US now
• The innovation in China was probably there for a few years already, since they did not tried to use mobile phone at all. Perhaps it turns out that the ad-hoc match-making on the undivided highway works better, as passengers do not have to wait at all.
• An unrelated, but similar observation of how a different market environment can change business practice is HK, where the high rent has driving up sales/area to be many times higher than, e.g. US. It also helps to explain the low BigMac price in HK, the rents, labor cost per unit sold is much lower in HK, because of extremely high utilization

"The Long Tail" on DRM, downloading and digital media

(Updated Aug 25 pm)

The Long Tail (Chris Anderson) has great insight on the digital media, and in fact, the insight applies to many internet businesses, and business in general as well.

His has a new post about DRM, basically explaining why Movielink and CinemaNow have so far failed. While I do not fully agree with his argument, he made a few interesting points worth discussing

1. "Any protection technology that is really difficult to crack is probably too cumbersome to be accepted by consumers
2. Instead, efficient software and entertainment markets should exhibit just enough piracy to suggest that the industry has got the balance of control about right: not too loose and not too tight. That number is not zero percent (which requires protection methods so invasive they kill demand), and it's not 100% (which kills the business). It's somewhere in-between
3. piracy can actually let you raise your prices: The usual price-setting method is to look at the entire potential market, from the many at the economic lower end to the few at the top, and set a price somewhere in between the top and bottom that will maximize total revenues. But if you cede the bottom to piracy, you can set a price between the top and the middle. The result: higher revenues per copy, and potentially higher revenues overall."

His point #1 is intuitive and is supported by his other points.

I have another good example for his point #2, it proves the "could" but not his "should" assertion. See for example the encryption of DVD, CSS. Free DeCSS softwares such as DVD Decrypter and DVD Shrink are available across the internet (e.g., here). Does this damaged the $15bn DVD market? No. Does the ridiculous region code prevented decrypters at work? No. Those who went to length at DeCSS are not going to buy the legitimate products if pirated copies are not available. The only difference is that the region code has greatly reduced efficiency and increased the cost of manufacturing and distribution. In this case CSS is appealling to consumers, because it is not as cumblesone as DRM. The fact that CSS is cracked does not damage the key areas of its target market.

His point #3 is not really right, and it requires some elaboration and discussion.

• In making this point Anderson has implicitly assumed price uniformity across the world (for software, or media content products), which is fine. Unlike that of pharmaceuticals, it is easy for software and media content to surf cross national coundaries, thanks to the internet (and the small size/weight of the DVD which facilitates shipping). Therefore, we can assume that parallel import has will effectively equalize price, roughly, as we have observed in reality.
• The second assumption he has made is that the long tail (the yellow portion in the chart above) is not very sensitive to price. (i.e stiff price elasticity). This is where I do not agree. The x-axis of the graph is price, the y-axis the volume. Price is the line that separates the two areas. Total revenue is the yellow area times price (the cut-off). Therefore, if the revenue loss of the portion above the cut-off is not compensated by the increase in volume, Total revenue will decrease. (In pharmaceutical, it was possible to apply differential pricing to different markets (Canada and France, vs US) up to this moment, so the argument here does not really work. However, more and more people are importing drugs from Canada.) This is where his logic falls apart. As Brad at Panopticologist correctly pointed out, "When a firm with market power sets their price they are always making a trade-off between receiving a higher price from a few and a lower price from many. The rational firm looks at the entire market and chooses a price which maximises profit. If a portion of that market leaves, revenue will either decrease (if the price was sufficiently low to sell to that portion) or stay the same (if the price was too high for them anyway)." Brad's argument asserts that for a monotonic function volume(price), the revenue function (P * V) has only one maximum. The simple form of his proof assumes uniform pricing, but one can construct a more elaborated proof for tiered pricing as well.

However, what we have observed is that some degreee of piracy is associated with the successful marketed product (e.g., DVD), while none of the fully protected products make any success in the market (e.g., movielink), especially for software and media content products.

Now let me argue in defense of Mr Anderson, that there is an optimum point for tolerating piracy, and that optimum point is not zero piracy.

• There are two choices, 1) abandon the red portion (low end segment) and forbid them to use without purchase (they can't afford to), or 2) cede the low end to piracy. Microsoft's example has proven that ceded it to piracy (hence the total revenue decreased a tiny amount in the short term) will trap the market and train the potential customers, hence helping them the grow of the yellow part much faster when income level increases
• To prove Mr Anderson's hypothesis one needs to assume that the volume curve (the chart above) would expand, which is not difficult to show. Such volume increase due are found in the examples of LD vs VCD vs DVD, in Asia and US. The VCD market in Asia flourished largely as a result of the wide-spread of piracy (also see below). One could even argue that the Hollywood studios made more money over VCD than LD, for which piracy technology was too expensive. In short, the media industry has mistaken that it is a zero sum game, but it is not.
• Or alternatively, to maximize sum of revenue over time, instead of the static sum at current time. This is analogous to the free trial promotion for shampoo from P&G, except that the cost is zero for such promo. Bill Gates cleverly used piracy to accomplish his promotion campaign. The DVD Forum got their free promotion passively (see below).

In addition to Anderson's illustration with Windows OS, we could
also look at the DVD machine market, from DVD Consortium's perspective. It was the Chinese manufacturers
(assemblers) who have commoditized DVD machine, and in turn drived the DVD
market upward. Without the Chinese players, we will still have to pay for
$350-500 per DVD machine. It would not be surprising that DVD suffer the same
fate as LD in North America. And we may still be watching VHS today.

But how did the Chinese managed to cut the cost so much? A few
reasons

1. During the mid-1980s and mid-1990, Chinese companies have
   competed fiercely with each other on the home appliances, from refrigerator to
   microwave machine, to TV set and VCD players. The huge domestic market of 10-40M
   unit is great playground to move on the experience curve when they entered the DVD player
   market around 1999. As we can all see in Wal-marts and Best-buys
   today
2. The learning curve on DVD players is boosted by the learning
   from VCD player assembling (which is entirely absent in the US market, like the
   LDs)
3. Most importantly, before these Chinese players export en mass
   to the US, they perfected their skills within China, where they did not have to
   pay loyalty to the DVD consortium

The results are that the DVD consortium made a lot more money
from licensing to these Chinese factories than they could have otherwise.
Additional sales were also made in the DVD drivers, the chip and other stuffs.
Without some "piracy", Toshiba and Philip would not have profited so much in the
DVD market. This is in support of the Microsoft experience.

The problem of DRM, and that of Movielink and all the pre-iPod online music stores, in my view, lies in their business models. More precisely, the product itself. The restriction DRM imposed on the products just make them repulsive to consumers. There is no "ownership" under DRM, and the pricing for DRM content is totally wrong. If they call it "rental" instead of "sales" it might fare better. But then DRM cannot compete with streaming media. It is caught in the middle of no-man's land.

