All posts by George Baeder

About George Baeder

George Baeder has spent 35 years helping corporate leaders and policy makers to unravel the complexities of Asian business and economics. China’s growing global role will continue to radically alter long-held assumptions about market priorities, innovation and rules of competition. After nearly four decades in Asia – as an economist, strategy consultant, entrepreneur, investment banker and line manager – George is dedicated to helping organizations challenge and rethink their assumptions, pinpoint the risks and opportunities inherent in China’s emerging global leadership and develop actionable strategies and initiatives to create tangible high-impact outcomes.

What Happens When China Overtakes the US in R&D Spending?

dreamstimelarge_32983125Having spent the last two weeks visiting several leading Chinese research centers, two things are clear: First, China’s basic scientific capabilities still lag those of the US. Second, the gap is closing as China progressively increases across-the-board spending on basic science as well as technology commercialization. American’s assumption of permanent US technology leadership is clearly an illusion – regardless of how unacceptable this admission has become for political and business leaders in the US.
This one page graphic from Nature tells a compelling story about the scale and growth of Chinese R&D spending. Click on the link:
China R&D Spending

Xi Jinping’s “War on the West”: Managing Global Transformation and Changing Rules of Competition US-China bilateral conflict sparked by China’s challenge to established rules of global competition poses a growing threat – particularly over the next 18 months as US elections loom. Avoiding crisis requires that Western policy makers and executives urgently develop deeper objective insight on China’s future global role and dispassionately reappraise the three pillars that underpinned past US economic influence.

US academics, policy makers and executives express growing concerns about China’s leadership under President Xi Jinping’.  A long time friend addressing a Harvard seminar recently characterized recent Chinese policy as “Xi’s war on Western values and Western business”.  While some consider this overly dramatic, points of friction appear larger and more numerous by the day.

Responding effectively makes it essential that Westerners put the growing competitive challenge from China into broader perspective. Objectively interpreting China’s actions and critically re-examining our own deeply held assumptions about “how the world works” will be vital to charting a course through rough waters ahead.

China’s “anti-Western” policies generally fall into three – sometimes overlapping – categories that render them more comprehensible than viewing these moves as attacks that presage some sort of economic Cold War conflict.

Expectations of Equity: China expects to be treated as an equal to the US and EU. Policies designed to provide the government with access to IT infrastructure installed in China are reported to be less onerous and no more invasive than US and European practices. Limiting sales by Cisco, IBM and other technology firms mirror barriers the US erects to Huawei and ZTE. When the US treats the world’s largest trading nation as “another Asian market” that is welcome to join the Trans Pacific Partnership if Beijing follows Washington’s rules, America seems of touch with current global economic reality. In Chinese eyes, “equity” does not merely mean being granted a seat a Western poker table. It also assumes a key role in deciding whether the game will use mahjong tiles or playing cards.

Demonstrations of Leadership: China is playing a transformational role in the global economy, much as the US once did. Its aid and concessional lending already outdistances World Bank development support to Africa and Latin America. Xi’s “Silk Road” and a Hong Kong company’s proposed $50 billion Nicaraguan canal indicate the scale of China’s ambition. It is inevitable that China use its political, economic and financial influence to shape global trade, economic development, infrastructure and finance rather than meekly accept the Western status quo. US opposition to such initiatives – including castigating UK support for the Asia Infrastructure Investment Bank – have proved embarrassingly counterproductive.

Domestic Political Imperatives: Resurrection of Maoist-like rhetoric and management tools form one part of the intense battle Xi is waging on the corrupt and complacent political-bureaucratic-industrial complex that blocks reform. That Xi and 5th generation leaders selectively adopt tone and tactics reminiscent of the Cultural Revolution reflects lessons from their upbringing, not their underlying policy beliefs. Today’s ideological rhetoric helps coopt one segment of the body politic while having limited impact on key policy choices. Imagine if China took seriously American ideological demagoguery used to marshal support from extremists in Congress and their followers.

US thinking and actions seem predicated on the assumption that three central drivers of past US leadership remain powerful pistons in US economic competitiveness and diplomatic influence. Yet the power of all three is rapidly, irrevocably diminishing:

  • Market Size: China has replaced the US as the largest global market. Forget arcane debates over validity of GDP comparisons. Chinese demand already surpasses the US in most industrial and consumer sectors; in smart phones, luxury goods and advanced industries such as alternative energy, China’s market is already two to three times larger. Limiting or granting access to the US market no longer provides the powerful leverage it did when the US imposed its version of global trade liberalization in the last century.
  • Financial Leverage: The US has become the world’s largest debtor nation and China the world’s largest creditor. Neither nation will change its role soon. The groundwork is therefore in place for the progressive transformation of financial markets to accelerate as China gradually eases control over capital account convertibility.
  • Scientific Leadership: The US legacy built through past investment in science and technology is rapidly eroding as public spending basic scientific research declines in parallel with the number of American science and engineering graduates. China’s research spending and cadre of scientists and engineers is expanding rapidly, facilitated by the return of Western-trained post-docs.

Even as the original sources of US leadership lose potency, alternatives to perennial conflict with China exist. The US-China climate change agreement offers a collaborative template that supports domestic priorities in both countries and hews the missing cornerstone of global agreement. Melding US basic research capabilities with China’s capital and its urgent need to deliver affordable solutions to health, energy, environmental and agricultural challenges provide vast, fertile areas for cooperation.

America’s entrenched myth of its own exceptionalism daily collides head on into China’s conviction that the Middle Kingdom will regain its position as the center of the world. A century of undisputed US global leadership – capping 400 years of European domination – makes it difficult to let go of outdated concepts that no longer serve us. Coming to grips with the complex reality of China’s future global impact and developing a coherent strategy that transcends the US ideological divide requires clear thinking and honest self-appraisal – precisely as America’s perennial election cycle makes such capabilities desperately scarce.

