In 1989, Alan M. Webber, then the managing editor of the Harvard Business Review, returned from a trip to Japan and wrote to his readers:The world is changing, and Japan is different. On both sides of the Pacific, the old, entrenched interests are hard at work denying these conclusions, pretending that business as usual will do, and silencing the observers and analysts who call attention to the new situation. Japan’s motives are not hard to fathom; after all, every day the country gains in wealth, economic power, and global momentum. The longer Japan successfully confounds U.S. leaders into thinking that all the old rules still apply, the longer the transfer of wealth and power can continue unimpeded. It is not Japan’s job to inform us of our blind stupidity.
What Webber found in Japan was a nation actively pursuing a mercantile trade policy, the approach to global commerce where the government and industry work together to build national wealth through increased exports while maintaining an economic moat around their country to stop direct foreign investment, sharply limit imports, and build up huge financial reserves. Adam Smith would have immediately recognized this Japanese policy as mercantilism; however, even after more than a quarter century of engagement, U.S. leaders still do not.
If we fast-forward in time about twenty years, what Webber found in Japan in 1989 is happening all over Asia and in parts of South America today. And, as then, U.S. leaders and opinion elites do not recognize that they are witnessing a new rise of mercantilism, particularly in China. Rather, they view China’s economic and trade activities as a steady march from socialism to market-oriented capitalism like that of the United States, though a bit more exotic.
China is actively creating a hybrid economy that the Chinese define as a “socialist market system” (SMS). While to many outsiders that system appears to be market-oriented and largely controlled by the private sector, it is neither. China is well along in creating an economy where the government owns and controls the strategic industries while secondary and service industries are left to private ownership, which the government also controls.
The giant enterprise called China, which accrued a historic global trade surplus of $262 billion in 2007, is pursuing export-driven, beggar-thy-neighbor trade policies that are so blatantly nationalistic they are undermining the World Trade Organization and putting the entire global trading system at risk. To understand China’s approach to global economics, we must examine its basic elements.Mercantilism
In the sixteenth through eighteenth centuries, the dominant economic theory in Europe, mercantilism, held that national prosperity depended on a nation’s supply of capital, which at the time was gold. The fastest way to acquire capital was to run a trade surplus with other nations by exporting more goods than were imported. To facilitate this economic dynamic, governments subsidized production and exports, at the same time imposing barriers on foreign imports. The idea was simple: to make exports so inexpensive that foreign consumers would prefer them over domestically made goods and conversely make imports so expensive that local consumers would prefer domestic goods over foreign-made ones.
England, under the intellectual influence of the economists Adam Smith and David Ricardo, gradually abandoned mercantilist policies in the nineteenth century and replaced them with an ideology of free trade and comparative advantage. The United States continued to pursue a mercantilist economic agenda until the early 1930s, when Roosevelt’s secretary of state, Cordell Hull, began a move to a free- trade regime, which also promoted FDR’s foreign policy objectives.
China is taking the mercantilist path abandoned by England and once used by the United States. The principal differences are that the United States did not own the major enterprises on which its economy depended, as the Chinese government does, and the U.S. government operated under a two-party, democratic system, while China is governed by one-party rule.
The ownership and democratic differences between the United States and China are fundamental. The Chinese government announced in December 2006 that seven industries were critical to the nation’s economic security and would remain under strict government control. They are defense, power, oil, telecommunications, mineral resources, civil aviation, and shipping industries. This list, moreover, is not exclusive; Chinese officials noted that the government intended to expand the volume and structure of those industries so that they would become leading world businesses.One-Party Rule by the Techno-Elite
In a nation of 1.3 billion people, about 63 million Chinese are members of the Communist Party. Its principal national body is the Party Congress, which has about 3,000 delegates and meets every five years. The real control of the government resides in the Politburo Standing Committee (PSC), which since 2002 has consisted of nine persons drawn from the twenty-two- member Politburo. One of these nine serves as head of state (president) and another as head of government (premier). The number is kept uneven to prevent deadlocks.
All of the nine members of the Sixteenth Politburo Standing Committee (2002–2007) are trained engineers, experienced in various national development disciplines. One is a civil engineer, another is a geological engineer, three are electrical engineers, and four are mechanical engineers. All have extensive development experience in which they began at the bottom of organizations and worked their way up.
Unlike when Mao Tse-tung and political ideologues governed the nation, China’s development planning now reflects leadership by a techno-elite. Major projects are phased. Industries are clustered to gain the efficiencies of colocation. Transport systems, from local industrial areas to seaports, are entwined. Basic infrastructure, such as electric generating power, is being given priority in planning and allocation of resources. Foreigners are involved when they can bring something China lacks, but their actions are controlled. The nation is developing along the lines set forth in Five-Year Plans, which set strategic directions and overall priorities. All of this is precisely the type of order that trained engineers would impose.
