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Despite an impressive rebound, an innovation shortfall may hobble sustainable growth
At the parade marking the 60th anniversary of the People's Republic of China, tanks and missiles trundled past the Forbidden City and down Beijing's Chang'an Avenue. Battalions of soldiers goose-stepped in perfect unison. Overhead, fighter jets soared in tight formation.
But close on the heels of this military extravaganza came floats highlighting a less bellicose side of China, what the leadership calls "indigenous innovation." On one, a 10-foot-high microscope, giant test tubes filled with blue liquid, and a white telescope signified China's scientific and technological achievements. Another featured a replica of a bullet train and a passenger jet to represent China's ambitions in transportation. A green-energy float was studded with windmills and oil rigs and flanked by hundreds of red-helmeted energy-industry workers, each carrying a solar panel.
From a rostrum perched above the giant portrait of Mao Zedong at the Gate of Heavenly Peace, President Hu Jintao watched over the proceedings. "The Chinese people have stood up," Hu declared, quoting Mao, who uttered those words at that very spot 60 years ago. The country, Hu added, is "full of confidence in the bright prospects of the great rejuvenation of the nation."
VINDICATION, FOR NOW
That sense of triumph permeates China these days. The mainland's quick rebound from the worldwide financial meltdown seems to have vindicated its brand of state-led capitalism. As the West struggles to recover, China is on track for 8% growth this year and is about to overtake Japan as the world's No. 2 economy and Germany as the No. 1 exporter. Now the mainland is charging ahead in new industries, unveiling homegrown airliners, electric cars, and high-speed trains.
But delve beneath the muscular statistics and hype about advances in strategic industries, and China doesn't seem so prepared to catapult into a role of global economic leadership. Experts familiar with highly touted Chinese achievements such as commercial jets and high-speed trains say the technologies that underpin them were largely developed elsewhere. There is no Chinese Sony, Toyota, or Samsung on the horizon. While Beijing's $586 billion stimulus package and a 150% increase in bank lending have spurred impressive growth, "the question," says Morgan Stanley (MS) Asia Chairman Stephen S. Roach, "is the quality of that growth."
By Beijing's own admission, the economic model that has powered China for three decades can no longer be counted on to move it forward. The mainland has prospered largely through construction and by exporting all manner of consumer goods churned out in low-wage factories; workers parked their savings in state-run banks, which then loaned the money to companies to make more stuff. But technology and managerial knowhow came mostly from multinationals, and the costs—pollution, decaying social services, and a yawning gap between the urban rich and rural poor—were largely ignored. Though that model has fueled phenomenal growth, Hu and others now call it "unbalanced" and "unsustainable."
So in recent years, Beijing has been heralding a new economic vision. The key elements: Grimy factories will give way to renewable-energy industries and a growing service sector; Chinese consumers, rather than stretched Americans and Europeans, will underpin demand; and instead of churning out me-too goods for little profit, Chinese companies are supposed to create innovative products based on home-grown technologies.
As President Barack Obama prepares for his first state visit to the mainland on Nov. 15 though, some economists are taking a skeptical look at China's evolution. While Beijing has honored many of the market-opening commitments it made to join the World Trade Organization in 2001, promised reforms such as allowing greater foreign investment in telecommunications and financial services have stalled. Over the past three years a steady stream of directives flowing from a raft of ministries and the National Development & Reform Commission—successor to the old central planning agency—have tightened the state's grip on the economy. In June, for example, the commission ordered that wherever possible only goods made by Chinese-owned companies be used in any project funded by the government.
The state's comeback is easy to spot. The vast majority of new loans are now going to government-controlled enterprises, for instance, while less than 20% end up at small and midsize firms, which tend to be private, Standard Chartered Bank estimates. And in strategic industries from wind turbines to nuclear power generators, Beijing is favoring its national champions and trying to whittle down the role of foreign companies. "They are rolling up the red carpet," says Joerg Wuttke, president of the European Chamber in China, which recently released a 584-page white paper arguing that China has hit the brakes on opening its economy. Says a U.S. trade official: "China's focus seems to have shifted from accelerating market reforms toward a more state-controlled model. It is very worrying."
Besides aggravating trade frictions, the Communist Party's renewed penchant for control could undermine China's competitiveness overseas. Clamping down on the ability of foreigners to do business in China would make life easier for Chinese companies at home; the downside is that it would let them avoid honing the skills needed to succeed outside the mainland. And funneling funds to state companies and connected insiders leaves creative entrepreneurs starved for capital. "The government wants to stimulate innovation and job creation but is doing the opposite," says economist Xu Xiaonian at the China Europe International Business School in Shanghai.
