This is an article on China from _The Economist_ -- but not from this week's propandistic feeding fest. Rather it's from the business section of the week before. Although its most obvious point is the usually pollyannaism about the market's ups and downs (Never a sign of trouble! Always a good thing!), the underlying arguments seem to be completely in contradiction to everything _The Economist_ stands for -- and fairly forceful. Most of it is contained in the last four paragraphs: that the model for the Chinese model is Japan, and that China has been successfully implementing that model, gaining technology from abroad while giving away little in terms of market share. The article also argues that a major reason why foreign companies having been losing money in China is that they were beaten in head to head competition with state owned enterprises. And it argues further that the precipitous drop in foreign direct investment is as much an artifice of accounting as was the boom before it because most of the capital that has been invested in China is Chinese, either originating from Hong Kong, or "round-tripping" through Hong Kong to avoid taxes.
For all these reasons, I found it pretty interesting. They've had some pretty sharp stuff on Korea too over the last month. Maybe they have a new Daniel Singer but now in the Far East department?
Infatuation's End
INDEX TERMS China| business anxiety and falling investment; China| multinationals, anxiety and falling business investment|
DATE 25-Sep-99
WORDS 2195
SHANGHAI
For most of this decade, multinationals have celebrated China as the market of the future. Now business investment is plunging. What happened?
INFATUATION'S END
CHINA intends to put on a hell of a show on September 27th. Hundreds of western bosses will be landing at Shanghai's sparkling new airport for the Fortune Global Forum, the country's biggest gathering of business leaders since it opened up to the West two decades ago. They will be greeted by China's president, the world's tallest hotel, a new subway line and an ultra-modern conference centre. It is all meant to mark the coming-of-age of Pudong, an extraordinary business district built in only eight years in the rice paddies across the Huangpu river from the Bund, which was Shanghai's foreign-business district before 1949.
Yet the welcome is also partly meant to hide growing anxiety in China. After two decades of rapid economic growth, this year will be the first in which total foreign direct investment ( FDI ) will fall—and it will do so by more than a fifth (see on). This is a shocking decline in China's best single indicator of business confidence. It belies both Shanghai's new concrete-and-glass metropolis and also the unbounded optimism that was found in western boardrooms only a few years ago.
In 1979, as part of his market reforms, Deng Xiaoping invited foreign companies to return to China. Simple arithmetic -- soaring GDP, a market of 1.3 billion people, and a bit of purchasing-power magic -- foretold the world's biggest economy as early as 2020. When business people fell under the country's statistical spell, huge amounts of investment began to arrive. The annual increase in FDI averaged more than 40% over the 1990s, and peaked in 1993 at an astounding 175%. A total of more than $270 billion has been invested, by thousands of foreign firms, since 1992. That is nearly half of all investment in the developing economies.
Some multinational investors wanted to tap into China's pool of cheap labour to make goods for export. Others sought to supply the Chinese themselves. Still others came to supply the factories of other foreign firms, or they simply opened representative offices. But one way or another, most came, many with stars in their eyes. Executives loved to show s proving that China would one day be the biggest market in telecoms, cars, beer, you name it. Others felt they couldn't afford to stay away. As Alex Trotman once said: "I can't go down in history as the Ford chairman who missed China."
They still come, but China's numerology has lost its power to enthral. Too many companies have lost millions, and wasted years of management time dealing with Chinese bureaucracy and the Chinese partners that had been imposed on them. What had seemed to many investors like a market of infinite possibility now looks instead more like a black hole of infinite dimensions.
Today's news is still filled with such names as Caterpillar, Pittsburgh Plate Glass, Fosters and the Royal Bank of Canada, but now the headlines are about factory closures and disinvestment. It is a commonplace that almost no western firms make money in China. And worse may be to come, what with China's economic troubles, its banking crisis and crackdowns on dissent. Relations with America are strained, following the bombing of the Chinese embassy in Belgrade and hard bargaining over China's membership of the World Trade Organisation. Some firms are concluding that perhaps they can afford not to be in China after all.