Property: Myth of Imminent Collapse and End of the Chinese Growth Miracle modest slowing of China’s GDP growth to more sustainable levels – largely blamed on the residential property and construction – has rekindled familiar dire warnings forecasting “deflation of the country’s debt-fuelled property bubble”. Fortunately, basic facts and a bit of historical insight easily dispel such fears (click to download narrated slide presentation) .

As China’s technocratic leadership continues to steer the world’s largest nation through a complex multi-faceted economic transition to global leadership, it has become essential to bring real insight to China’s unique sector-specific dynamics.  Given the business importance of China’s market expansion and the country’s role as the primary driver of global growth and trade expansion, separating reality from media-hyped myth is increasingly critical to global decision making.  As China’s property market bottoms and rebounds, a classic example of the gap between Western perceptions and reality will come into sharp focus.

Western Conventional Wisdom

The myth of a coming Chinese property collapse purports a massive surplus of debt-financed housing across numerous Chinese cities.  Most of the locations seem obscure, with names many Westerners have never heard – despite the fact that most are larger than the largest US cities.  A decline in Chinese housing purchases and prices last quarter again sparked wild extrapolation of recent Western experience onto a Chinese property market that is the mirror opposite of the US and Europe.

China’s “glut” of empty property:  Nearly 15% of the US housing was vacant in 2008; about 20% of China’s 220 million urban housing stock – or 40 million units – are currently vacant.  Ergo: collapse must be imminent and the impact must certainly be more severe and prolonged than the protracted decline in the US posing a similarly life-threatening crisis for the financial system.

The first key China difference:  85-90% of China’s 40 million vacant urban apartment units have been sold and are neither being offered for sale nor for rent.  Chinese developments are “pre-sold” when they reach 50-70% completion by the developer.  Once the developer finishes his “bare wall” construction, the buyer-owner then hires a contractor, begins selecting plumbing fixtures, finishing walls, installing electrical outlets, etc.  The time between the “sale” and “occupancy” is at least one year and often closer to two years.  Hence only 10-15% of the 40 million vacant units – or approximately 4-6 million – are available for sale or rent.  This is in contrast to the US, where some 34% of the vacant housing was either for sale, in foreclosure or for rent.  Of China’s 4-6 million “available” units, around 2-2.5 million (or 1% of the housing stock) will always be on the market at any given time.  Thus China’s actual “surplus” of urban housing is only 2-4 million units – far from the glut of 40 million apartments that worry naive Western analysts.  A clearer understanding of China’s property demand helps put these numbers in further perspective.

Basics of supply and demand: Chinese urban property is fairly straight forward.  China has consistently built 7-8 million units annually. While the Western conventional wisdom would have you believe that there has been a dramatic acceleration of construction in recent years, the rate of growth has progressively slowed over the past decade.  Conscious government policy restricting land use and tightening mortgage lending beginning in 2009 instigated the recent slowing.

Property GrowthAt the same time, underlying demand continues to expand.  Over the course of this decade, China will add more than 100 million urban households – or 10-11 million annually – driven mainly by rural-urban migration.  Hence the historical shortage that has been driving rapid housing price increases has now come into rough balance.  Put in this context, China’s  2-4 million “surplus” units do not represent a threat. Selective easing of mortgage restrictions and lower interest rates have led to an upturn in sales, which seem likely to end 2014 at the 10 million unit level.

Threats from speculators and debt:  Faced with the simple facts of supply and demand, Western analysts quickly substitute another set of myopic assumptions:  Purchases are driven by “speculators” and/or Chinese who cannot afford today’s high urban housing prices.  With speculators unable to “flip” these properties and household incomes constrained by China’s slowing growth, a Western style crisis is still imminent.   While this accurately describes the US and selected European markets circa 2006, it has little to do with China’s reality.  Research-Works, a Shanghai-based equity research firm that I advise,  conducted a survey of two dozen Tier 2 cities.  Key findings?

Untitled 2

Only 16% of demand comes from investors, the majority of whom are of the buy-and-hold variety.  Unlike US-style quick-flip artists of yore with their zero-down interest-only mortgages, Chinese investors are required to make a minimum down payment of 60%.  The remaining 84% of purchasers are owner-occupiers whether first time buyers – the largest proportion – or families who are upgrading to larger more modern buildings with additional amenities and access to newly constructed transport infrastructure and commercial/industrial zones.  These buyers must make at least a 30% down payment, although the government has raised this to 40% in selected overheated markets.  Hence the debt structure of China’s property market is not at all like the US bubble:  20% of buyers pay the full price in cash and across the entire market only 50% of property is debt financed.

While China’s shortage of urban housing supply – not excessive mortgage lending – drove higher property prices over the last decade, Westerns still struggle to escape another set of home-grown assumptions that they project onto China.

Lack of affordability:  The Western conventional wisdom assumes that dramatic price inflation over more than a decade has made Chinese property unaffordable.  Comparing average household income in a city to the price of new housing provides ironclad evidence for yet another set of flawed assumptions.  Chinese urban housing prices have indeed risen dramatically over the last decade.  But so to have urban incomes (chart on the left).  Now that property price increases have moderated as a result of government policies, property is becoming more affordable.  Perhaps more importantly in the longer term, overall growth in household incomes is creating a  relatively affluent Chinese middle class.  Unlike the US, where middle class incomes have stagnated for more than a decade, the chart on the right shows the dramatic growth in Chinese household income lifting 170 million new households into the $16,000+/year income category between 2010 and 2020.

Affordability slide

Bringing a “Ghost City” to Life

With these fundamentals in mind, let’s visit Zhengzhou – that same scary ‘Ghost City” that 60 Minutes toured recently.