There are already signs that Beijing's policies are undermining the transition to a more balanced economy that might propel growth around the world. Over the past decade, consumer spending—what should be the mainstay of a new Chinese economy—has slumped from 45% of gross domestic product to 35% and now stands at about half the U.S. level. A full 88% of this year's GDP growth, Morgan Stanley's Roach estimates, will come from the usual source: fixed-asset investment in infrastructure, real estate, and yet more production lines. In the past two years, Chinese steel capacity has swelled by a third, and the mainland's idle capacity this year will nearly equal the combined steel output of the U.S. and Japan. "If anything, we are seeing a retreat to the old formula of support for large-scale manufacturing and exports," says David Hoffman, China managing director for the Conference Board, a business group.
For a glimpse of what may lie ahead if China fails to transform its economy, head to the southern city of Dongguan. The thousands of factories in the Pearl River Delta industrial hub churn out televisions, furniture, toys, and a seemingly infinite number of other products for consumers worldwide. But with China's exports down 15% in September—the 11th consecutive month of decline—Dongguan is reeling. In the Changping district, once dubbed "little Hong Kong," shuttered factories are overgrown with weeds. The karaoke bars and restaurants, which once catered to the thousands of Hong Kong and Taiwanese managers who have fled, are quiet. Sure, the economy of Guangdong Province is on track for 9% growth this year, but that's due mainly to massive government spending on public works, such as an airport expansion and a nuclear power station. "What Guangdong is facing, all of China is facing," says Wang Yiyang, vice-director of Guangdong's development research center, an arm of the provincial government. "We have to find new sources of competitiveness."
In response, Guangdong is launching a crash restructuring that the provincial Party boss calls "emptying the cage and changing the birds." Dongguan and eight other Delta cities are moving low-wage factories into new industrial zones 50 miles or more to the north in poorer parts of the province. Greener industries, such as biopharmaceuticals, renewable energy, and information technology, are to replace them. But hopes for a surge in foreign investment have been dashed by the global recession. So Guangdong is courting state-owned companies from elsewhere in China and pressing local enterprises to become more innovative.
In pockets across the country, officials have made far more progress toward the new economic vision. China is aggressively promoting wind power, greener solid-state lighting, and high-speed trains. Shanghai, Beijing, and dozens of other cities are building vast subway networks to complement the highways already in place. To persuade citizens to spend more and save less, Beijing is expanding public health care and subsidizing small cars and electric appliances. Millions of small private companies have sprouted, and hulking state industries that provided cradle-to-grave benefits have been downsized. Cities and provinces are boosting research spending, retraining workers, and courting investment in new industries such as biotechnology, which is attracting top Chinese scientists from the U.S. "China's growth seems unstoppable," says Rao Yi, a former Northwestern University neuroscientist and now dean of Beijing University's life-sciences school.
NO INCUBATOR OF INNOVATION
China has a long way to go, though, in innovation. The mainland has dramatically boosted research spending and boasts the world's biggest pool of science and engineering graduates. But aside from Internet games, the country creates few breakthrough products, due in no small measure to the perennial problem of rampant counterfeiting. China last year exported $416 billion worth of high-tech goods. But subtract the mainland operations of Taiwanese contract manufacturers and the likes of Nokia (NOK), Samsung, and Hewlett-Packard (HPQ), and China is an electronics lightweight. Beyond Tsingtao beer and low-end Haier refrigerators, "China has zilch brand presence in the U.S.," says Kenneth J. DeWoskin, director of the China Research & Insight Center at Deloitte & Touche. Instead, most mainland companies mine existing technologies and compete on high volume and low cost in commodity goods.
Take cars. For decades, Beijing has sought to shore up the industry. But Volkswagen (VLKAY), Toyota, Buick, and other foreign brands dominate in midsize sedans and SUVs. Domestic carmakers such as BYD Auto, Geely, and Chery have thrived by developing subcompacts that sell for as little as $4,400. They're now China's great hope in electrics and hybrids. Beijing, meanwhile, is ramping up support. To meet a goal of producing 500,000 such vehicles by 2011, the Science & Technology Ministry plans to put 60,000 electric buses and taxis on the streets and offer subsidies to buyers in 13 cities.
BYD Auto has generated the most buzz. The Shenzhen company this year expects to sell 400,000 cars, and its parent is one of the world's largest producers of lithium-ion batteries for mobile phones, PCs, and other gadgets. Next year it plans a U.S. launch for the e6, a five-seat electric plug-in with a claimed range of 249 miles. BYD's stock has rocketed so high that fabled investor Warren E. Buffett's 10% stake already has earned him a paper profit of more than $1 billion. BYD vows to be China's largest carmaker by 2015 and overtake Toyota as the world's leading brand by 2025, producing 10 million vehicles a year—half of them for export.
