Misconceptions About China

There is no China.  The sooner Western executives grasp this, the less likely they will be to make serious investment mistakes in this area.

Now, of course, there is a political entity known as China. It has embassies around the world and exercises significant political power domestically, moving vigilantly against any signs of political opposition. And, from an investment perspective, the central government of China has been a catalyst for, and general supporter of, the economic liberalization that has helped to transform the country over the past several decades. The central government also has control of some powerful economic levers like currency policy. But these basic facts also generate many misconceptions that can get executives into a lot of trouble.

Western views of an authoritarian central government in China that controls all activity in the country help to reinforce the misconception that there is a single China. There is no doubt that the central government is authoritarian, but it is easy to overstate the control it exercises throughout the country.

Andrew Browne’s article on the front page of the Wall Street Journal on September 15, 2006 helps to challenge this misconception.  Carrying the headline “Booming Municipalities Defy China’s Effort to Cool the Economy” (registration required), the article points out that:

Local governments are encouraging a frenzy of construction to boost their economies – even as China’s central government seeks to throttle back economic growth . . . .

More than a quarter century of economic overhauls has produced a striking contrast in China.  Politically, the Communist central government maintains a tight grip over the entire country: economically; it is losing control.

China’s leaders are caught in a trap as they cast around for ways to rein in investment.  The old administrative methods – ordering state banks to stop lending, restricting land sales, halting government approvals for major projects – aren’t working as well as before, partly because local governments are defying Beijing

It is ironic to find an article in the Wall Street Journal lamenting the diminished power of the central government to more effectively control investment.  The article darkly suggests that unrestrained investment by municipalities could lead to property bubbles and rapid escalation of inflation with ripple effects throughout the global economy.

There is no doubt legitimate concern about the efforts of municipalities to outdo each other in terms of elaborate and often uneconomic construction projects.  But the article misses a more fundamental point. 

Much of the economic growth of the country has been triggered by intense competition across municipal and provincial governments to attract private investment.  As I pointed out in an earlier blog, this is in sharp contrast to Europe and even the United States. In these regions, public policy discussions tend to emphasize the benefits of harmonization of economic policy. China has been pursuing a different approach. Economic policy diverges significantly across provincial and municipal boundaries, leading to very different trajectories of growth and rates of growth. This produces a rich environment of public policy competition, where local governments compete with each other to design more attractive economic policies to attract investment. In many cases, as illustrated by the example of Panyu’s emergence as a center of diamond polishing, the competition leads local governments to choose not to enforce burdensome regulations defined by the national government.

The result has been an increasingly complex tapestry of economic policies across China. This in turn has led to the emergence and evolution of highly diverse local business ecosystems that make regional centers like Beijing, Shanghai and Shenzhen quite different from each other in terms of business specialization, infrastructure capabilities and talent pools.  Adam Segal’s book on Digital Dragon remains one of the most insightful explorations of the business impact of this regional diversity in China's economic policy.  Although his particular focus is on the high tech industry, the dynamics he explores are playing out in such diverse industries as diamond polishing, motorcycles and textiles.

Recently, the newspapers have carried stories (registration required) about the high profile dismissal of Chen Liangyu from his post as Shanghai’s Communist Party secretary. The charges against Chen focus on corruption related to the mishandling of Shanghai’s $1.2 billion pension fund.  There has been much speculation that this dismissal represents an effort by China’s central government to assert greater control over provincial and local governments in terms of economic policy.  Shanghai certainly has been one of the most aggressive regions in attracting foreign investment and funding ambitious commercial real estate development, not coincidentally in part using funds from the city’s pension fund. If this is the motivation behind the corruption charges, it is unlikely to lead to a wholesale shift towards centralized control of economic policy but instead may lead to a re-balancing on the margin to slow the growing power of local governments in setting economic policy.

As always, though, politics in China are complicated. This high profile dismissal could have other motivations.  It is true that the central government has a penchant for using corruption probes and charges selectively to discipline party and government officials. But in this case, it is not entirely clear what the focus of discipline is. The charges against Chen may represent jockeying for political position within China’s Politburo in anticipation of a meeting of party leaders next year.  Chen has been a member of the Politburo and widely viewed as a protégé of former President Jiang Zemin, now officially retired but continuing to exercise influence.