Zhengzhou has a population of 8.6 million, slightly bigger than New York, the largest city in the US.  Its population grows 5.6% annually.  It’s the capital of Henan province: population 94 million. To put this in perspective, that is the same as the four largest US states – California, Texas, New York and Florida -combined , but with only 15% of the land area.  And Henan forms the crossroads of a regional population of 450 million people – the same as the US and Mexico combined.

To accommodate population inflow and move existing residents from increasingly crowded inner urban districts being taken over by commercial development, the municiple government started building Zhengzhou  New District, which opened in 2003. It currently has a population of more than 1 million growing at 35% annually. The subway connection openned in 2013, accelerating the inflow of people.

As new phases of housing have been built here, they have generally sold out within 8-9 months. Now, with the slowdown, the sales cycle has been extended to 10-12 months. It typically takes a total of 5 years to reach full occupancy as the last units are completed, the new owners complete the outfitting and move in.

This progression –  repeated across more than 150 cities in China with populations in excess of 1 million –  explains the persistence of the myth of China’s looming residential property collapse.  A trip to Zhengzhou New District at any time in the last five or ten years would have yielded the same picture as today: several massive new phases of residential projects moving through a well established path toward completion and occupancy.

The government’s engineered slowdown is real. A handful of property developers will indeed get stuck with poorly planned, designed or located developments in some of these 150 Chinese cities, just as their brethren did in Beijing, Shanghai and Guangzhou at various times in the last three decades.  As has been the case in the past, these developers will raise fresh funds or – if the fail to do so – will be acquired by better managed and more credit worthy firms.

It’s hard to turn real insight on Chinese property into eye catching or exciting headlines.  It appears much easier sell the myth of an imminent property and debt crisis that sounds all too familiar to a Western audience.

Alibaba: Just Another Record Breaking Chinese IPO… Or Window on Dynamics Shaping Future Global Competition?

jack-ma-motivational-quotes-2Despite a market cap of more than $200 billion and leadership positions across a variety of high-growth business platforms in China, Alibaba and founder Jack Ma seem to be viewed by as an e-commerce novelty led by a somewhat “quirky” CEO who found success in the limited confines of a single emerging market (China). Media coverage generally obscures the profound strategic implications for the Western companies and policy makers of Alibaba’s success. Much more important than the scale of the offering or its initial 30% ascent above the offer price, Alibaba’s origins, innovative bias and corporate culture all presage a fundamental shift in the shape of global competition.

Until recently, it has been easy to dismiss the global significance of “leading” Chinese companies.  With good reason: at their current stage of development, the likes of China Mobile or China Agricultural Bank were typical examples of massive state-owned institutions with little hope of competing effectively on a global stage.

What makes Alibaba different?

Three characteristics – shared by Alibaba and hundreds of other fast-growing Chinese private sector entrepreneur-led firms – illuminate how the rules of competition are beginning to change at a global level. Future posts will explore each in more detail, but here are the headlines:

Leadership Across Multiple High Growth Platforms. Alibaba’s 75% share across multiple components of the world’s largest and fastest growing e-commerce market provide distinct advantages in terms of scale and resources. Tomes have described numerous state-owned enterprises (SOEs) that gained similar positions via government-directed industry consolidation or regulatory favoritism, debating and ultimately dismissing the SOEs’ global relevance. Some observers (mis)use similar logic to discount the global success of firms like Lenovo and Huawei.

The reality of a private sector firm building a leading market position across an industrial and consumer customer base that will soon be larger than the US and EU combined is indeed game changing. The result: Alibaba is larger than Amazon and Ebay combined, growing faster with higher margins and profitability.

It is difficult to avoid the obvious comparison with leading American firms of the 1950s and 60s when the US was clearly the world’s largest market. Despite their lack of global sophistication, limited cultural understanding, aggressive business tactics and frequent stumbles (remember Servan-Schreiber’s Défi américain in 1967), firms like GM, GE, IBM, Pfizer, DuPont succeed globally using strong home-market positions to subsidize their learning curve in complex international markets.  In the process, US multinationals, often supported US government policy, changed the shape of the global economy and the nature of global competition.

It should not be surprising that Chinese firms moving offshore have focused first on other fast growing national markets – mainly in Asia (see Rick Payne’s post on Opportunities Through an Asian Lens). Why prioritize sclerotic North American and European markets when a focus on your back yard will more effectively enhance the competitive advantages derived from scale and rapid growth with lower investment cost and less risk?

Genetically Innovative. Excitement also surrounds Alibaba’s rapid moves (outside of the listed vehicle) into related businesses ranging from social media and e-gaming to innovative on-line financial services. But such smart business moves underplay the true depth of innovation built into Alibaba’s DNA. Over the decade and a half since Alibaba was launched, Western firms have bemoaned China’s lack of transport infrastructure, credit and supplier data, national retail distribution and a host of other barriers inhibiting the application of Western business models to the Chinese environment.

Unshackled from fixed ideas about what “should be”, Jack Ma and his team approach such barriers as opportunities. While local managers of MNCs in China can often be equally innovative in their thinking, few have been able to alter the mindset at headquarters sufficient to produce truly radical change in products, pricing or business models. Increasingly many of the most innovative China-based executives are migrating to local firms that “get it”, bringing with them a level of international sophistication and selected business disciplines that further enhance the competitiveness of Chinese companies.

Fast Adaptable Risk Takers.  The salient feature of Alibaba’s organizational structure monopolizing Western interest is concern surrounding “opaque” decision rights concentrated in the hands of the management board. This is understandable from the perspective of institutional shareholders who have been mistreated by publicly listed firms of all nationalities. But it misses a key point. Alibaba and other entrepreneur-led Chinese firms are likely to differentiate themselves around three organizational characteristics that are critical to competing in 21st Century:

  • Speed of decision making
  • Tolerance for risk
  • Adaptability (fixing it when it goes wrong or dropping it and moving on)

None of these three traits could be construed as distinctly “Chinese” in ethnic or cultural terms.  While it has long been a popular subject for academic debate, Chinese culture does not dictate corporate cultures that are fundamentally better or worse than attributes imposed by being “American” or “French”.