BYD has a long way to go. This year it will be lucky to match its 2008 export record of 8,000 cars, all sold in Russia and developing nations from Africa to Latin America. It says it has delivered only about 100 of its $22,000 F3DM plug-in hybrids in China this year—far from its sales target of 4,000. BYD's biggest advantage? It's not design, cutting-edge technology, or state-of-the-art manufacturing. Instead, it's a fairly conventional battery that BYD manages to produce cheaply. "Making affordable products is key for the development of the electric vehicle industry," says Henry Z. Li, BYD's general manager for international sales. BYD declined a request to tour its factories, but visitors to the company's plants say its batteries and electric motors are hand-assembled by long lines of blue-uniformed workers rather than the robots that have become standard in most of the industry. Whether BYD or other Chinese carmakers are anywhere near meeting European and U.S. safety regulations is another question. "In mature markets the barriers are very clear and standards very high," says Yale Zhang, China director for auto consultancy CSM Worldwide.
WESTERN TECHNOLOGY INSIDE
Disassemble other widely hailed successes of indigenous innovation, and there is little Chinese about them. Beijing has long craved its own commercial aircraft industry, and its first offering—a 90-seat commuter jet dubbed the ARJ21—is to hit the market next year. Next up is the C919, a midrange plane with up to 190 seats that state-owned Commercial Aircraft Corp. of China (Comac) unveiled on Sept. 9. The airliner, scheduled for delivery in 2016, is intended as a direct challenge to Boeing (BA) and Airbus.
Western experts familiar with Comac's planes say they're based on older jets designed by McDonnell Douglas two decades ago, before the U.S. company was acquired by Boeing. The avionics, engine, and other key systems on the ARJ21, meanwhile, come from Western suppliers such as Honeywell (HON), General Electric (GE), and Rockwell Collins (COL). "China wants to be self-sufficient, producing everything itself," says Nathan K. Smith, aerospace analyst at market research firm Frost & Sullivan. "But it simply doesn't have the capabilities to develop these aircraft without Western technology." The prospect of Comac competing with Boeing and Airbus outside China even two decades from now, says Smith, "is a long shot." Comac declined interview requests.
Some Chinese industrial policies have flopped. Beijing has long viewed semiconductor manufacturing as a key industry, for example, and eight new silicon wafer plants—some heavily subsidized—have been built just since 2005. The aim was to start out competing as low-cost contract manufacturers for foreign chip design firms. But China's wafer factories rely on technologies that are at least two generations behind those of Taiwan, the U.S., Japan, and South Korea, and few have ever been profitable. At the nadir of the recession last winter, 60% of China's capacity sat idle. But with next-generation wafer plants costing $3 billion and up, a major shakeout looms, says Len Jelinek, semiconductor analyst for market research firm iSuppli. "Most Chinese companies don't have the technology and the money to invest in research and development to stay in the game," he says.
Of course, China has plenty of smart entrepreneurs who are steering their companies in new directions. They're tapping the mainland's engineering talent, stressing design, and reorienting old-line manufacturing operations to unearth new opportunities. Guangzhou's Devotion group typifies the shift. The 17-year-old company's primary business—making huge diesel-fired boilers for factories and big buildings—has been hit by the slowdown, rising fuel costs, and growing government efforts to reduce air pollution. Sales plunged 45% in the first half, and its Singapore-listed shares trade below their 2003 offering price.
So Devotion has shifted its focus to biofuels and the boilers that burn them. Outside its headquarters are piles of broken wooden pallets, containers filled with corn and rice husks, a patch of elephant grass (a fuel source that can grow 10 feet high in a few weeks), and a hulking refinery that turns such materials into biogas, oil, and flammable pellets. Devotion offers to install boilers for free and says it makes its money on long-term contracts to sell the biofuels. The company says it now has 30 biofuel customers and aims to triple sales, to $600 million, within five years, with most of the increase coming from new-energy products and services. But with diesel boilers accounting for 90% of sales, it will have to ride out tough times. The biofuel business "is still small," concedes Devotion's burly president, Ma Ge.
Given China's many signs of progress, it's easy to forget that it remains an underdeveloped economy facing huge challenges. Yes, it has an immense, youthful population, gifted entrepreneurs and scientists, ambitious officials—and lots of money. So it's likely Beijing will someday get the formula right. But China's economic reforms are now three decades in the making. That's several years longer than Mao Zedong and his loyalists spent imposing their extreme brand of socialism. "Japan and South Korea took 30 years to make a similar transformation" to an economy driven by innovation, consumer spending, and services, says Guangdong Academy of Social Sciences economist Ding Li. "Our expectations can't be too high." But expectations of China's arrival as a superpower already are high both at home and abroad. The longer Beijing waits to update its tired growth formula, the longer it will take for China to fulfill that destiny.
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In separate papers published this autumn, the U.S.-China Business Council and the European Chamber of Commerce in China both identified rising protectionism and economic nationalism as pressing concerns for foreign companies doing business in the mainland. Some markets are effectively closed to international investors, while in others, laws and regulations are selectively enforced to favor domestic companies at the expense of foreign-owned rivals. And while China's immense stimulus package has created opportunities for a few foreigners, es