Behind the mask
Mar 18th 2004
From The Economist print edition

by Sameena Ahmad

World Trade Organisation, IMF, World Bank and Asian Development Bank give information on China. Transparency International's Global Corruption Report details graft in China. See also What to Think About China, an article by Orville Schell first published in the New York Times.

Hailed as the business opportunity of the century, China is bound to disappoint. Sameena Ahmad (interviewed here) examines the mismatch between excitable perception and sober reality

THE whole world's gaze is fixed on China—not just because the country is vast and growing rapidly, but because it profoundly affects the fortunes of companies everywhere. Around the globe, shelves are stacked with the low-cost goods churned out by “the world's workshop”. Chinese-based manufacturers suck in imports and dictate global prices of everything from steel to microchips. For foreign companies, a huge market beckons as China liberalises its relations with the rest of the world, having acceded to the World Trade Organisation in 2001.

China's progress since it first opened to foreign investment and reform in 1978 has been dazzling. Over the past 25 years, its real gross domestic product has expanded at an average of 9% a year. Growth in foreign trade has averaged 15% annually since 1978; China's trade surplus with America is now twice the size of Japan's. And every week, more than $1 billion of foreign direct investment flows into the country. All this testifies to the global integration of China's economy, now the sixth-largest in the world with a GDP of $1.4 trillion.

This rapid growth has ensured political stability. Whereas socialist regimes around the world have crumbled, China's Communist Party survived the 1989 Tiananmen Square uprising, the 1997 Asian crisis and last year's SARS virus without making concessions to democracy. The present leadership is well-educated, capable and pragmatic.

Internationally, China has become respectable, more a partner than a threat. The continuing debate about the “undervalued” yuan says more about partisan American politics than about Chinese mercantilism. Domestically, the government is well aware that its political acceptance derives solely from rapid economic growth, and will do whatever is necessary to meet its internal benchmark, an annual rise of 7%. China's leaders still call themselves communists, but they have become capitalists in practice. If they have a guiding philosophy, it owes nothing to Mao or Marx, but is best summed up by Deng Xiaoping's famous dictum: “It doesn't matter whether the cat is black or white, as long as it catches the mouse.”

The combination of growth, stability and potential has set off a tidal wave of foreign enthusiasm for China. Businessmen return from pilgrimages to Shanghai and Beijing convinced that this is China's century. Robert Bestani, head of the private-sector arm of the Asian Development Bank, calls the phenomenon “future shock”—change so rapid that it seems like a vision of the future. Dietmar Nissen, East Asia president of BASF, a huge chemical company, says that “the speed and scale of growth in China over the past 12 years is a miracle. It is a miracle that China is developing in such an orderly fashion.” Messianic terms are de rigueur when discussing the country's 1.3 billion consumers, its vast pool of low-cost workers and its need for every imaginable product and service. Goldman Sachs, an investment bank, predicts that by 2040 China will overtake America as the world's biggest economy.

This survey will cut through some of the hyperbole currently enveloping China. Progress there is as real as it is dramatic, but the country is still in transition from one political and economic system to another. The constraints imposed by the communist leaders (not least on themselves) have produced “a darker reality” behind the impressive statistics and soaring skylines, in the words of Orville Schell, a professor at Berkeley who knows the country well.

Diminishing Returns?

Look on the dark side

China needs 12m-15m new jobs every year just to keep pace with its population growth. It has to provide opportunities for the 800m people living in rural areas who have been left behind by the current boom, and a third of whom are under- or unemployed. It also has to deal with the 100m-150m migrant workers in the cities who have no job security, no long-term housing and no health care. And it needs a functioning pension system. No wonder the government is concerned, above all, with growth and job creation.

Currently there are worries that the economy is overheating. Bubbles are beginning to form in property, steel and cars, and power generation is running up against capacity constraints. China's real problem, however, is not inflation but overinvestment. In its quest for growth, the government has directed its state-owned banks to open the taps. Easy credit is producing massive overcapacity, leading to deflation, more bad debts and fewer new jobs. Already, nine-tenths of manufactured goods are in oversupply, yet investment in fixed assets last year grew by 30% and contributed 47% of GDP. Three-quarters of China's growth comes from capital accumulation, according to Paul Heytens and Harm Zebregs of the IMF, yet total factor productivity—a measure of overall economic efficiency—rose by only 2% a year in 1995-99.