Instead, these keys to success are more closely aligned with a particular stage of corporate development – more like Google, Amazon or Apple, at least in their early days:

  • Led by charismatic founders with a clear vision
  • Founder/employee owned
  • Personal trust outweighs corporate controls and org charts
  • No perceived limits to using new technologies and/or business models

The best summary of the traits of this new competition comes from Bain’s Jimmy Allen who describes it as the Founders Mentalitysm.

21st Century Competition

Chinese private sector market leaders will – like Alibaba – begin to emerge in the frontlines of a new form of global competition. China – and Asia generally – provide a unique incubator, driving home grown firms to capture advantages of global scale over a relatively short period of time;  bias their managers toward innovative action to overcome a myriad of operational challenges; relentlessly pursue fresh approaches to swift, cost-conscious customer-oriented decision making. Today’s emerging global leaders are weaving these threads into entirely new ways of winning. Can large, slow-moving Western corporate bureaucracies effectively respond?

Steel: An Example of China’s Disruptive Global Impact does China’s marginal economic slowdown really mean in practical terms? For a growing number of industries much more is at stake than a slowing of double digit sales increases in China’s domestic market. For industries in which China has already established its global leadership – as both a market and as a producer – the coming tsunami will challenge swamp established assumptions. 

With Chinese domestic growth moderating – and construction cooling in particular – a 73% hike in Chinese steel exports has begun rippling through the global economy.  While today’s headlines focus on the slight decline in China’s overall GDP growth, the industry- and sector-specific fall out is where radical structural change occurs.

China’s leading position as the world’s largest consumer and producer of steel means that these swings have dramatic impacts on  competing producers as well as end-user industries and all those in the value chain.  So far, the direct impact has not yet shown up in massive US steel imports from China.  Instead, Chinese exports to other emerging markets, particularly in Asia, have disrupted overall global supply/demand balances.  Hence the full impact of falling Chinese domestic prices (see graph below courtesy of the Financial Times and Bloomberg) have yet to hit.  But they will.  Falling US steel prices and a surge in imports will inevitably be followed by mounting trade friction.

Under a reform-oriented leadership, these economic realities may well accelerate further consolidation of the Chinese steel industry. The least efficient mills will be shuttered and salvageable assets will be shifted to better managed firms and upgraded. But so to will marginal producers in other markets.  And China’s position as the world’s leading steel producer will strengthen.

How much of today’s enthusiasm for the revival of US manufacturing, predicated on low-cost (i.e. underpriced) energy, will prove sustainable when China’s much larger demand and product capacities create shift in those industries?

2014 Steel exports and price.img

iPhone 6: Can Apple Survive?

iPhone 6 in China
Guess we don’t count, Mei Mei

A company hits “phenomenal record-breaking” sales with its latest  product in Ohio. The CEO proudly promises to launch within days in North Dakota, Vermont and Wyoming.  Would investors or the industry see this as a savvy strategy?  Unlikely.

Welcome to Ohio.

While I have nothing against the folks in Ohio – or no more than anyone else who grew up in Michigan – it’s difficult to take Apple seriously as a global company. “First weekend” sales for the new iPhone 6 are universally hailed as an indicator of Apple’s latest smartphone success.

IPhone 6 salesWhile “Bendgate” and the withdrawal of iOS8 have slightly marred the celebration, much less coverage has been given to Apple’s failure to get approval for it’s launch in China or Samsung’s decision to launch it’s Galaxy Note 4 in China first.  The graph below shows the US for what it is: a mid-sized slow-growth market. Apple’s press release says the phone was on shelves within three days in Canada, France, Germany, Australia, Hong Kong, Japan….   And will soon be available in roughly 20 more markets. But among these first 30 priority markets, we find no mention of the largest and fastest growing ones.  In domestic terms, it’s as if California and Texas were not among a firm’s US launch priorities.  How might financial markets treat such a firm?  Would competitors take them seriously?

2014 Smartphone Forecast

In 2014, US consumers will buy roughly 85-90 million smartphones at “subsidized” prices built into their cellular contracts.  At the same time, Chinese customers will purchase nearly 300 million smartphones, paying cash upfront at prices ranging from $200-600.   India will top 200 million. Which markets do you think should drive the growth strategies, product priorities and marketing investment of a true global leader in smartphones today?

Innovator or Slow Follower?

The most notable innovation with the iPhone 6:  larger screens to compete in the “phablet” segment soon projected to account for the majority of smartphone sales globally.  In 2015, the category that others (e.g. ATT, Dell) invented and that Samsung fully established with its Galaxy Note, is forecast to overtake traditional (sub 5-inch) smartphones.  If this much-debated phablet mania holds, Apple may now have an opportunity to be a player.

Phablet Growth

Where will the growth come from?  Over the next three years, the North American share of the phablet market will drop from nearly 60% to less than 30%.  Asia – led by China – will not only replace the US as the leading market within the next planning cycle of most firms.  It will be larger than both the US and Europe combined.  In the time it takes to conceive, design, build and launch most new products, the global smartphone market will have turned upside down.

Phablet sales 2013-2017-by-region

Samsung chose to launch it’s Galaxy Note 4 in China before the US.  Having watched Samsung’s China market share slide in the face of intense competition from Xiaomi, Lenovo and other local firms, the Koreans no doubt face a struggle.  But at least Samsung seems to know where the bigger opportunities and most threatening sources of competition reside.

Will Apple be able to climb out of its second-tier position in the world’s largest market?  Cupertino is now working with all the Chinese mobile providers after years of dithering.  It now has a smartphone with broader appeal to global consumers, albeit  one developed at speed unlikely to qualify Apple as a fast follower.  Better late than never? Perhaps.

