DiligenceChina

We discussed the emergence of a dominant model for China’s economic organization, which for convenience’ sake can be referred to as China Inc. Economic models are not fool-proof blueprints, but rather general rules and trends that can be used to analyze and predict behaviors and motivations. Japan Inc. was characterized by a strong symbiotic relationship between a protectionist government bureaucracy and a small group of business conglomerates. The 4 Tiger economies – Taiwan, S. Korea, HK and Singapore – were export driven economies that relied on cheap labor, hi-tech factories and OEM relationships with international brands. Likewise, the emerging model of China Inc. can explain the relationships developing between the government bureaucracy, state owned enterprises, pure-private businesses and international brands.

The best way to understand the properties of China Inc. is to understand what China is NOT.

China is not an old style centrally controlled economy where profit is considered at best incidental and at worst criminal.

China is not privatizing and fostering individual entrepreneurship.

Instead, China Inc. is a refinement of the state-owned enterprise system. Private enterprises are tolerated – for the time being. The central government will stay in its present form for the foreseeable future. They may stop calling themselves communist or socialist someday – but probably not. There is no serious threat to the ruling system’s structure or integrity, and there is no viable alternative. I don’t know anyone in Shanghai who even talks about things like democracy or civil liberties. If you want to read about stuff like rural unrest and protests, you have to go to the western media.

The line between “state-owned” and “state-directed” is becoming increasingly blurry. Companies like HuaWei and Lenova receive benefits of old-style SOEs (approvals, access to capital) and execute state policy (injecting advanced technology and climbing the value ladder by exporting relatively high-value goods & services). They LOOK private and are listed on international equity markets, so western finance & managerial types are happy. It’s a win-win deal – while markets are booming. The problems will show up down the road, when the interests of the bureaucracy don’t necessarily align with those of the shareholder. The bureaucrats have definite plans for what China will look like in 5 and 10 years, and these large exporters are the instrument of those goals.

Meanwhile, pure SOEs are developing, refining and improving. I recently had to visit the electric company in Shanghai to fix a billing issue. I expected to spend the day in a concrete beehive, shuttling from one uncaring bureaucrat to another. Instead I was immediately greeted by a professional, friendly and charming young woman who directed me to a customer service rep who handled my problem within 5 minutes. Their English was not advanced, but they knew exactly what they needed to get the job done. The level of customer service was far higher than many international hotels or businesses I’ve been to in China.

Multinationals in China thrive because A) they sell goods and services that Chinese consumers like, B) they represent no threat to the integrity of the central government and C) they are developing markets and training managers. The goals and methods of MNCs in China align perfectly with those of the bureaucracy. If that changes in the future, the MNCs will be invited to leave – and they will do so.

Independent private businesses in China are tolerated, but the central government is suspicious of them. Private entrepreneurship represents the single significant threat to the long-term health of the central government, and everyone seems to know it but the western media. Pure-privates will play a role in the future of China Inc., but it will be in the quasi-creative service industries like media and internet and marketing. They will be routinely co-opted by the bureaucracy and will be subject to regulations and administrative decisions. This insecurity will continue to foster short-term decision making, guanxi relationships and corruption. These things will diminish – but they simply aren’t ever going to go away.

There is nothing inherently wrong with this system, and during boom times everyone will make lots of money. The questions that western investors and managers SHOULD be asking themselves are – what happens when the steep growth curve flattens out? There are two ways this may happen: 1) an economic slow-down (which would almost certainly start from a drop-off in demand from overseas markets – the dreaded R. word) or 2) market saturation within China.

Both have the potential to upset the delicate balance between the international investment community and Chinese bureaucrats. Two fashionable myths have the potential to cloud international managers’ judgment and exacerbate potential problems.

Myth #1 is about the slow down. Forget about a Chinese government engineered soft-landing. No one knows how to do it, the policy levers are too clumsy and unpredictable, and the structure of China’s government system makes it all but impossible. China will slow down when international markets start buying less from China. That will be in the next recession. My highly-paid investment banker friends like to say that a US recession could actually be good for China, since lower spending power favors inexpensive China-made goods. That may be true in a handful of highly specific cases – but such a huge percentage manufactured goods are already made in China that a broad-based economic slowdown would hit China hard. Haier might sell a few more inexpensive laptops to businesses that can’t afford Sony’s, but their mid-range refrigerator business would be slaughtered by households that will put off the purchase for another year or two.

Myth #2 is about the size of the Chinese market. While I think there is still plenty of potential for growth, the roll-out of MNCs to the second cities has taken place much faster than people were predicting just a few years ago. China’s middle class is still growing – but it’s not nearly as big as western pundits seem to think. Some time in the not-too-distant future growth curves are going to start flattening. When that happens, developing Chinese SOEs and state directed companies are going to start eying MNC markets. China never made any bones about why MNCs were here in the first place – to develop the market and educate local managers. No one said anything about what happens once that was done.

Western managers in China are reading this and saying, “Of course. We’ve known this for years”. But there are plenty of western investors, management consultants and managers who seem to think that the China market is so vast and has so much potential that due diligence and market research aren’t necessary. This just doesn’t make sense. Every China plan needs a set of worst-case scenarios and an exit strategy. No exceptions.