We learn from the above discussions

1. Highly successful products are often correlated with certain degree of piracy
2. Ceding the lowest segment to piracy might help nurture for future growth
3. Cumblesome anti-piracy measure such as DRM will drive away potential customer, simplifying the technology and making it more user-firendly will help boost volume significantly, even though that might mean losing a portion of potential volume to piracy, as that would be more than compensated by the volume gain in the other segments
4. The failure of DRM related products such as Movielinks are due to their business models, which is in part dictated by the inflexibility of the DRM technology itself

When it comes to new technology, one just has to bear in mind that this is not a zero sum game. Opportunity rewards the risk-takers.

Sun Tze: "supreme excellence is winning the war without fighting" - there's no point stocking weapons

Sun Tze said, (Chapter 3) "...Hence to fight and win in every single battles with 100% stat is not supreme excellence; supreme excellence is winning the war without fighting (是故百战百胜，非善之善者也；不战而屈人之兵，善之善者也)"

• The best modern example of winning a war without going into fighting is the cold war between US vs USSR post-1975, credit to the Nixon-(Carter?)-Reagan administration. Nixon's famous ping-pong diplomacy and Reagan's Star War Arms Race
• An earlier "close example", albeit controversial and not really a non-fighting war, was the dropping of the A-bomb on 60 years ago.

"The next best strategies in order are: (1)intelligent maneuvers, (2)diplomacy, (3)fighting in the field, (4)besiege the city. Besiege the city ONLY when you have exhausted all other options." (故上兵伐谋，其次伐交，其次伐兵，其下攻城。攻城之法，为不得已。) (1) and (2) are among the major means to achieve the supreme objective of "winning without going to war"

• This is what mainland China tried to do earlier this year, by passing its anti-secession law. To increase the stake so that they can avoid being pushed (by hawks from both sides of the straits) into war. They hope to buy time, perhaps 30-50 years of time in status quo, until China's GDP/cap is comparable to Taiwan's, and maybe also political system as we would hope. But first of all, they don't want any instability or give the hawks an excuse. The hawks in China would gain wide support if Taiwan cross the line.
• As Lee Kuan Yew pointed out, "I think they have put themselves into a position internationally that if Taiwan declares independence, they must react and if Beijing's leadership doesn't, they would be finished, they would be a paper tiger and they know that. So, they passed the anti-secession law to tell the Taiwanese and the Americans and the Japanese, "I do not want to fight, but if you allow Taiwan to go for independence, I will have to fight." I think the anti-secession law is a law to preserve the status quo."

Many politicians in Taiwan knows that. I suspect that includes Mr Chen Shui Bian himself, as he has been doing more or less what Lee Tenghui had done while he was in presidency. So are many in the opposition parties in Taiwan. They know that buying $15bn of weapons cannot prevent a war nor win a war with the mainland. And these weapons are getting obsolete almost as fast as our laptops. What's the point?

(This applies to mainland China as well, as they wisely chosen to
focusing on learning the technology, instead of building an arsenal. Meanwhile,
they tried to lay low to avoid any potential international conflict.)

Unfortunately, the supposedly brilliant Wall Street Journal editors seem unable to understand this. Or maybe they do, but someone paid them to say something they do not personally believe. WSJ Op-ed Aug 24 attacked Taiwan's democracy, blaming its Legislative Yuan for blocking the $15bn arms purchase from US, reminding me of China's Foreign Ministry "demanding" US Congress to reverse the Unocal vote. Apparently many people do not understand democracy. Then it said, in an 'optimistic' tone,

• "The good news is that recent Pentagon report on China's military has put opponents on the defensive by highlighting how Taiwan risks "being quickly overwhelmed" by Beijing's rapidly modernizing forces."

Oh, that is what's behind the China Military Report, to sell more arms ($15bn) to Taiwan (and to the US DoD). And there won't be price negotiation. Because "US [approved the sales] by taking some diplomatic risk". Lucky for Taiwanese people, they have a democracy now, and they are beginning to use their brains. WSJ hoped Ma Ying-jeou would support the arms purchase, but failed to mentioned that Lien Chan probably opposed the purchase because of his voter told him to do so. I hope Ma is not that stupid. At the end of the day (next decade), it would be the peopleo both sides of the strait who would win this "war", when they embrace democracy, if the rulers could just hold on to status quo and wait.

As for the WSJ op-ed, yesterday they had proposed another "brilliant strategy" against Iran, to bar them from playing in the FIFA World Cup, as discussed by Brad Sester. ROFLMAO.

(Updated Aug 29)

• Kishore Mahbubani in his recent essay on Foriegn Affairs, "China today is like a dragon that, waking up after centuries of slumber, suddenly realizes many nations have been trampling on its tail. With all that has happened to it over the past 200 years, China could be forgiven for awakening as an angry nation, and yet Beijing has declared that it will rise peacefully. This good disposition stems partly from China's awareness that it is relatively weak. But it is also a sign that Beijing has endorsed the vision of progress that the United States has extolled since World War II. States no longer need to pursue military conquest to prosper, the theory goes; trade and economic integration pave a surer path to growth. And Beijing has noted how much adhering to this philosophy helped Japan and Germany emerge from the ruins of World War II."

(Updated Sep 2)

• Ma Ying-jeou said (in a foreign press interview), the arms purchase is not only a price issue (noting the price tag has more than doubled since it was first proposed in 2001). He mention the priority is to avoid an arms race between the strait. -- Finally someone who makes sense.
• Ma further criticized the DPP governement for playing fire on one hand (create excuse for mainland intervention), and fire hydrant on the other (arm purchase at elevated price)

Textile quota, how protectionism backfires and a proposed solution

From The Economist: "Europe’s textile war with China—and itself" described a situation when protectionism backfired, "Chinese-made bras, blouses and T-shirts are piling up at customs checkpoints across Europe, having already bumped up against import limits set earlier this year. The European Union has sent a team of officials to Beijing to negotiate a way out of the crisis. But European retailers are just as annoyed at the quotas as the Chinese...Barely a month after the deal was agreed, China exceeded its quotas for pullovers. Less than a month after that, men’s trousers hit their import quota, followed rapidly by blouses, then bras, T-shirts and flax yarn. Tens of millions of garments are piling up in warehouses and customs checkpoints, while the prospect of shortages has consumers and shop-owners up in arms."
This is how productivity at home is destroyed by these bureaucrats. Not exactly due to protectionism, but myopic planning and bad implementation, as I would discuss later, after quoting the reasoning from The Economist:

• "At best, the quotas are only delaying the inevitable. It is hard to see how rich-world workers can compete with the low wages that their counterparts in poor countries are willing to accept
• Nor is it clear how much the quotas on Chinese goods will help domestic producers, when there are so many willing firms in low-wage countries like Bangladesh and Costa Rica waiting to take up any Chinese slack
• It’s not clear why it is better to provide jobs in Tunisia, where per-capita GDP is $7,100 a year, than in China, where income per head is 20% lower. (note, in PP terms, China's nominal GDP/cap is $1200)
• While large retailers will probably be able to find new sources for their autumn and winter lines, many are warning that smaller stores may be driven into bankruptcy
• Government ministers from the Netherlands, Denmark, Sweden, Finland and Germany have all spoken out against the quotas, and one German businessman has filed suit in Germany’s Constitutional Court"

It said, "The European Commission, the EU’s Brussels-based executive, is frantically trying to hammer out a deal that will please manufacturers, retailers and the Chinese. It has floated the idea of “borrowing” quotas either from next year or from categories that have not yet hit their import ceilings. But this has reportedly met with a distinctly cool reception from the Chinese..." It seems that now China wants to teach EU a lesson. But I tend to think otherwise. China has learned to compromise, and the Chinese very good in doing that. But they are trying to leverage the retailers to speak up for them, and playing the Northern European who do not rely on low tech jobs against the Southern European protectionist lobbyists.

Why China can be "cool" at this, because the proposal does not work. It is wishful thinking at best. Borrowing quota is only going to delay the problem into the following year, and make it much more serious then. The problem EU encountered today is a direct result of lacking a clear and longer term plan, of a fickle rule. How can you impose quota all at a sudden, leaving no time for merchants to plan? They need to at least waive quota for all those who have already signed the contract prior the quota implementation. I thought this is common sense for any policy setter, apparently not for the EU bureaucrats. Prior this year exporters need to "buy" quota before they could ship out the merchandise, and the buyers are clearly aware of and prepared for that. Now all of a sudden the quota is set at the EU border and no one knows when it is filled. Importers just continue with their orders. Perhaps the Chinese negotiators already saw through this a couple months ago but they just kept quiet.

More likely, the effective total quota for 2005-2007 would be somewhat increased. e.g. a potential solution will be

• For all retailers who have signed the contracts before a certain date (e.g. before the previous round of negotiation 2 months ago) quota should be exempted, irrespective of the duration of these contracts.
• Therefore 2005 quota has to be adjusted, hence also 2006/07 because the growth has been agreed upon, though very likely the growth percentage figures would be adjust down accordingly
• In return, EU negotiator might need a couple minor categories to add to the quota list, so as to pacify Italy and Spain
• In the quota categories, there still needs to be a clear set of rule. Messy problems now arise, who is going to get these quota? How to make sure it is fair? "First come first served" basis will only lead to chaos, and further pressure to increase the quota. But there are better solutions, e.g., China could set up a bidding system at the beginning of the year, and any unused quota will be taken back around Oct/Nov and go to auction again

This is happening while US and China are negotiating for a similar deal. I hope US is learning the lesson and I also hope California speaks up (as Tyler Rooker spelled out the reasoning in his fantasy of CCFTA). Nonetheless, they would probably wait and learn from the results the new negotiation between EU and China, or read the Economist, or try the alternative proposed here :).

Updates: see also Mandelson and EU taking the clothes off our backs via Asiapundit.

A picture is a thousand words, and about gradualism

Bingfeng showed the original quote of gradualism in Deng's words, in this picture. He lamented there are too many stones in the river now. However, as we saw in the picture, the shore is prominently visible, with a lot of trees.

Therefore, with good vision and the feel for direction, it is not that difficult about which stone to feel next. For Bingfeng's concerns,

• Oil price? This is a small river. Let it float, you can't be wrong.
• Exchange rate? This one we are not sure if we can see the shore, it is so foggy here. Fortunately, we switched to a basket now. There are only two directions to go, and you are not going back. The question is, how fast to charge forward, which takes good reading of the flow speed. 2% each time, wait 6 months (look around) to feel the impact (flow) and decide how fast to go
• Healthcare safe net? You got trapped in a big pile of stones in the middle of the river, you have to move your stones to create your path. But the shore is visible. The Singapore model works in the cities, sort of, well, at least better than the past. But the poor migrants and rural residents are not covered. The root of the problem lying in lifting the poor people from poverty. Without that, it will still be socialism.

Of course, this is easy said than done. But a carefully thought through strategy should point to the right direction. Feeling the stones just help to reassure you don't get drowned, in case the strategy is not really thought through. But there is plenty of small creeks and medium size rivers before we see the big ocean. The Americans are way ahead, let them face the ocean.

To form a strategy you need good vision, to make use of your good vision you need first to see the big picture. :-)

Pleistocene Park: Darwinism, free market, and conservation

The Economist has a great discussion on a recently proposed idea on wildlife conservation, to create a Pleistocene Park in the great plains of North America (see excerpt below for details).

This seems like an off-topic digression, but it is not. I believe understanding evolution and Darwinism is crucial to the understanding of free market, business competition and strategy. See, for example, "The Natural Laws Of Business" by Richard Koch.

• Koch said, "According to Bruce Henderson, the founder of the Boston Consulting Group (Sun Bin: Bain, who is among the first few employees hired by Henderson and made the first partner of BCG, created the spin-off Bain Consulting; and Bain Capital, which recently teamed with Haier to bid for Maytag, is a spin-off of Bain Consulting), "Darwin is a better guide to competition than economists." This is an important observation, although perhaps hardly surprising: Darwin's idea of natural selection was, as we have said, in part analogous to the theories of competition of Thomas Malthus and Adam Smith. So, in applying the lessons of natural selection to business, we are in a sense coming home to a common intellectual heritage."
• Henderson also said the difference between business competition and biological evolution is that one can apply strategy to create and advance one's advantage in business competition, while in natural selection competitive advantage is created largely through random mutational events. (Not entirely true, as the choice of the organism may also help to select which genetic trait to preserve, e.g. male peacock's tail is chosen and selected by the female, songbird train their singing skill and pass to their offspring. Today we can even alter the genes to create gigantic mouse or blue rose.)
• A free market is thus analogous to earth before human being arrives (and sans "god")
• Each niche ecosystem (such as the hot-spring sulphur eating bacteria system, tropical rain forest, or an island in the Galapagos) represents an isolated business environment with its special set of rules
• Geographical barriers such as ocean or mountain are analogous to the boundary for protectionist nations (and also geographic separation between the economies in the old days). Boats and planes represent limited trading between islands. It is now easy to understand why the Eurasia-Africa continent nurtures the most competitive organisms and civilizations (Jared Diamond discussed about this in "Guns, Germs and Steel"), because it is the largest genetic free trade zone.

The pros and cons for the Pleistocene Park idea are already very well described in the excerpt below, so I am not going to enter the debate. I would just note that they should probably start with a fenced colony, following Deng Xiaoping's "Gradualism" principle.