The looming market battle in China during the 12-18 months following launch of the iPhone 6 may well decide whether a globally recognized market leader and one-time innovator can survive the next decade and compete effectively in the Asian Century.

Four China Myths Driving Misconceptions on Sustained Growth’s sustained GDP and export growth contradicts Western conventional wisdom. Our previous analyses describe the critical role of expanding intra-Asian trade and China’s industrial transformation – two key dimensions of the tectonic shift now underway in the global economy. But much of the skepticism regarding the sustainability of China’s growth stems from fundamental misperceptions regarding the role that exports play and China’s ability to sustain its export competitiveness.

Four tightly intertwined beliefs enmesh many decision makers in a paradigm that comfortably supports the current conventional wisdom on China:

  • Export Dependence: China’s overall growth is heavily reliant on growth in “global” demand – which in New York, London and Frankfurt is shorthand for US/EU demand – and China’s continued ability to be the lowest cost producer serving these markets.
  • Wage Costs: China’s rising costs and appreciating currency mean labor-intensive industries will move to lower cost sites in Asia or Africa. The thinking is that if China cannot be a low-cost manufacturer, it cannot be a successful manufacturer/exporter at all.
  • Globalization “Rebalancing: Advances in manufacturing technology (think 3D printing), “personalization” of consumer demand (design your own Nike sneakers) and renewed US cost competitiveness (driven by the drop in real wages and energy costs) mean globalization will go in reverse (hence much talk of “re-shoring”).
  • Innovation and Quality Gap: China is far from ready to make the leap to producing high quality/innovative products in more sophisticated industries (assembling iPhones is infinitely easier than fermenting and purifying monoclonal antibodies).

From these tenets flow two flawed sets of conclusions:

Macro paradigm:  Three decades of export-driven China growth has now ended, creating a negative multiplier effect through the entire economy as manufacturing slows, draining liquidity from the export surplus that fed property inflation, stock market investment and high-end consumer spending. Unlike 2008’s hiccup in export growth, this will be permanent and negative. So will the macro, financial and social consequences likely to accompany it.

Micro paradigm:  Chinese revenue and earnings growth will slow or decline. Caught in the vice between slower growing export markets in the US/EU and rising domestic costs, Chinese manufacturers will see growth stagnate. Companies will not be able to add value through product upgrading and moving up the value added chain. Without inexpensive land and financing (via support from the government), their competitiveness and profits will tumble.

Origins of the Export Dependence Myth

The first stage of China’s industrial transformation profoundly changed the global economy. After decades of economic isolation, China seemed suddenly able to conquer one export sector after another, moving from garments to consumer electronics in much the same way that Korea and Taiwan emerged in the 1960s and 1970s.

But to extrapolate the industrial model of the so-called NICs (Newly Industrialized Countries), with their modest (or miniscule in the case of Singapore/Hong Kong) domestic populations onto the continental scale of the world’s most populous nation was always a flawed conception.

Thus understanding the next stage of China’s industrial growth starts with correctly framing the foundations for the economy’s industrial growth since reform began. China’s post-reform industrialization was characterized by two sequential – albeit overlapping – waves of development:

  • Rapid growth of labor-intensive light industries. In the wake of initial economic reforms in the second half of the 1970s, China suddenly leapt onto the global stage of world trade, taking a dominant position in both global production and export of a wide range of consumer products. It moved from a zero market share in the US clothing market to capture 10% by the end of the 1990s. Foreigners (unsurprisingly) tended to see this as “export-driven” growth due to the dramatic change in China’s global market share and the catalytic role played by “foreign” (mainly Hong Kong/Taiwan Chinese) investment in export-oriented factories in the Pearl River Delta.   But while export-focused factories helped drive rapid improvements in both production processes and product quality, the vast majority of output from China’s rapid growth in light industry was designed to meet the needs of domestic Chinese customers.
  • Parallel development of modern capital-intensive industries.   Domestic market reforms over the course of the 1980s meant prices of inputs and outputs as well as ownership of assets were gradually untethered from the command-and-control mechanisms of the centrally planned economy. This unleashed massive expansion in heavy process industries using imported equipment and technologies. These were designed to meet higher quality standards and capture economies of scale in contrast to the plants built during the Great Leap Forward or in the period of collaboration with the Soviet Union.   While China’s role as an exporter of basic industrial products – ranging from cement to truck tires – rapidly expanded, the key driver was again rising domestic demand.

Export Dependance

Since the mid-90s, China’s industrialization “story” has been simple: Move up the value curve, producing more technologically sophisticated and higher quality products at ever-lower cost. But is was not Foxconn producing iPhones for Western consumers with technology from Silicon Valley that led the transition from cassette recorders and transistor radios to mobile phones. Instead, the dramatic growth in Chinese domestic demand for mobile phones catapulted China from a non-producer of mobile handsets in 1998 to the world’s leading producer with half of the global supply in 2007 and 60% in 2010.

Similarly, it was China’s emergence as the world’s largest car market that drove the development of not only automotive output but also created a network of Chinese component suppliers as well as transforming the steel and chemical industries from producers of low grade commodity products to ones capable of delivering quality sheets and thermoplastics needed to make cars to the quality standards demanded by Chinese customers.

Thus the forward march of Chinese competitiveness has progressed steadily based primarily on the needs of China’s domestic market, with export markets providing a window on technology and customer needs that helped expand and deepen China’s manufacturing capabilities.


China’s Future Manufacturing Growth: Winners and Losers in Next Wave of Global Industrial Restructuring

global winners

The drivers behind the current transformation underway in Chinese manufacturing are much more complex than those that initially led the Middle Kingdom to become the world’s leading manufacturing nation. Over the past 30 years, Chinese manufacturing radically transformed global supply chains, up-ending established industry structures. In the next five to ten years, China’s new phase industrial growth is likely to have an even more rapid and profound impact on a range of industries that we often assume to be the birth-right of companies domiciled in the aging slow-growth economies of the US, Europe and Japan. This in turn will spark not only a new clutch of corporate “winners and losers”, but also unleash painful and complex trade and geopolitical frictions.