Even for a developing economy, China's level of investment is unusually high. South Korea in its period of rapid growth in the 1970s and 80s had investment levels closer to 25% of GDP. But the biggest concern is that China's growth is staggeringly wasteful. Whereas in the 1980s and 90s it took $2-3 of new investment to produce $1 of additional growth, now it needs more than $4. Even India, often compared unfavourably with China, is now more efficient on that measure (see chart 1).

Only a very high domestic savings rate—around 40% of household income—and the uncontrolled exploitation of its natural resources make it possible for China to waste capital on this scale. But neither is sustainable. With little social welfare on offer from the state, the Chinese need to save to provide for themselves. And environmental degradation and noxious pollution are storing up costs for the future. All this means that China's growth will have to slow markedly unless its government wants to drown in debt—maybe not this year or next, but soon.

That is yet another risk for businesses already facing a host of challenges. China's developing capitalism is not solidly based on law, respect for property rights and free markets. It is unbalanced and potentially unstable. Multinational companies operating in China have often failed to produce an adequate return on their investment, or indeed a profit of any sort. That is partly their own fault, because they overestimated the market and underestimated the competition. With experience, more are getting it right. However, the business climate in China remains capricious and often corrupt.

Chinese firms contribute to that climate. State-owned enterprises are much more concerned to maintain patronage and employment than to generate profits, and even the best are not globally competitive. China's fledgling private businesses, by contrast, have shown astounding growth and produced the country's first crop of wealthy entrepreneurs. But they are still too small to offer an effective counterweight to the state sector.

It is in the financial sector that China's brand of “not wholly black, not fully white” capitalism works least well. The banks do not allocate capital rationally, and they are vulnerable to external shocks. Yet the potentially huge cost of reforming them will constrain the government's ability to finance economic growth. That will have implications for China's political stability, and for its attractiveness as a place in which to do business.

A billion three, but not for me
Mar 18th 2004
From The Economist print edition

The prospect of a vast domestic market of 1.3 billion consumers has lured countless companies to China

OUTSIDERS have dreamed of China's riches for 700 years. Marco Polo was awed by its scale in the 13th century. Two hundred years later, Christopher Columbus annotated his copy of the Venetian adventurer's “Travels” with the words “Mercacciones innumeras” (“an incalculable amount of trade”) before setting out for mythical Cathay. British merchants in the 19th century hoped that selling opium and silver in exchange for silk and tea would give them access to the huge country. But it has been with the rise of globalisation, as Joe Studwell writes in his book, “The China Dream”, that “the belief in China's unparalleled potential has taken on the order of an obsession.”

So far, China has always disappointed. Marco Polo came home with little more than his memories, and Columbus never reached it at all. When George III's ambassador, Lord Macartney, headed a 700-strong trade mission to China in 1793 to sell advanced western telescopes, barometers and airguns, Emperor Qian Long told him that China had not “the slightest need of your manufactures”.

And so it has proved. A British writer observed in the 1840s that “if we could only persuade every person in China to lengthen his shirt-tail by a foot, we could keep the mills of Lancashire working round the clock.” But the length of Chinese shirt-tails remained the same. Carl Crow, an American who marketed pharmaceuticals for foreign firms in Shanghai between the two world wars, wrote in his 1937 book “400 Million Customers”: “No matter what you may be selling, your business in China should be enormous, if the Chinese who should buy your goods would only do so.” They never did. Astonishingly, in his 25 years there, Crow's agency failed to launch a single successful product.

This time it will be different, or at least that is the hope of the current generation of businessmen and politicians streaming in and out of China on trade missions and corporate visits. Patricia Hewitt, Britain's trade secretary, ended a trip to the country in January with an exhortation to British businesses that echoes Crow and Columbus: “What is staggering about China is its size, its scale, the enormity of the numbers, the scale of the opportunities. Even a very small part of this very large action will be good for Britain.”