However, it struck me that conservationists seem to lack an overarching objective. Is our objective to save every species currently on earth with our best effort? Or is maximizing biodiversity our objective? The debate arises because these objectives often are in conflict with each other. Without a clearly spelled-out, and quantifiable objective how could a strategy be formulated, let alone implemented?

Let's examine our options

1. Make sure we do not interfere with Darwin's rule. This is unrealistic. Because homo sapien is already the clear winner. Total laissez-faire means to do nothing, and let homo sapien destroy the rain forest to maximize its population, and bring along those organisms which manage find a niche with the homo-centric ecosystem, i.e., mice, roaches and crows. This is not an option.
2. Preserve status quo as much as possible: minimize any further change to the ecosystem by limiting human territory expansion, let Darwinism rule in national parks but minimize human intervention of these existing systems, let lions eat antelopes and prevent exotic organism from interfering with indigenious harmony -- this is closest to what the conservationists are doing today
3. Actively manage evolution and save the "endangered species": e.g., the giant panda santuary -- also part of a separate conservation effort, but effort is more haphazard
4. Maximize biodiversity. e.g., by creating and set aside (leave alone) multiple isolated ecosystem/biospheres, apart from one macro-system with human beings; and save all endangered species as we could -- this is more said than done as no one really figured out how (or is bold enough to try); except for option 3, which is actually a sub-category of this option

Options 2 and 3 are intrinsically contradictory, as illustrated in this Pleistocene Park debate. One cannot help but ask, "Is protecting endangered species such as the giant pandas an act against evolution?", in other words, should we protect the giant pandas if they are ugly as the hyenas? If not, why is the indigenious ecosystem treated as sacrosant?

Or perhaps we should pursue option 4, in which option 3 is just one of the many means. Option 4 also sort of includes option 2, and brings to us the advertised benefits such as "herbal/natural medicine" from a larger gene pool, and the option to reverse any mistakes (since the gene diversity is preserved) human might make in the future. It is probably premature to claim any of the three options (2-4) is a superior over the others. And there might well be other option. However, what we have today is incohrent and inconsistent. The conservationists need to write down a coherent set of objectives and rules.

If biodiversity is what we are after, we may be able to apply what we have learned in free market back to ecology. i.e. allowing gene flow between geographies would ensure diversification. Create isolated sub-colonies can nurture specialization. As a preliminary conclusion, maybe we should give Mr Donlan a chance to try his idea?

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Excerpt below (my excerpts from Economists and WSJ tend to be very long, because they are so well written. I would just have to make the fonts smaller and post the links to encourage people to subscribe to them)

Back to the future
Aug 18th 2005 From The Economist print edition
Michael Long

"Conservationists tend to be conservative. But not always. Here is one strikingly non-conservative conservation idea
PEOPLE and wildlife don't get on too well together. Large mammals, in particular, have a hard time at the hands of humanity. Their habitat gets taken for farms, their bodies for dinner and their heads for trophies. As human populations grow, the pressure increases, and it seems to decline only when people are rich enough to focus on the aesthetic as well as the economic possibilities of wild beasts. Often, such aesthetic appreciation thrives best in the safety of the city rather than in the rawness of the wilderness.
Observing all this, a group of conservation biologists, led by Josh Donlan of Cornell University, have made a modest proposal in this week's Nature. They suggest a piece of ecological arbitrage.
Africa and Asia are continents where wildlife is under particular pressure. Their human populations are growing and their people are not yet prosperous enough to make conservation a higher priority than simply getting by in life. But many of the world's endangered mammals live in Africa and Asia. In North America, by contrast, rural populations are shrinking, people are rich enough to care about wildlife, and many of them do. Moreover, most of the large North American mammals that existed when humanity arrived in the continent are now extinct. When the first immigrants entered North America at the end of the Pleistocene epoch, more than 13,000 years ago (how much more is the subject of vigorous debate), they found a continent full of large mammals—elephants, lions, cheetahs, camels, horses and more. Within a few thousand years most of these animals were gone, probably the victims of overhunting. Their ecological niches are therefore wide open for occupation. What could be more logical, Mr Donlan suggests, than introducing endangered Old World mammals into the New World, thus saving them from extinction while returning wild America to something like the state it was in before Homo sapiens took up residence?
Pleistocene park
Mr Donlan's plan is to create game reserves of a quarter of a million hectares or more in the Great Plains of North America, and populate them with a mixture of native American and alien animals. If returned to grassland (not a stupid idea, as the government now pays farmers large sums not to grow crops on quite a lot of them) the plains could support both grazers and their predators. Beginning gradually on small, private reserves, wild horses, asses and camels would be introduced and biologists could study their effects on the ecosystem. Later, if all had gone well, elephants would be added and finally, to provide predators, big cats. If everything worked on a small scale, the large public nature reserves envisaged as the plan's culmination would then be created. Mr Donlan reckons that the whole process would take about 50 years. “It is important”, as he puts it, “to realise that we're not advocating backing up a van full of cheetahs and kicking them out the door.”
Although none of the animals Mr Donlan and his colleagues propose introducing are the same species as the ones that went extinct, many are related and all would fill similar ecological niches. Elephants, for instance, would help to preserve the grassland by eating shrubs that encroach on it—a role previously filled by mastodons (pictured above). Lions and cheetahs would control the populations of horses, asses and camels much as their sabre-toothed cousins once controlled similar ungulates. Cheetahs would also act as predators of pronghorn antelopes, which can outrun anything around at the moment, and whose speed is suspected to be an evolutionary response to the North American cheetah, now extinct.
In theory, the return of the big mammals would result in more diversity throughout the ecosystem. It would also, the researchers suggest, bring tourists flocking to the Great Plains and provide an alternative income for people there. That may sound fanciful. But, as Mr Donlan's paper points out, there are already some 77,000 large exotic mammals, most of them African or Asian species, roaming freely on private ranches in Texas and, in some cases, attracting paying customers.
Many mainstream conservationists are naturally (in more than one sense of that word) suspicious. Chris Haney, a conservation biologist at Defenders of Wildlife, a voluntary conservation group, fears the effort might detract from what he describes as “more realistic” goals, such as the reintroduction of wolves, bison, grizzly bears and North American elk (not to be confused with the European sort, known to Americans as moose). These reintroductions have faced bitter opposition from some ranchers, farmers and politicians. In Yellowstone National Park, a wolf-reintroduction programme begun in 1995 was ultimately successful, but not before a number of lawsuits were heard, thousands of dollars paid to ranchers for lost livestock, and two of the wolves illegally shot. If programmes like this were seen not merely in isolation, but as the first steps in a grand plan to reintroduce lions and cheetahs, they would be even harder to implement.
Eric Dinerstein, chief scientist at the World Wildlife Fund US, another conservation charity, has a related objection. He suggests Mr Donlan's idea might be damaging not only to efforts to conserve North American species, but also to the very Old World species it is intended to save. He thinks Mr Donlan is too pessimistic about the chances of preserving endangered animals in their African and Asian homes. Rather than spending money to establish those species in North America, Dr Dinerstein would prefer to see it spent conserving them where they live now.
Both of these objections are sensible, though not overwhelmingly so. But Dr Haney has a more visceral worry, too. Modern conservation is generally against the idea of species being spread into novel habitats, and he opposes Mr Donlan's idea on those grounds, as well.
One reason conservationists try to stop alien introductions is pragmatic—they sometimes do serious damage to native species. Rats, cats and pigs, for example, have wrecked the native fauna of many a small island. But part of the objection to alien introductions has an ideological flavour. There is a feeling that what exists now (or, at least, what existed before man stuck his oar in) is what ought to exist. It is pristine. Shipping in other species is, in a sense, a form of pollution.
Perhaps it is, although such pollution does happen naturally from time to time. But even if such introductions are not the ideal solution, they may be the best one available. Mr Donlan's idea is a big and imaginative proposal to solve a clear and present danger. It is certainly worth some careful scrutiny."