Four Pillars

In contrast to the simplistic assumptions heralding the “end” of Chinese manufacturing competitiveness, consider four different sectorial drivers of China’s future growth, each with its own unique dynamics and regional/global impact:

  1. Building on Labor Intensive Positions.China will not withdraw from “labor intensive industries”, it will merely change its role in the value chain to a higher position. For example: In textiles, cut and sew for low-price garments moves offshore while fabric, dyestuffs and design remains in China. In electronics, assembly moves offshore or automates while chips and components expand rapidly. Moreover, China’s competitiveness is now based on the strength of industry clusters, not on low-cost labor.It now has a new league of well-established suppliers working across the value chain in the traditional industries. These companies have built a reputation through long-term cooperation with global buyers. This experience and trust has now become a key element in China’s competitive advantage in the “traditional” areas that Westerners (mistakenly) think of as the core of China’s manufacturing.
  1. Heavy Industry Now A Key Building Block. Past investment in heavy industry now becomes a key building block for China’s manufacturing future as it moves up the value added curve. Local steel companies originally met the need for construction rebar. Now they supply quality sheet for autos and white goods (refrigerators, washing machines) as well as specialty steel for heavy/transport equipment (cranes, excavators and ships). Integrated chemical clusters produce both commodities as well as higher value added specialty products. Continued consolidation across most of these basic industries – as occurred in the US and Europe at a similar stage of industrial development – is now underway, raising competitiveness.
  1. More Technology Content. Heavy machinery for such sectors as construction, power generation and general manufacturing are not particularly sophisticated but they definitely have more technology content than garments or furniture. China’s growth in these areas will cause some global price deflation as it introduces simpler technologies and avoids over-engineering. This will drive its market share gains for China-based manufacturers, pushing down global prices of heavy equipment as it drove DVD players from a $500 price point to $50.

The most interesting development is China’s entry into more sophisticated consumer and industrial goods driven in many cases by the growing scale and rising sophistication of Chinese domestic demand:

  • Generic pharmaceuticals which are rising in quality to meet Chinese domestic demand (Corporate examples: Hisun, Huahai)
  • Medical equipment and devices (Mindray, Microport, LePu)
  • Telecom (Huawei, ZTE)

All of these are much more regulated (health, safety, security, environment), capital intensive, IP-rich and higher value-per-item product areas than China’s traditional manufacturing growth sectors. Thus the vested interests on the Chinese side as well as among Western competitors suggest a much higher level of risk and potential friction as China asserts its dominance.

  1. Industries of the Future.The area likely to generate the biggest surprises in the long run, however, will be industries of the future – those such as aerospace and biotechnology, where innovation is critical and in which Western firms as well as political leaders generally assume an Anglo-Saxon birthright. Disruptive innovation from China is likely to take multiple forms ranging from scientific breakthroughs to the application of scale and entirely new business models. For example nuclear power and alternatives such as solar and wind represent sectors where government policy aims to make China a leading manufacturer, requiring innovation. With the scale of China’s need for clean fuel and its heavy investment in it, China will continue up the technology curve in what will be the world’s largest nuclear and alternative energy equipment market.

Which Industries Are Next?


Our Need for New Assumptions

What are the implications for both companies and policy makers? China’s next phase of industrial growth trends seem likely drive five disruptive changes that challenge our current assumptions about the way the world works:

  1. Rapidly alter the map of global and Asian production. China will increasingly become the “hub” of global manufacturing, not just in labor-intensive industries, but also in those that increasingly depend on both scale and innovation. Its impact will ripple through the Asian region in the form of continued rapid integration in regional capital and trade flows.
  2. Redraw the rules of competition across a wide range of global industries. Some sectors will be “commoditized” and driven to radically new price points as production costs fall and new market segments thus become the driver of growth.  Much of this growth will occur in countries where Western firms have a relatively weak presence and their premium products/services are misaligned to local customer needs.
  3. Generate new and infinitely more complex trade and geopolitical friction. As China enters the global market in more regulated industries (eg pharma) and those considered strategically sensitive (think of the barriers that have already emerged in telecom/IT equipment and energy), the West’s political and business resistance are likely to become much more vociferous than the ill-fated efforts to slow China’s dominance of the global garment trade.
  4. Drive China’s continued economic reforms and become a focal point of internal policy debate as well as political battles. In the 1990s, Premier Zhu Rongji astutely used China’s WTO entry as a catalyst for radical policy change. China’s new President appears equally decisive but faces entrenched vested interests, not unlike those Zhu battled. Leveraging the needs of the Chinese population as a political justification for painful change, we are certain to see growing range of policy choices that create rapid change in an increasingly complex domestic operating environment.
  5. Determine a new group of corporate “winners and losers” within China and globally. Given the pace at which Western corporations typically make the fundamental decisions that shape their product portfolios, business models and organization structures, the next five years are likely to yield a sharp division between those that successfully navigate this transition and those that do not. In the global industrial restructuring of the past three decades, many executives in textiles, consumer electronics and auto components failed to grasp fully the speed and the radical nature of the changes taking place in the needs and locations of customers or the competitive challenges they faced.   Many of those who did accurately assess the threat were simply unable to alter their respective firms’ strategies fast enough or radically enough to survive.

Western executives in many of the “next wave” industries live today in the same terminal denial that characterized their counterparts across America’s “rust belt” two decades ago. Some will be able – for a time – to rely on traditional customers in slow-growth markets at home to reinforce their complacency. Many of these firms adopt “global” strategies focused on increasingly specialized market niches. In the 1990s, one US specialty chemical company convinced itself it could sustain its competitive position in ABS plastics because it “was the only firm capable of making all 14 shades of pink ABS required for Mary Kay bottle caps. Two years later – as Chinese customers dominated global demand for ABS – the company was forced to divest this business to a commodity chemical firm.