Yet such managers risk being just as wrong about China today as they were ten years ago. For every company publicly washing its hands of China, hundreds are quietly running successful businesses: paint or fibres, special plastics or industrial bearings, all sorts of humdrum products. One of the most profitable operations of Germany's Hoechst is a Chinese plant that makes cellulose for cigarette filters. With sales of foreign brands falling after a crackdown on smuggling, Hoechst now has a virtual monopoly supplying domestic cigarette makers. Who could have foreseen that?
The constant in China's recent dealings with western business is misunderstanding: first, of the magnitude of China's problems, now of the significance of its reforms. Yet the real task for firms is not to decide either to spend more or to withdraw, but simply how to manage their Chinese projects. The reversal in FDI may not even be bad for China. What the country needs is not so much more investment as better investment.
GRIT OR PEARL
The story of foreign business in China can best be told as a series of fallacies unravelled, often through painful experience. Few companies are stupid, but many have behaved stupidly in China. In a market that is both complex and fast-changing, firms have launched schemes based on market research so scant that it would never have satisfied them elsewhere. One of General Motors' first ventures, a factory making pick-up trucks, failed because the company did not realise that such vehicles in China are used to carry people as well as goods. The two-door cab favoured by Americans was too small. Others did better research, but waited too long. By the time they had built their factories, competitors had already grabbed the market.
Foreigners also underestimated their Chinese competitors. When Whirlpool set up factories to make refrigerators, air-conditioners, washing machines and microwave ovens in China in 1994, it assumed that it was racing against other foreigners. Instead, its chief competitors turned out to be Chinese appliance makers, such as Haier and Guangdong Kelon. Their technology was nearly as good as Whirlpool's, their prices were lower, and their styling and distribution were better suited to China.
By 1997, having lost more than $100m, Whirlpool had shut its refrigerator and air-conditioner plants. The microwave factory survived mainly by devoting itself to exports. And Whirlpool's washing-machine factory now makes appliances under contract for Kelon, which sells them under its own brand, a reversal of the usual hierarchy between western and Chinese firms.
Chinese companies have been no less successful in other industries. Motorola is losing market share to Eastcom, a distribution partner that now makes and sells its own competing mobile phones for less than the American firm. Ericsson, Lucent and other equipment makers are losing ground to domestic telecoms firms such as Huawei, which make gear that is almost as good and a lot cheaper. Compaq once led China's PC market; now Beijing's Legend does. Markets for video compact-disc players and televisions are overflowing with domestic products. Local beers have crowded out international ones.
Multinationals make much of their world-class management. But they cannot run their Chinese operations as they would elsewhere, or even as they please. Although foreigners are now winning approval to set up wholly owned ventures, most of those that are around today are joint ventures, burdened by an uneasy sharing of power and layers of committees. Many partners are state-owned, with a long legacy of socialist inefficiency.
Companies had assumed they would benefit from being the first to arrive, establishing a brand and privileged links with distributors. In fact, price-sensitive Chinese consumers have proved fickle about brands. The first multinationals had to deal with Chinese bureaucracy at its worst, and had little choice over where they would set up or with whom. Later, the government relaxed its rules; most new foreign ventures in China today have no local partner at all, something their predecessors could only dream about.
Many bruised early comers now fall back on the line that China is a long-term investment: eventually their foresight will be rewarded. Perhaps, but not yet. A survey earlier this year by Tenbridge, a consultancy, found that 60% of the multinationals that had arrived in China after 1993 had achieved positive cashflow. Only half of those there since 1985 or before could say as much.
The most efficient companies in China are new privately owned domestic firms, which make an average return on equity of 19%, according to research by the City University of Hong Kong. Foreign ventures rank just above state-owned enterprises, with a miserable 3%. No wonder that, of the multinationals surveyed last year by A.T. Kearney, a management consultancy, and the Economist Intelligence Unit, a sister company of The Economist, more than a fifth had pulled out of at least one money-losing venture in China.