But as in imperial times, the country's scale can prove more of a hurdle than an opportunity. China has 31 provinces, 656 cities, 48,000 districts, seven major dialects and 80 spoken tongues. Climate and geography vary from the freezing northern plateaus to the semi-tropical south. There are enormous disparities in income, education and lifestyle between city dwellers and farmers, and between the wealthy east coast and the poor west and north-east. For most products, there is no such thing as a national market. China's consumers are too dispersed, too inaccessible and too different from each other.

Underdeveloped transport, lack of sophisticated logistics and the need for countless middlemen mean that foreign firms struggle to set up regional distribution networks, let alone national ones. Efficiency is a distant dream. B&Q, Britain's largest DIY retailer, has 600 vendors supplying its 350 British stores, but 1,800 for its 15 Chinese ones. Yet as Tex Gunning, president of Unilever Bestfoods Asia, says: “Foreigners still think they can tackle China in one go, when they would never start in 17 countries in Europe at once.”

True, even a single regional or urban market in China represents a big opportunity, particularly given the country's rapid growth. That combination lured more than $300 billion of foreign capital to China in the 1990s and $50 billion last year alone. But anything can grow rapidly from a low base, and in China almost everything is starting from next to nothing. Car sales, for instance, soared by 75% last year. But then China has only 15 cars per 1,000 people, compared with America's 700.

That elusive middle class

So what is the real size of the Chinese market? At the end of 2002, the date of the most recent official estimate, China had a population of 1.28 billion, of which two-fifths (502m) lived in urban areas and the rest in rural ones, and which was growing at 0.65% a year. Average disposable income per person was 4,520 yuan ($545), nowhere near the $5,000 level at which economists say discretionary spending takes off, and little more than 2% of America's $25,000-plus. Measured by GDP per person, which breached $1,000 in 2003, China is only half-way to becoming a middle-income country as measured by the World Bank, ranking below places such as Namibia, Guatemala and Morocco.

Rural households, with disposable income of 2,620 yuan per person in 2003, still spend nearly half their money on food and less than 15% on culture, education or recreation. Urban dwellers are better off, with disposable incomes of 8,500 yuan per person, but even the top 20% of this group—numbering 100m—earn on average just 15,380 yuan, which at less than $2,000 is still well shy of that $5,000 threshold. Undoubtedly there are rich people in China, people who can afford villas, limousines and foreign holidays. But they are a tiny minority.

To be sure, urban incomes have been rising by an astounding average of 14% a year since liberalisation in 1978. But they would have to keep growing at that rate for another 13 years to reach the magic $5,000. Most Chinese simply do not have spare money to spend, and won't have for many years—if only because they are so worried about the future that they are saving a large proportion of their meagre incomes. Before market reforms, they earned very little but enjoyed a measure of security of food, housing and employment under the “iron rice bowl” system. Now they themselves have to make provision for unemployment, sickness and retirement.

According to Andy Xie, chief Asian economist at Morgan Stanley, a bank, the Chinese have accumulated household wealth equal to 140% of GDP over the past two decades, largely in bank deposits and property. But experience in richer countries shows that populations do not stop saving until they reach 300-400% of GDP, and Mr Xie hazards a guess that because of rising life expectancy, one-child families and an early retirement age, China will stabilise at the high end of that range. All this means it will take another two decades before the mass of Chinese become consumers in the accepted sense.

But few corporate business plans take a realistic view of the commercial opportunities in China. Mobile phones are a good example. Thanks to soaring demand for handsets, America's Motorola, which started up in China in 1987, is now the biggest foreign company there, with locally generated revenues of $5.7 billion in 2002. China, in turn, has become Motorola's second-largest market, worth 14% of group sales. But now the company is on the defensive. Growth is levelling off, even though market penetration is only around 20%, suggesting that most people who can afford a mobile phone already have one.