Within China, the shift is likely to have an even more dramatic corporate impact. As the balance shifts from preferential treatment of state enterprises to one that relies increasingly on market forces, a fresh shakeout will occur. This will be accompanied by a painful consolidation of industrial assets as subscale producers that account for much of China’s inefficiency are allowed to go bankrupt or are acquired by larger, better-managed firms.



Three Questions to Pressure Test Your Global Strategy Against Radical Changes In Global Demand

Three Questions to Pressure Test Your Global Strategy Against Radical Changes In Global DemandA radical and rapid transformation of global demand is underway. Traditional assumptions about market leadership and global competitiveness are under threat as Chinese consumption begins to dominate a growing number of product sectors and industries. The speed of change is phenomenal – with China moving from relative insignificance to become the top market within a two to three year planning cycle. Firms risk being lulled into complacency by the US/European “recovery” and the much-heralded slowdown in Emerging Markets.  

Take 10 minutes to pressure test your current global strategy.

The Financial Times recently summarized (and neatly graphed) the World Bank’s latest GDP estimates based on purchasing power parity:  “China poised to pass US as World’s Leading Economic Power This Year.”

Some economists expressed surprise that this should happen in 2014 instead of the end of the decade as many anticipated.  Others down played the macroeconomic significance (at current exchange rates, China is only half the size of the US).  Still others were quick to ridicule the idea that GDP in any form was an indictor of “real” power.  And the perennial “Coming Collapse of China” crowd chimed in with their familiar refrain.

Take 10 minutes to pressure test your current global strategy.

This increasingly well-documented macroeconomic case gets treated much like the headlines describing the growing body of scientific data on climate change:  While clearly true, little change occurs in the perceptions of Western decision makers. Urgent, perhaps radical, solutions are shunned in favor of “safer” incremental bets.  The growing frequency of the headlines cataloging China’s continued growth may even add to the level of complacency that permeates thinking at many Western firms.

How to Pressure Test Current Mindset and Strategy

Yet dramatic change is already well underway.  China has embarked upon its “next stage” of industrial development; one that will redefine its role in global manufacturing and reshape the global economy.  Central to this change underway is the role of China’s domestic market – and the Chinese consumers and industrial customers who will determine a firm’s global success or failure.

Simply for the sake of “pressure testing” current plans, strategies and policies, explore the possible impact of three alternative assumptions about the near term future.  How would your firm’s thinking on market size, growth, costs, customer needs, competition and innovation change if your management team accepted these assumptions?  What confidence would you – and your investors – have in your current strategy if the following were the central realities – or the new “conventional wisdom” – for your industry?

1.    China has already overtaken the US and EU in market size and growth; the speed at which this “scale and growth gap” is widening will become the critical determinant of future global leadership in our industry

Instead of being lulled into complacency by the debate on whether China’s economy a) can, b) will soon or c) might catch up with US GDP, consider the scale of the China market.  Ignore obvious products – such as basic food items – where you would expect a nation of 1.3 billion people to easily surpass American or European consumers.  Focus on “modern”, “sophisticated” and “expensive” products:

•    China’s 2014 replacement market for smartphones (yes, smartphones, not generic cell phones) is larger than the entire US smartphone market. Total Chinese smartphone purchases will be three to four times larger.  This year.  And Chinese customers will mainly pay cash up front of $150-600 per phone instead of signing on for “subsidized” two year monthly contracts favored by American consumers.

•    Capital goods have long been an area where Chinese customers dominate global demand.  This has generally been measured in multiples of the US or Europe in such “traditional” areas as textile machinery, ceramic kilns, construction equipment or shipping cranes.  Not surprisingly, Chinese manufacturers have emerged as global players in these areas.  But what about gene sequencing?  Sophisticated chip-making machinery?  Medical equipment?   These represent just a handful of the areas where China has already become the world’s largest market, where demand continues to grow at rates three to four times those of the US or Europe and where local firms and/or other Asian upstarts are already staking their futures.

2.    Chinese demand will soon dominate virtually all market segments, creating a global leadership platform for companies that choose to lead in China

It took only four years for China’s purchases of automotive vehicles to double from 8 million units in 2007 to more than 17 million units in 2011 (surpassing the US in 2009).  But total market size – even in this relatively sophisticated category of expensive durable goods – has prompted some to assume that “low end” demand predominates; that China is not prepared for their high-end value proposition.  Look again:

•    China is indeed the largest market for cheap cars. But it is also the world’s largest market for BMW and Bentley.  Porsche’s Chairman expects China to overtake the US in 2016.  Rolls Royce recently announced that the US had passed China by a handful of units to regain the top place among its global markets.  As one wag quipped: “It sounds like well heeled Chinese want Rollers in their US garages too!”

•    A paltry 6,795 electric vehicles (EVs) were sold in China in 2013, compared to 96,000 in the US.  In the first four months of 2014 BYD sold 3,300 units with another 8,000 already on order.  Its new plug in hybrid reportedly sold more than 6,000 units.  BYD’s SUV will launch in the second half of the year and its recently signed JV with Daimler presages additional models in the near future.  Nissan, GM and others are also launching EVs. Tesla is designing a longer “S” model specifically for the Chinese market. With municipalities introducing aggressive purchase incentives and subsidized charging infrastructure being required in leading cities, the Chinese EV market could move from “negligible” to become the world’s largest over the course of a single year.  And – as with smart phones – China seems likely to out-distance the US by a factor of three or four times within three to five years.

3.    Competitors can – and will – offer a better value proposition, not just a “cheaper” alternative, designed for Chinese customers

The assumption that “our superior   (fill in blank: brand, cost, quality, technology…) will allow us to win in the long run” carries high risk. It is increasingly apparent that the risk of miscalculating China’s pivotal role as a platform for global competitiveness will prove infinitely greater than the perceived operational risk of building a globally-oriented business platform in China.