BETTER THAN IT LOOKS
Yet today's relentless pessimism is not the right antidote to yesterday's mistaken optimism. Although the average return is low, most surveys reveal that most companies are profitable, or at least breaking even -- although the proportion (55-65%, depending on the survey) is smaller than in most other markets. That is hardly a triumph, but it is a long way from the assertion that nobody makes money in China.
The popular misconception arises partly because companies say one thing in an anonymous survey and another when asked direct. Those bragging of their profits are sure to attract the notice of tax authorities. Tax avoidance may not be the policy of multinationals elsewhere, but in China joint ventures typically adapt their ethics to fit local "best practice". Do not tell head office, but plenty of respectable -- and desperate -- multinational ventures in China have bribed officials, spied on their partners or competitors, done favours, and even fiddled their books.
That the best-known foreign companies in China tend to sell consumer goods makes the received wisdom even more misleading. There are, for a start, fewer potential consumers of foreign-branded goods than it might appear. Out of China's 1.3 billion people, only a few tens of millions, mostly in coastal regions and cities, are yet rich enough to become consumers of foreign brands.
Reaching other consumers is often too expensive, since China still has only pretty basic national distribution -- and the system that exists is designed to get exports to the coast, not the reverse. The few successful retail products are soon pirated, forcing companies to fight for shelf-space with what appear to be their own wares (copying is so pervasive that market research usually reports sales far in excess of actual production). The Tenbridge survey found that about half of multinationals in China had found the market for their goods smaller or much smaller than expected, although the bigger a company was and the more market research it could afford, the more accurate were its predictions.
Just as the travails of consumer-goods firms are misleading, so it is also easy to make too much of this year's fall in FDI . The size of the drop says more about China's efforts to avoid a fall last year, in the midst of the Asian crisis, than a sudden reverse in the past 12 months. In 1998 China emptied its pipeline of big deals, pushing through multi-billion-dollar projects with Eastman Kodak, BASF , Royal Dutch/Shell and Krupp. Had it not done so, FDI would have fallen last year, too. By bringing investment forward, China made this year's slump look much worse.
Of course, the fall in FDI is nevertheless real and sustained: the boom in Chinese investment is over, at least for now. But it has been replaced by a harder-edged realism, and that is surely healthy. Certainly, investors will benefit: fewer, more successful, ventures should acquire a market discipline that operations in China have lacked in the past.
MIDDLE KINGDOM'S MIDDLE WAY
For China, too, the decline in FDI is no disaster. For one thing, investment's importance to the economy has often been exaggerated. FDI has never amounted to more than about 5% of China's GDP over the past decade. Companies with at least some foreign investment make up only 3% of all Chinese firms. Their share is greatest in the export sector, where Hong Kong- and Taiwanese-backed firms on China's coasts make boatloads of toys, clothes, computer parts and so on. Yet even there, foreign-invested firms are still the minority. Moreover, all this puts too much emphasis on the word "foreign": the biggest source of FDI in China is Hong Kong, and much of that is actually Chinese cash "round-tripping" through Hong Kong to avoid domestic Chinese taxes.
Neither does a slump in FDI mean that China will reverse its economic reforms. Attracting investment was not the main reason for the reforms in the first place. China's development is modelled on the experience of South Korea, Taiwan and Japan, which all did their best to keep foreigners out. The Asian crisis only reinforced China's suspicion of foreign capital.
To the extent China seeks FDI at all, it is as a source of technology, hard currency and a way to corral the country's vast private savings into useful investments. Such a policy has always been seen not as an end in itself, but as a temporary measure aimed at kick-starting China's domestic economy, while domestic reforms take effect.
Those reforms are far from finished. But Chinese firms are now coming into their own. As multinational investment slows, world-class Chinese companies such as Huawei, Haier, Kelon, Legend and Eastcom are creating employment, models for managers, and even starting to export their own technology. The golden age of foreign investment in China may have come to an end. But so too has China's need for it.