At the same time, a newish crop of domestic handset producers has doubled its market share to 40% in the past 18 months, threatening a glut. Brian Modoff of Deutsche Bank in San Francisco says that China has 40 mobile-phone makers selling over 800 models. Annual demand should rise from 80m units to 100m in the next two years, but supply will double to 200m. Prices are plummeting. With government backing, Ningbo Bird and TCL, two Chinese manufacturers, have overtaken both Motorola and Nokia with their 10% market share, though a lot of their “sales” are simply sitting in warehouses. But that is no comfort to Motorola. Daniel Shih, the president of its operation in China, admits he faces “extreme competition”, though he claims to be “very happy” with handset margins in China. Mr Modoff, however, reckons they are even thinner than the group's poor 6% global average.

The competitors are not finding life much easier. In Ningbo, a coastal town in Zhejiang province, Bird's modern factory is full of industrious workers and high-tech machines, but Dai Maoyu, Bird's executive vice-president, looks tired. The former economics professor says he is making phones he cannot sell, that a price war is destroying everyone's margins and that Bird wants to diversify into cars.

Hot airbags

He is not alone. Cars are China's hottest consumer product. Sales of locally made passenger cars jumped by 50% in 2002 and by 75% last year, to 1.97m, as ministerial purchases of dated VW Santanas were replaced by entrepreneurs buying their first Honda Accords and Buick Regals. Even the professionals were surprised. “There wasn't anyone anywhere in the world in 2001 who forecast even close to what we've seen,” says Philip Murtaugh, chairman of General Motors China. He predicts that China, having overtaken Germany in 2003, could surpass Japan as the world's second-largest new-car market after America in two years.

Mr Murtaugh expects annual growth of 10-15% until 2010. Many private analysts are even more bullish, forecasting 20-25%. The previous spurt in car sales in 1991-92 was followed by years of single-digit growth, but strong private demand may prevent such a slowdown this time. There are still one-year waiting lists for many models, despite tariffs that virtually block imports and keep prices high.

Yet those high prices in themselves are bound to limit the size of the car market. Michael Dunne, president of Automotive Resources Asia, a consultancy, says a third of the cars sold last year cost more than $25,000, and 70% were paid for in cash: “China's rich are not a limitless pool. There is talk of an emerging middle class, but I don't see it.”

For now, this may not matter. With prices and capacity utilisation high, the big Sino-foreign joint ventures are making money hand over fist, so they are ramping up capacity (see chart 2). In the past year, GM, Volkswagen, Toyota, Honda, Nissan, Peugeot Citroën, DaimlerChrysler and Ford between them have announced more than $20 billion of fresh investment. KPMG, a consultancy, forecasts that next year overcapacity will reach 90%, with China producing 4.9m cars when demand is for only 2.6m. Add in trucks, and total vehicle output could reach 15m by 2007, against sales of only 7m, according to the National Development and Reform Commission (NDRC), the economic-planning arm of China's cabinet.

Mr Murtaugh calls overcapacity concerns “overblown”. He thinks that the first to suffer from competition will be the small, indigenous manufacturers among China's 120 carmakers. Looking round his Shanghai Buick factory, which churns out 33.5 cars an hour, six days a week, with every one sold, it is easy to be sanguine. But the big producers will be hit eventually. Car prices are falling by 10-15% a year. Yet it costs 5% more to build a Buick in Shanghai than in Detroit, because expensive imported materials outweigh cheap local labour, so margins are being squeezed. Average operating margins for the sector, at 8-9% last year, were high by global standards. But Goldman Sachs estimates that in the past 18 months, eroding market share and prices have halved the Chinese margins of the market leader, VW, to 5.8%.

Cheaper cars will attract more consumers. But at the bottom of the market the indigenous Chinese carmakers are more competitive than the incomers, and the government is unlikely to cede the market to foreign-led ventures forever. Mr Murtaugh dismisses talk that a “car policy” document drafted by the NDRC will give half the market to local makers by 2010, but local car companies such as Geely and Chery are unofficially being encouraged to pirate foreign designs.

Undoubtedly China's potential is huge, and there are more multinationals making money there today than ever before. But for most foreigners, the market will turn out to be smaller than expected and take longer to develop; and because so many foreign businesses are piling in, competition is likely to be fierce. The question then becomes: how can foreign firms generate acceptable returns in China?