China's development and diplomatic strategy - money can't buy love

Back on strategy again, China's development strategy.

I want to comment on the mis-understanding of China's development strategy by Howard French. To be fair Mr French's discussion was not about strategy. So I am just following up on the issues he started. Mr. French first asked "What sort of power does China aspire to be?", then he went on to say "can a country make a successful transition to great-power status without real friendships". While he has made good analysis and deduction based on that premise, unfortunately, the premise where he started does not hold, in my view. China does not aspire to be the kind of "great power" most people have in mind.

French claimed that "Today, China is closer than it has ever been to superpower status". First, China was a superpower for most of 200BC till 1800AD, sort of, although unlike the superpower at present day, it remained largely local. Second, I have never heard of any superpower with a GDP/cap of $1200, or even if in PPP, $5000. Many people disagree with French that China is a superpower, e.g., Stan Crock ("The China No One Talks About"), and Richard Fisher of Dallas Fed Reserve Bank. Mr. French started his deduction with a false hypothesis. If Chinese leadership is deluded by such "superpower" dream, it will not only be detrimental to China, it may also not be a good for this world.

As discussed in my early post Tao Guang Yang Hui (and also noted by French), China's preferred strategy is Tao Guang Yang Hui, which translated into English by (Mr.) French as “lay low at a time of adversity”. This was Deng's instruction before he passed away. Deng knew that China is far from qualified to the great power aspiration. It is a few generations behind the Western powers. He has set a very realistic objective of "re-doubling" China's GDP/cap in 20 years, which was in fact achieved in about 15 years. In addition, Deng also anticipated (correctly) that because of China's size, many countries are vigilant about China's rise, even if one excludes the neo-conservatives and China bashers in US and Japan. On the other hand, China needs a peaceful environment to emerge from the mess that started 150 years ago, and play catch-up for another 200 years prior to the Opium War. This is not something which can be accomplished in a couple generations. It took Japan over a century (1860-1980) to catch up with the West even though they started with great visionaries like Ito Hirobumi (伊藤 博文). Even discount the mis-steps in WWII Japan still used a full 100 years.

So Deng was right, China should not aspire to be a great power, not before 2050. China just wants to be the same as others in this world. China should concentrate on its internal problems, which are plenty (e.g., SOE and SHE still account for 41% of industrial output). Any departure from this objective will both risk internal instability, and worse, feed to the China bashers and "containment" advocates. Any gain will thus be negated by more active "containment" by, e.g. the US and its allies. The difference between Mr French and me is that I believe China should stick to this "laying low" strategy for at least another two generations. China's future lies in being a part of the global community, and making a lot of friends and no enemy, as Mr French pointed out. China's future does not lie in being a "real power".

It is not that China does not want to make friends in, e.g. Africa. If you see how the neo-conservatives in US react to even the most capitalist driven investment of China there, you know what French suggested is not feasible, well, unless China is "asked" or invited by the US to do so. This is not to belittle China or exaggerate the American influence. This is just the reality as seen by Deng, and by ordinary people like myself.

Regarding China's aids to the tsunami disaster, or famine in Africa. China should contribute what it can afford to, i.e. at the same (per capita) level as other country with the same GDP/cap, such as that of Philippine or Indonesia, provided such action does not provide an excuse to "China containment" advocates. Plot a scattered graph of donation/cap vs GDP/cap one would see that China did not undercontributed compared with its peer. Again, this is not to say one should yield to these lunatics, it is just not worth the trouble. Sending worker to rebuild roads, or medical team and drugs, are much more cost-effective options for China than sending cash, because Chinese generic drugs are cheap, so are its labor costs.

Mr French also made a mistake in his example (although that is peripheral to the theme of discussion). Norvatis has patented the combination therapy (ACT) of the active ingredient artemisinin (extracted from sweet wormwood, artemisia, or Qinghao-su) with lumefantrine globally. China is not allowed to sell or donate the medicine outside China. WHO has only two authorized suppliers, Norvatis and Sanofi. For a publication on IHT perhaps they should to learn to use google (I made a similar mistake myself, see comments below)

• According to Kathleen Deoul, "They claim that using Artemisinin in combination with Lumefantrine will protect the herb against losing its effectiveness. This makes sense on first glance except for one thing: Artemisinin has been used for over 2,000 years without losing its punch.
  Why would it suddenly do so now?
  The simple truth is that Novartis is not afraid of Artemisinin losing its medicinal power. It’s afraid of losing the drug’s financial power. As long as it is sold in combination with a conventional pharmaceutical product, the combination can be patented even if the herb cannot. That means that whenever the patent on Lumefantrine is set to expire, all that Novartis has to do is combine it with another pharmaceutical product "
• see also this economist article on the ACT therapy, which China does not have the patent.

Finally, Mr. French's claim that China does not "have real friendship". True, there is no real friendship with Japan, US or many European world, or India or Russia. But it has been improving on all fronts, perhaps except for Japan. In addition, China does have a lot more true friends in the third world than US, UK, or Japan, "truer", at least. Malaysia has been turned from a foe into a friend, so was S Korea. Money cannot buy friendship, as we have all learned from Taiwan's micro-nation diplomacy (aka silver bomb diplomacy). These nations can switch loyalty from the mainland to Taiwan and back to mainland all within a few months. Donation to disaster should be a decision independent of geopolitical considerations, nor whether you view the country as a friend or not. Greeks aided Turkish when earthquake shaked. Indonesian helped Aceh when tsunami hit. They both won friendship sfrom their enemies. The day Bush would do the same when hurricanes pass by Cuba we can see world peace. (corrected thanks to matthew's comment below)

Money can't buy love. If China wants to win real friendship, it should use its heart, and treat its friends with respect. Aspiration to be a superpower itself is a friendship repellent, look at Mr. Unilateralism.

