What Lurks Ahead?

CEOs swept up by “China euphoria” could one day be surprised.

March 1 2005 by Chief Executive


 

Chief executives of many major companies, ranging from General Motors to Citigroup and from Motorola to Lucent, are investing billions of dollars in China. To a large extent, they have learned how to engage with the Chinese leadership and, in many cases, to make serious money.

But as a journalist who has been watching China since being posted to Hong Kong in 1979 to chronicle Deng Xiaoping’s Four Modernizations and then moving to Beijing in 1981, I learned that China is capable of surprise. Current straight-line projections of China’s economic progress are almost certainly wrong because China rarely pursues a straight line. That means CEOs who, in a collective euphoria, have invested so heavily in China could one day face disappointment if they aren’t aware of the risks.

The fact that Beijing is hosting the Summer Olympics in 2008 will serve as a powerful rallying point for the Communist Party’s leadership because national pride is at stake€¦quot;and nationalism is a potent force today. But in the years after the Olympics, there is a risk that China will have difficulty sustaining its rate of economic growth. Because the very legitimacy of the 68-million member party is based on its ability to deliver 8 percent and 9 percent annual rates of growth (the ideology of Communism has all but disappeared), the risk of political and social instability could increase. Here is a short list of what could go wrong in China:

  • Politics. Some Asian experts have argued that, as it gains economically, China will inevitably evolve from a one-party state toward a more pluralistic system, much as Taiwan and South Korea did. But there is no evidence that the party is relaxing its iron grip on the nation’s political life despite more than two decades of rapid economic gains. Obviously, there has been a huge expansion of individual liberties in the economic and lifestyle realms, but politics is still strictly controlled. There can be no open discussion of what happened in Tiananmen Square in 1989, for example. And security forces engaged in a thorough crackdown after the death of leader Zhao Ziyang, squelching any real discussion of his legacy. So it’s difficult to see how the Communist Party will ever allow itself to be drawn into a genuine multiparty system.
  • Stratification. Decades ago, when the party was led by workers, peasants and soldiers, there was a remarkably even distribution of wealth. But today, the elites drive Audis and BMWs, live in well-appointed high-rise apartment buildings and party into the night at karaoke clubs. It’s easy to distinguish them from the poor immigrants who have flocked to the cities to find work because the newcomers’ clothes are ragged and their faces weathered. There is a dramatic gap between the cities and the countryside, and between eastern China and western regions. Historically, these sorts of gaps have been a source of instability. Already, there are thousands of small incidents a year in which farmers protest losing land to urbanization or workers protest the closing of a state-owned enterprise.
  • Corruption. There are high-minded and scrupulously honest leaders within the party. But there are also those abusing their positions to make money. Since most business decision-making ultimately hinges on the party, many members are getting rich. There is the potential for the party to emerge as a new dynasty, isolated from the masses. To be in China around the Chinese New Year is to witness huge exchanges of money, flowing upward to those in positions of authority.
  • Financial system. One of the crucial tools of development is a country’s ability to funnel its wealth toward nation-building. China is awash in liquidity these days, but its financial system is still controlled by the government and party. Bankers have little idea of what the term “credit risk” means and are still making bad loans. Even while the economy has boomed, the stock markets in Shanghai and Shenzhen have been depressed because investors don’t trust them. There is very little financial transparency in the system as a whole. The number of “related-party transactions” taking place behind the scenes must be large, judging by the recent debacles at several large banks. As long as the party has ultimate control over the financial system, and there is no genuine rule of law, China’s wealth may not be intermediated in the most effective, long-term manner. And if the financial system remains weak, the government may never allow the renminbi to float and it may never be valued on the basis of market forces.
  • Intellectual property protection. Despite the vague assurances that Commerce Secretary Don Evans received on his recent visit to Beijing, I don’t believe China will ever respect intellectual property rights. Chinese newspapers made a great deal about the closing of the Silk Alley near the American Embassy in Beijing, where many counterfeit goods were openly for sale. But in dozens of other places in Beijing and Shanghai, fakes are available for every brand name imaginable. In fact, the Chinese have perfected a system of fakery. For any Louis Vuitton wallet or Rolex watch, there are A-plus fakes as well as A, B and C level fakes. Prices vary accordingly. Shopkeepers maintain a veneer of abiding by the law and signs proclaim “Say No to Imitation Products,” but the availability of counterfeit goods is systematic and pervasive.

    The Soft Infrastructure
    One Chinese friend who is knowledgeable about official thinking made a revealing comment to me. “We Chinese know what it costs a Western company to make something and yet they want to charge so much money,” she said. “They have created an opportunity for arbitrage.” In other words, her thinking goes, “the Western companies are cheating us by demanding such high prices. We have every right to try to obtain those products at the best price.”

    If China never chooses to protect intellectual property, that will hinder its own innovation. And Western CEOs will find newer, bolder threats to their brands. For example, General Motors’ Rick Wagoner has had to fend off a Chinese company trying to market the Chery, obviously based on a Chevrolet, and Cisco’s John Chambers is facing a similar challenge with Huawei, which attempted to sell routers based on Cisco designs.

    Where does it all lead? China is making huge gains in manufacturing and that is going to continue. The country’s “hard” infrastructure of highways, factories and skyscrapers has made breathtaking progress. Beijing looks a great deal like Los Angeles. Shanghai’s Pudong District has exploded.

    But the “soft” infrastructure necessary to emerge as a full-fledged, technology-based powerhouse has not made nearly as much progress. There may be political and cultural reasons why it never will. Obviously, no one can forecast the future. As the Chinese say, “meo yi ge ren zhidao,” or “not even one person knows.” But there’s a risk that the Chinese won’t be able to make it to the next level of economic development.

    I realize this is a contrarian point of view and that not everyone in the world must embrace American views of economics; multiple models do work. Still, the Chinese could reach a plateau, and growth could slow, particularly if foreign investment slows. In many ways, this is a nation hooked on rapid growth. If growth were to slow, the party’s legitimacy would be undercut. In such an environment could lurk the seeds of trouble for investors who have not carefully hedged their bets.