However the Shanghai saga plays out, Western executives need to move away from a view of China as a single economy or country and craft much more nuanced business strategies designed to tap into the increasingly diverse ecosystems and markets emerging regionally within China. It is no longer (if it ever was) sufficient for companies to have a “China strategy” – they need to define a Shanghai strategy, Shenzhen strategy, etc.

But this is not the only dimension where nuanced strategies are required.  Generalizations about China can get Western executives into trouble in other ways as well. 

I have written before about the need to differentiate three Chinas.  In this context, the second China refers to the massive state-owned enterprises (SOEs) that still dominate the economic landscape in terms of employment and production statistics.  Many of these SOEs are now being privatized (at least in part) in terms of ownership structures, but they retain the cultures and work practices of large, bureaucratic entities.

In sharp contrast, the third China consists of smaller, entrepreneurial companies that have emerged on the periphery (literally, in the sense of coastal regions, as well as figuratively).  These companies were the focus in part of my recent book, The Only Sustainable Edge. They represent an innovative group of companies that are reshaping global industries as varied as textiles, consumer electronics and motorcycles.

When most Western executives go to China, they tend to meet with counterparts in the second China and these meetings become their frame of reference for thinking about the capabilities and potential of Chinese business.  They rarely even become aware of the companies comprising the third China and completely miss the strategic challenges and opportunities created by these much less visible companies.

A prominent article in the September 18, 2006 issue of Fortune provides just one example of this misconception. Written by Alex Taylor, III, the article entitled “A Tale of Two Cities” contrasted the performance of a plant opened by Tenneco, a maker of auto parts, in Shanghai in 1998 with another plant owned by Tenneco in Litchfield, Michigan. These two plants make the same product for the same company, so they appear to be particularly useful to compare performance across two countries.

The conclusion, written in sweeping terms, is very comforting for Western executives:

China can be scary. . . .  For many people in high-wage countries like the U.S., Pu exemplifies the China threat – a hard worker making a tenth of U.S. wages.  Who can compete with that? . . . There is no question that, thanks to the labor of tens of millions of people like Pu, China has become a genuinely fearsome economic competitor.

Although wages in Shanghai are rising sharply, labor is still comparatively cheap.  But that is an advantage that goes only so far. Consider: At Tenneco’s plant in Shanghai, labor represents just 1% of production costs; at its Michigan plan the figure is 12%.  It is Michigan, however, that wins hands down in terms of profit, reporting gross operating margins that are a third higher.  The death of U.S. manufacturing has been greatly exaggerated.

Phew! Don’t be scared – we still can beat them in head to head competition. Dig deeper into the story and the article mentions one interesting fact but doesn’t really develop its significance.  Tenneco’s Shanghai operation is actually a joint venture with a state-owned company, Shanghai Tractor & Engine Co., a subsidiary of automaker Shanghai Automotive. So, we are comparing the performance of a state-owned company in China (albeit in a joint venture with a Western company) with a the domestic facility of a U.S. manufacturing company. The challenges faced in the Shanghai operation that limit its performance – resistance of workers to change, friction between workers and supervisors, high turnover of workers, difficulty in firing troublesome workers (meaning the good ones get hired away and the low productivity ones stay forever), primitive tools – are all classic symptoms of the low productivity state-owned enterprises in the second China.

There is no indication of any awareness of a completely different set of companies operating in China – the private, entrepreneurial companies of the third China where worker productivity is world class, where rapid incremental innovation is a foundation and where value is amplified by sophisticated networks of companies with complementary capabilities. If we generalize from the experience of state-owned enterprises in China, we build misconceptions that lead to complacency. 

Look to the edge in China – operating below the radar screen of many Western companies, the entrepreneurial companies of the third China are pioneering sophisticated management techniques that make them formidable competitors – or potentially helpful allies – in global markets. Combine this with a clearer view of the diverse ecosystems evolving in China and Western executives may finally discover ways to harness the enormous economic potential emerging in this part of the world. In fact, it is the complex interplay between these entrepreneurial companies and the diverse ecosystems reshaping the business landscape in China that makes these companies such formidable players in global markets.

Just keep reminding yourself – there is no China. It will help to keep you out of trouble and make you more alert to the developments that are reshaping both the domestic Chinese economy and, increasingly, the global economy.

Comments

[soberxp]

haha,yes, It's all about education.