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Updates and reading:

• highly recommend this great essay by Wang Jisi, a rising star within China's think tank and academics, recently promoted to become the Dean of School of International Studies of Peking University, and also Director of the Institute of International Strategic Studies at the CCP Central Party School: China's Search for Stability with America, the original Chinese version is 中美关系：寻求稳定的新框架; and his more recntly article 三十年来中美关系的变与不变 where he said "China has never become a rival of the US" and "China and America's non-rivalry suits both sides' long term interests"

RMB update (ii) - Implied basket weight

According to Oriental Daily HK, PBC continues its effort in making the new basket mechanism more transparent

• Transaction volume will be announced annually, once in every May. (this is actually a step backward from the daily disclosure prior July 21st. But I presume it is part of package of the basket peg.)
• Other statistics will also be released regularly: Current Account Balance (semi-annually - did I translate this correctly?), Foreign Debt Stats (Quarterly), Cross exchange of foreign currencies vs USD in China (monthly on 20th), inter-bank forex volume (annually), etc.

Stephen Jen of Morgan Stanley had some initial analysis of the RMB data

1. "USD/CNY has been extraordinarily stable. Since July 21, 2005, USD/CNY has declined by a cumulative one-sixth of a percent, or 0.15% — half the daily allowable range.
2. Implied USD weighting very high. An alternative way to justify the stability of USD/CNY is to calculate the implied weighting on various currencies. Based on the actual movement in USD/CNY, it is as if the USD weighting is some 85% or so of the basket. "
3. Transition period. It is possible the PBoC is only gradually allowing the basket index to be revealed so USD/CNY remains stable in the initial period of the BBC. "
4. There is no mechanical link between the basket weighting and the currency composition of reserves. ...although China has a basket reference scheme, the USD will remain the sole intervention currency.
5. The PBoCÂ’s holdings of JPY in its reserves are likely to be substantially below 18%.
6. I still do not grasp why Governor Zhou announced the content of the basket. The desire to guide domestic investors to learn to hedge aside, I am still not convinced it was a good idea to announce the content of the basket. If it was such a good idea, why, then, was it not announced on July 21, 2005?"

The "Implied USD weighting" means the result of multi-variable dimensional regression. Since I do not have access to the international rate at the exact minute, I could not do an accurate analysis like Jen did. But this is something we could all do with an Excel spreadsheet (without using regression tools).

1. Go to PBC's site (in Chinese, the column headings are Date/USD/EUR/JPY/HKD) copy and paste the data into your Excel.
2. Define weight factors: wu,we,wj,wh for USD, EUR, JPY, HKG(which is aligned with USD). Let's ignore other currencies such as KRW for simplicity (also because we lack the data)
3. Calculate for each day this number: RMB(date)=usd/8.11*wu+eur/10*we+jpy/7.3*wj+hkd/1.05*hkd (or instead of these values, divide by the previous day's rate)
4. Now try different weight factor values for wu/we/wj/wh, until you find the values for all these days are closest to 1.00, you have found the approximate value of the 'implied weight'
5. It helps if you create a cell to calculate sum((1-RMB)^2) over all dates, then if this number is minimum whether you change the weight factor up or down, then you have found the "implied weight" for that currency
6. (I am happy to email you the spreadsheet if you are interested - don't know how to upload table/chart in blogger)

I found USD weighting to be even higher than the "85%" number which Jen mentioned. It is probably because SGD, KRW/etc are closely linked to USD (mathematically it is called linear dependency). In fact, it is hard to calculated USD's rate this way because there might have been some intervention and that the gaps for USD is different from (smaller than) those of EUR and JPY. Other findings

• HKD seems to be not in the basket at all (the value of RMB does not change if you change the number)
• JPY implied weighting likely to be around 10%, EUR perhaps only slightly larger
• The fact that RMB is still so highly correlated to USD is still puzzling. Maybe PBC is smoothing out the transition, by adjusting the USD basket weight slowly from 100% down to the the target weight of 50% or 43%. In other words, in July, USD might have still been the sole content inside the basket, or RMB continued to peg to USD alone for a few more days, until the peg is slowly loosened. If Jen's implied weight at 85% is correct (the average over the period), USD weight might have decreased from 100% down to around 70-80% now, via gradual adjustments

My guesses as to why Zhou decided to reveal the basket content are:

1. to make sure his people (and his superior) cannot mess up with the system (e.g., by over-riding the mechanical rules)
2. he is not too worried about reverse engineering the content because there are other uncertainties such as the different gaps for different currencies, the drivers for the weights are not disclosed, and also that the weight mix will be revised sooner that it was figured out (and as I mentioned previously, speculators need ultra-accuracy to profit from their highly leveraged bets)
3. rebuff at the "black box" allegation

Updates (Aug 23)

• Johnson Electric Holding, the market leader in micro-motor (powers 50% of the car windows, windshield vipers in the world), said, their cost will rise by 0.2% after the 2.1% RMB reval (i.e. only labor, rent and some G&A, while the raw materials, copper and steel are largely unaffected)
• Yu Yuen Industries (largest suppliers to shoe brands such as Nike) said the impact is 0.5%, labor content for sports shoes is higher than assembling micro-motors
• These are exactly as predicted in my earlier post, I am sure the productivity improvement per year for these companies is faster than the rise in cost due to RMB reval. In fact, isn't the reval an effect of improvement in productivity?

Merck, Vioxx, the moral of the lesson and how to align the incentives

I mentioned Merck's case in my previous post in relation to strategy (and the comments under that post). I was also aware that the verdict will be delivered in the next few days.

Today Merck was found liable for $253M for a Vioxx lawsuit. CNN said there are at least 4200 similar cases waiting on trial, many cases even stronger than this one. That would put the total liability to over $1000bn, not counting the non-death related suits. (In reality the punitative damage would not scale up in the same rate, but the total would reach $100bn, even without the punitative portion. )

Merck's market capitalization according to yahoo at this moment: $62bn (based on $28.25/share), net income $4.5Bn IN 2004, total asset $43bn.

With these numbers, Merck cannot afford the payment of $100bn even if it were to sell off the whole company (all future anticipated income based on market projection and discount rate), or twice its total asset. It would take 22 times its annual income to settle these suits, more for non-death related ones. This is no better than what the tobacco industry received. In fact, the fine for the tobacco industry, who is more guilty that Merck in any measure, has been significantly reduced recently. Where is justice?