•    In the smartphone market, Samsung, Lenovo and Xiaomi, Huawei, Coolpad and ZTE have tailored products to meet the needs of Chinese customers. Apple, generally considered the world’s most powerful brand, struggles to maintain 4th position (in unit share), with a product and an approach that seems only to work in the relatively small US market.

•    In oncology, Zhejiang Betapharma has launched a patented innovative EGFR drug for lung cancer.  It sells at 65% of the price charged for competing products from Novartis and Roche.  The Chinese firm developed the product in half the time and less than 10% of the development cost of the Western firms by focusing only on China – the world’s largest population of lung cancer patients.

•    In medical devices, Chinese market leaders Microport and LePu make drug-eluting stents at one-fifth the cost of firms like Abbott and Boston Scientific, capturing the majority of the world’s largest stent market with products that many Western experts and Chinese physicians consider to be equal in quality to the imported Western devices.

As Chinese customers come to dominate global growth, leadership by Chinese or Asian competitors is not a foregone conclusion.  China’s growth platform and accompanying competitive advantages can be leveraged by Western firms too:

•    In the traditional car market, aggressive long-term commitments – to manufacturing, product development and engineering – by Western firms like GM and VW – are driving sustained share gains against local car makers.

•    P&G has consistently built leading market share positions across the majority of its product categories.  Rejoice (hair care), Olay (skin care), Tide (powdered detergent), Pampers (baby care), Safeguard (personal cleansing), Gillette (male grooming).  Colgate has done the same it dental care.
•    As much as 2/3rds of all branded luxury goods are purchased by Chinese – either within China or while travelling abroad.  Traditional brands from Europe and the US have moved swiftly to tailor designs, retail infrastructure, market segmentation, advertising, and distribution channels in response.

Claiming that “our industry is unique” and sorting the available facts to justify an existing view of the global market seems a much larger threat than launching an independent effort – perhaps one divorced from the traditional planning process – to explore fundamental changes in demand with a truly open mind.  Without a concerted focus on meeting the needs of customers in the world’s largest market, today’s “global leaders” are likely to cede their positions to more astute and committed competitors.

Rising Conflict with China: Anticipating Risk in the Asian Century

Rising Conflict with ChinaRising geopolitical tension between China and other countries has the potential to suddenly and severely impact corporate growth and profitability. China’s economic ascendency will generate ever-increasing conflict with its immediate neighbors and with the leading powers of the last century, particularly the US.  Understanding forces at work, anticipating inevitable threats and discerning the real business challenges – as distinct from the emotional headlines – will not be easy.  Effective corporate decisions in the face of such uncertainty will demand a much deeper understanding of the geopolitical/economic topography than has generally been required from business in the past.  Moreover, a much more proactive role from US, European and Chinese business will be needed to help bridge national differences.

Political risk became a compelling topic of corporate attention in the wake of unsettling “surprises” in the 1970s and 80s.  Key milestones such as the fall of Iran or the collapse of Communism and German reunification stand out as dramatic political turning points.  Yet 10 to 15 years from now, these may well appear relatively modest compared to the disruptive potential from the next phase of China’s rise.

In the absence of a sea chart to the geopolitical future, a simple compass would come in handy.  Unfortunately, many of the key navigational points we have learned to rely on will be of little help those at the tiller.

“True North” no longer exists

Most of the world’s post-1945 political and economic institutions were conceived, designed and managed by a handful of Western countries, with the US playing a dominant role.   The rise of the US changed the “rules of the game” by instigating fundamental change in pre-war colonial modes of international interaction.  China will have a similarly disruptive impact.  Perhaps the most succinct summary of the challenge was made in a US economic and security policy review of China’s role in international institutions:

“The West is trying to accommodate China by rearranging the deck chairs; the Chinese are building a new ship.”

We face a long period of transition during which many of the most fundamental assumptions that underpin business decision making will be challenged, changed and – in some cases – completely up-ended.

•    Is the World Bank still the leading global development institutions when China’s financial and development support to Africa and Latin America is more than the Bank’s lending?

•    Will an Asian Monetary Fund displace the IMF now that the foreign exchange reserves of four Asian countries far exceed the Fund’s resources and the West is mired in excessive public sector debt?  Or will Asian governments remain content to let the US and EU hold veto rights over international financial governance?

From a corporate perspective, this represents merely the tip of the iceberg; the challenge from China’s rise will drive much deeper than a mere re-ordering of international institutions.  China’s displacement effect is also likely to impact a wide range of business practice that have determined our accepted “rules of the competition” globally.

•    Will the US Food and Drug Administration remain the sole “gold standard” for drug and device approval when China is the largest drug market in the world and must design a system that delivers better therapies faster and at lower cost?

•    Will US or UK rules governing business ethics become anachronisms hobbling the handful of global companies that continue to remain domiciled there come 2025?

Faced with this radical level of transformation in the global business environment, two pillars seem likely to prove critical to the bulkwark of a solid corporate strategy in the future.

1.    Deep understanding of national motives and the political/economic complexities of policy making will become even more important in the future.  Lobbying a particular policy or point of view will need to be supplemented by a much more fundamental educational process that targets both global policy makers and influencers externally and senior executives internally.

2.    Global industry-level collaboration will be essential.  Business will need to play a key role in defining innovative options as well as the costs and benefits of various policy alternatives.  In order to make a credible contribution to policy making, industry positions and supporting analysis will need to encompass the views of all industry leaders, not simply Western firms.  Using US national industry associations to “bash China” is likely to be no more productive than Chinese industry associations attacking US policy makers.  The converse is also likely to be true:  Cross-border industry dialogue and consensus may have a much greater impact on shaping progressive