[Sanjay Dalal]

I read your story on Misconceptions, Comments posted above, and also read about the growth of Education and Innovation in China in the book "The World is Flat" by Freidman. There appears to be an education revolution brewing in China -- one wherein Creativity and Innovation are getting emphasized. I briefly touched upon this in my blog at:
http://creativityandinnovation.blogspot.com/2006/09/education-driving-innovation-in-world.html>Education driving Innovation

However, Freidman's book has much more on the growth of Education and Innovation in China.

I do believe that original ideas at times in new economies begin with Imitative Innovations and Entrepreneurship. So it is a good thing that more companies on the Edge are trying out new ideas or retrofitting old ideas.

Chinesepod.com is a solid site.

[David Scott Lewis]

John, Ken is dead-on. You need to live here, work for a Chinese company, see what really goes on. I've been the VP, BD for the two largest U.S.-focused China-based IT outsourcing firms, Worksoft and Beyondsoft. Worksoft even dupped, IMHO, $30 million in its Series B -- which was led by Sequoia (no less). Innovation? Sorry, you're not to going to find much (if any) in the ITO sector.

And look at the China Web 2.0 Review blog. Take something from Techcrunch, add six to twelve months, and it appears on the China Web 2.0 Review blog. What amazes me is that there is not only a lack of innovation, but the domestic (in China) firms often grab higher market caps upon funding.

In your reference to SOEs, there are various flavors of SOEs, too. Not all are created equal. But, like you said, they are often laggards in innovation. However, this really depends on how one defines "innovation". How would you rate the innovativeness of Haier or Sinopec (and how would you measure this, by R&D expenditures, patents, ...)? Yet, to say that Western companies are most likely to have had interaction strictly with the "second China" (as you call it) is simply not true, at least not in the ICT sector (in Valley terms, "ICT" is IT + telecom; it's the favored acronym in China).

Fact is, when visiting different cities, each will showcase a wide-range of companies, both SOEs and privately-held firms. Over the few years that I've lived in China, I've visited over twenty 863 prime locations: I've seen the same show over twenty times!! However, this kind of hypercompetition between cities and regions isn't necessarily a good thing for China. The result has been a lack of geographical critical mass in many growth sectors.

In the final analysis, I would agree that a "China strategy" might be too broad. In general, I'd recommend Bohai Bay, Yangtze River Delta and Pearl River Delta strategies. But this really depends on the industry; in many cases, a broad "China strategy" is quite sufficient to start.

A couple of closing comments. First, chinesepod.com is a superb site!! If someone wants to learn Mandarin, this might be the best place to start. Second, you might actually remember me. When you were still at McKinsey, my boss and I tried to pitch a McKinsey engagement (that would have been led by you) to Ray Lane. I was Director, E-Business at Oracle back then. The three of us broke bread at the cafeteria in 3OP (building 300). The numbers you came back with were way too high and we were going to get too many recently minted MBAs for the $$$, so we opted out. What we wanted was you, but you didn't have enough cycles available for us. Instead, we picked up Patty Seybold, which was an excellent choice considering that our major problem back then was with Oracle apps, and more specifically with everything and anything coming out of 6OP -- where the CRM/SFA teams resided.

Let's hook up next time you're in China. I split my time between Beijing and Shanghai. Our company helps U.S. firms set up research centers in China; our CEO is also the head of outsourcing at Tsinghua. We're VERY close to what is happening in the high tech sector. MOST (Ministry of Science and Technology) golfing buddy kind of stuff ... at very high levels. I'm becoming something of an unofficial voice for the R&D sector in China.

Last remark: Ken and I are two very loyal readers, after all, it's the October national holiday here (kind of like Independence Week) and we're both reading and responding to your post, Ken in SH, myself from BJ.

[Ken Carroll]

John,

I think the oeverall thrust of your argument may be valid. I will have to go out now and buy the book!

However, as a 12 year veteran of the Shanghai business scene, I can testify to a serious lack of original business ideas around here. It seems you have observed it in the provinces, amongst some of the heavy industries, but it remains invisible to us in the fields of training, IT, services, and other areas. Is it a case of them simply copying? Do they generate original ideas/models? That is rare in my experience.

It's all about education. It still hasn't recovered from Mao and the cultural revolution. It seems almost designed to crush any sense of creativity and leadership in the young.

I think there are deep seated problems facing China in this regard. This is not to say they won't do it - there were deep seated problems in Japan, Taiwan, Korea, and the rest, and they all overcame them.

Btw, if you want to see an example of an edge perspective, have a look at my www.chinesepod.com - we're a Shanghai start-up, with an international flavor!