Merck probably was not doing the right thing before it voluntarily withdrew Vioxx, or withdrawing it too late. I certain would not pity Merck had it continued to sell the drug knowingly before the fault was identified, like Pfizer did. But I am not sure whether the Merck's voluntary withdrawal of Vioxx and the related disclosure of information has adversely affected the verdict. If it does, it would be a sad news for all of us. Because Merck is punished for finally doing the right thing, or at least voluntarily stopped doing the wrong thing to contain the damage. If Pfizer, which has stood firmly behind its Celebrex and Bextra despite strong evidence against the COX-2 Selective Inhibitors (which include both Vioxx, Bextra and Celebrex), and even promoted its products by capturing the opportunity of Vioxx withdraw, emerges as a winner over the conscience struck (although belatedly) Merck, it would surely set a bad example for corporate America. Gilmartin's following Merck's mission statement might pay off in the longer term, as demonstrated in the last 100 years. But Gilmartin is also guilty of not enforcing such principles to his marketing ans sales team before the withdraw. But the judge and the government has the responsible to align the incentives and encourage corporation to do the right thing.

Based on the verdict, Merck was guilty at concealing some crucial facts before the withdrawal. It would be unfair to the patient or the public if Merck can get away with it. Is there a better solution to this dilemma? Yes, there is. This is what I would do if I were the judge

1. Maintain the same verdict, and same amount of damage, but distribute the "punitative damage" of $229M to 3 parties: whistleblower, victim and a fund (e.g. 70%, 20%, 10%, with some flexibility by case)
2. Whistleblower fund should be distributed to the company and the individual who helped to control the damage. In this case Merck and Gilmartin and team should be the among the recepients of the whistleblower award. In this particular situation perhaps the whilstleblower should recieved the bullk of the punitative damage awarded, if it is proved that without the proactive release of information by Merck and decision by Gilmartin, the case would not have even been made. This will ensure the act of correcting the wrongs are rewarded
3. Even better, the well-behaved companies may be in a position to profit from their good deed. For example, if Pfizer is convicted in a similar lawsuit, Merck gets the share of whistlerblower award as well. Therefore, the "good" company might end up better off, if there are contrasting responses from these companies
4. The fund (this would require legislation and government effort) would be used to reward companies which does the right thing in future, e.g. when it does not get compensated by punitative damage from a third company with wrong doing but refused to correct the mistake
5. Now this is a competitive environment which encourage and reward compnaies that do the right thing

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Edited to add (Aug 22):

This is another proof that WSJ reporters are much brighter than the editorial writers.

Op-ed today on "Vioxx Verdict" appears like a sponsored ad by the pharma industry.

It said "[The verdict is] bad news for other COX-2 pain relievers and drug reseach generally.....also bad news for the millions of Americans who suffer from the kind of chronic pain for which stomach friendly COX-2 inhibitors like Vioxx, Celebrex..."

• How so? traditional NSAID (aspirin, ibuprofen), with side effect on the stomach (GI, or gastro-intestinal system), is now proved to be a good alternative to COX-2 inhibitors. Pharmacos do not like it because these are generic drugs and they don't make obscene profit from them
• COX-2 themselves can still be applied to patient with no CV (cardio-vascular) risk. As for Bextra or Celebrex, they deserve it. If my proposal is adopted, Merck is going to benefit from suits agaisnt Bextra
• For generally drug research, there is a golder opportunity to be innovative and find another blockbuster which will address both the GI and CV problems
• The verdict only place a clear warning agaisnt deceptive sales and marketing methods which try to conceal the potential risks and side-effects. In the long term, it is going to boost patient's confidence on drugs, just SOX do to corporate accounting governence. All Merck has to do is to honestly tell the physicians and patients what the risks are, exactly like what they have correctly done last year this time
• As the op-ed has noted, "earlier this year, an FDA advisory panel recommended that the drug go back on the market, with appropriate labeling"

The incompetent lawyers Merck hired are the ones to be blamed. As for the pahramcos, play by the rule and you will get rewarded.

Fareed Zakaria in Newsweek: and why I think Rumsfeld is a traitor, not a patriot

I have not expected mass market magazines such as Times or Newsweek would run essays in the league of the Economist or WSJ. So I was quite surprised, and repeatedly, by Fareed Zakaria's columns. It turned out he used to be a managing editor of Foreign Affair.

Zakaria has yet another great column in a recent issue: Mishandling the China Challenge. His essays are freely accessible through www.fareedzakaria.com, or www.newsweek.msnbc.com. I am going to bookmark them.

Great insights in the above linked article

• "And if the effect of the Unocal affair is to close the energy sector around the world to foreign investment, the damage done to American interests probably outweighs any gains in killing the deal. It also slows the opening of the Chinese economy, which is bad for the United States for both economic and political reasons.
• China pursues this strategy not by making noisy threats, but by making itself crucial to other countries in the region. Consider the turnaround in Indonesia. Ten years ago, when Indonesian officials spoke of their security concerns, China was usually on top of the list. Today, they speak of China only as a partner.
• China's growth strategy has been different from that of Japan. When Japan rose to power, it did so in a predatory fashion, pushing its products and investments in other countries but keeping its own market closed. China has done the opposite, opening itself up to foreign trade and investment.
• China's rise presents great opportunities and great challenges for the world. But they are new and quite complex. There are some in Washington—like Rumsfeld—who seem to see it as a replay of the cold war, with China playing the role of the Soviet Union. This misunderstands both present-day China and the world we're living in.
• George Santayana famously observed that those who can't remember the past are condemned to repeat it. Here's my variation: those who only remember the past are condemned to misread the future."

All great points. Since I only promised not to add my redundantnt view on Lee Kuan Yew (画蛇添足), I have not restrained myself from saying a little here.

• China has been following a deliberate strategy as part of DenXiaoping's's will, of maintaining low profile and seek peace with all neighbors, called Tao Guan Yang Hui.
• (Note it is not uncommon for respected leaders in ancient China to lead great advices in Chinese history or literature, e.g. Zhuge Liang left great tricks to scare off his nemesis Sima Yi as told by the Romance of the Three Kingdom. Such advices are generally followed through by successors)
• My view is that China sincerely wants to make peace with its neighbors, because its leaders have recognized a peaceful neighborhood would benefit China, at least for the next 30-50 years, as we all know. Would China become aggressive 30 years later? My answers is: all the current leaders would have all left this world by then. Even if it is their plot, it is unlikely they could plan for anything like that -- so there is no need to get too sensitive for the fact that US is not invited into an East Asian Summit. I wonder if it is the collective decision of all East Asian nations (sans Japan) that they want to keep it, East Asian.
• As for Rummy, I tend to believe Rummy is a very smart person and knows clearly what he is doing. Except that he is not intelligent enough to separate national interests from defense sector lobby interests or defense department funding interests. It is myopic to sacrifice national interest for selfish motivation of creating an enemy to justify the expansion of his department. It is treasonous to intentionally turn a potential friend into an enemy for your own country, eventually harming his own nation. For this I call these people traitors of the US.

Now, I have promised not to talk about politics for a while. Because it is the easiest way to attract subjective and irrational comments when one discuss about politics and people get emotional easily. I talk about Zakaria's essay because this post is related to strategy. General strategy has a lot in common with business strategy, and I think studying these cases would enhance one's business judgment. For example, companies like Merck has stuck to its corporate value of putting patient benefit first (mission statement), as part of its corporate culture and strategy ( "see the book Build to Last"). Although Vioxx related lawsuits are still in the air, I do believe its proactive disclosure in the Vioxx incidence is a great move to control damage (vs other option at the time), and this is going to pay off in the future. Similarly, China's peaceful development strategy will be proved to be its best option in the long run.

China's oil price (ii) - and transition of SOE

As predicted in my earlier post, China anti-market pricing policy is running into crisis. Gas stations in Guangdong refuse to sell and Sinopec/CNPC are not supplying the retail stations. Long lines make fueling wait into hour-long ordeal, or sold out when you reach the pump. Even People's Daily is admitting it now. WSJ also run a good report on "China's Fuel Shortages Add to Pressure to End Central Planning".

A few thoughts

1. The phenomenon in Guangdong showed that the oil oligarchs, although state owned, are rebelling by hoarding the gasoline. This is good evidence to rebuff China bashers in the CNOOC/Unocal incidence. Yes, the GM is indirectly appointed by the government, but P&L is definitely becoming a higher priority. This will likely set precedence as one of the crucial baby steps for the SOEs (state owned enterprises) to break free from state control.
2. Chinese gov't will eventually have to give in to market force, by liberating gas price soon. Can't think of other option
3. Well, there is a bad solution to the current mess. It could work in short term, provided oil price moves down in the international market. Not a good option. Anyway, this is the bad solution: subsidize the oil companies on a per-liter-sold base (sort of a negative sales tax). This is bad because it is easy to circumvent. And when it comes to finding loopholes against unsound policies, Chinese are genetically adapted and practically trained. e.g. a) parallel export /smuggling oil out of China (HK trucks have always been filling as much as they could before return to the border - now the risk is for regions outside HK and in a more organized scale); b) oil oligarchs can fraud higher sales # for more rebate from government; to name but a few. I am sure they are more creative than me
4. The better and easiest option is, of cource, to let RMB appreciate a bit more (thanks Brad for reminding me the obvious). There are pros and cons, the oil price has risen by a percentage much larger than any feasible RMB appreciation could counter, but by feeding all numbers into a formula, there must be a solution as to what is the best percentage RMB should appreciate vs subsidy needed. (Even if one includes the macro-GDP growth target in the calculation) Still this doesn't solve the artificial price issue.

updates: FT said Oil in many Asian countries are subsidized, it noted "China, the second biggest oil user after the US, is one of the offenders. Retail prices of most fuels are controlled and the domestic refined oil price has risen only 15 per cent this year, against 30 per cent for crude oil." Well, yes, China's oil price is not following international market price. But one has to note that price at the pump should always rise slower than crude. Because the cost include that of refining, additives (basically the difference between PON 87 and 93, or RON 90-95), and operating (transportation, rent, labor). That is true also in the US, although it maybe 20% instead of 15%.

and China Daily is bolder than People's Daily, saying, "it is time for pricing reform!"

see follow-up here.

Export market share -- when will china's export saturate?

Brad Sester argued that China's export growth of 30% p.a. is unsustainable. I agree, based on my gut feeling (and the theory of heat transfer under temperature gradient in physics). While a high export/GDP ratio means the economy is unstable and highly susceptible to foreign market changes, the common claim that only smaller trading entities such as Korea or Taiwan can reach high export/GDP ratio lacks the proper logic rigor, in my view. A better measure would be one that is based on export market share, by assuming that the world is peaceful and there is no major disruption in world trade. In this measure a small nation can have a huge value in export/GDP (larger than 1 - when the value added is a smaller percentage of the total value of good exported) while its export market share is still very low (hence lots of room for growth). It also provides an indication to how high is high for Export/GDP for each economy.

Let's take a look at the trading in merchandised goods, as an example. (trading in services, although only a quarter of that for goods in value today, is not to be neglected)

According to WTO, world import in 2003 is $7569bn, with a growth rate of 16% (! a jump from 5% in previous years)

For China, export=$438bn, import=$413bn, so China's export market share (addressable) is 438/(7569-413)=6.1%

For Japan, export=$472bn, import=$383bn, export market share (EMS) =6.6%

Germany has EMS=748/(7569-602)=10.7%, USA=11.6%, France=5.4%, Korea=2.6%, Chinese Taipei (Taiwan)=2.0%.

We can see that the export market share for China is still a lot lower than that of Germany or US. For China to catch up with US' share of 11.6%, it will need to grow in an extra 7% for 10 years continuously, riding over the global trading market growth of 5-16%. If we take the medium value of 10% for world average, China's room for growth can be (for example) around 17% p.a. for 10 more years, before it reaches the market share level of the US.

However, if we would boldly assume that when GDP/cap of different nations will converge in the long term, China would get its EMS of around 20% (same as its population share), then China would have 18 years of growth like that (7% on top of global average).

• Japan, with 2% of world population (let's denote it as PS, population share), has 6.6% of EMS, EMS/PS=3.3; US with 5% population for 11.6% EMS, EMS/PS=2.3; Germany's EMS/PS is even higher (7.8). We can postulate that EMS/PS may converge to 1-2 in the future, as developing nations such as China and India catch up
• More likely through, global trade growth will slow down from 16% to maybe 8-12%, gradually. While China's rate to outgrow other nations will decrease from 10% to below 5% gradually as well, i.e. from 20% in 2006-08 down to 15% in 2012-14 if we assume the global average is 10%. (i.e. extra percentage over world average has an average value of 7% over 10-18 years, maybe slower if the number of years it takes to converge to global average is longer)

As China's market share in service sector is still very low (total market size = 1/4 of that of merchandise goods), there is also more potential for growth in the service sectors.

Conclusions:

• China's export (in goods) can grow at 7% above world average for another 10-18 years, but no where near the 30% rate in 2004 (unless the global trade grows at 20% p.a., not likely)
• America and Germany have the highest export market share in the world already! Don't complain about your export, there is not much room for growth (perhaps making money by investing in developing countries is easier than boosting export)
• Korea and Taiwan still have plenty of room to grow, much larger than China's, despite its already higher export/GDP and GDP/cap
• While Export/GDP can measure the internal sustainability, EMS is a good measure for external demand and hence sustainability (EMS/PS ratio can also be used as an indicator, but there is no strong reason for it to converge to the value 1, except if one believes productivity would converge, which may not happen in a this millenium)