The point is that competent and experienced people lead China’s government. For instance, Minister Wu Yi, a senior petroleum engineer who has represented China in trade discussions since 1991, is what U.S. Secretary of the Treasury Henry Paulson calls a “force of nature.” Beyond having talented negotiators, China’s leaders are systematically strengthening their nation’s public infrastructure and consolidating and modernizing their industries so the enterprises can compete globally against those of Europe, Japan, and the United States.Restructuring to Compete
When the Communist Party seized control in 1949, it nationalized the economy. For the next thirty years, China’s economic enterprises had little contact with the outside world and were considered by most Western observers to be quite backward. As recently as the late 1970s, most of China’s industries were remnants of nineteenth-century investments or mirrors of those of the Soviet Union. Since 1979, however, China has been rapidly modernizing its economy, bringing to its production many of the world’s most advanced technologies along with the leading management tools of major Western corporations.
To close the gap with other nations, China began reconstituting its state-owned industries in the 1980s. In the process, the government has encouraged foreign direct investment, joint ventures, the elimination of redundant production, the transformation of state industries into joint-stock ventures, the outright sale of some operations, and the liquidation of tens of thousands of failing ventures.
The magnitude of this challenge is daunting. In 2002, China’s central government placed the responsibility for overseeing almost 200,000 state-owned enterprises in the state-owned Assets Supervision and Administration Commission (SASAC). Imagine SASAC as the world’s largest equity fund, whose sole owner is the Chinese government. The chairman is Li Rongrong, born in 1944 and trained as an engineer, who began his career in 1963 as a factory worker in a plant he eventually came to manage. In 1986, he was appointed vice chairman of the Wuxi Municipal Economic Commission in Jiangsu province, and from that position he took on increasingly important responsibilities, including secretary general and then vice chairman of the State Economic and Trade Commission.
At the first SASAC working conference in August 2003, Li Rongrong identified five priority sectors for future development: (1) national security, (2) monopolies for natural resources, (3) provision of key public goods and services, (4) critical resources, and (5) core enterprises and high-tech industries.
Within those five divisions there were originally 196 central enterprises, many of which controlled dozens of subsidiaries. In 2003, the 196 central industries were consolidated to 191, and in 2007 they were further reduced to 161. At the 2003 conference, Li Rongrong also announced that China would create 30 to 50 large corporations with international competitive power before 2010. These will be companies on the scale of Microsoft, Motorola, GE, General Motors, and Pfizer.
Under SASAC, it is clear that China’s economy is being transformed in a way that will form a pattern of development for the next generation or so. A cluster of state-owned enterprises (SOEs) will remain under the tight control of the central government. They include what the Chinese call the “lifeline” sectors: oil, coal, petrochemicals, metallurgy, power, telecommunications, defense, ocean shipping, air transport, defense, coal, scientific instruments, and related industries. In these industries the government maintains absolute control.
In 2003, China also announced that foreign investment would be permitted in banking, telecommunications, education, medical services, auto industries, civilian satellites, large-equipment manufacturing, and large-scale integrated circuits. While foreigners can own a minority position, the Chinese make the major decisions. In this way, the foreigners get a toehold in China and China gets their capital and expert help in becoming world-class competitors.
Under Li Rongrong’s direction, these state-owned industries are making sharp gains in productivity and overall production. In mid- December 2006, Li reported that their sales were up 21 percent over the same period in 2005 and profits were up 19 percent. They paid 23 percent more taxes to the central government. Thirteen of China’s top state-owned enterprises were on the Forbes
500 list of the world’s top companies in 2006, versus five in 2003. The average return on SOE assets in 2006 was 10 percent. Without a doubt, China’s socialist corporations are becoming efficient and globally competitive.
Equally interesting and important, Li also reported that the overall number and strength of Party members in the SOE were improving and building membership in the Party was being strengthened. Systems were being deployed to educate Party members constantly. The Communist Party is not planning to wither away in China’s new economy.
A reality of China’s economic transformation, however, is that hundreds of thousands of small and secondary Chinese businesses are now privately owned and operated. This gives the impression to outsiders that China is privatizing its economy. It also masks the growing competence and efficiency of the state-owned enterprises, which control the nation’s lifeline industries as they are being shaped into national champions, much as Japan did with many of its core industries in the early and middle 1960s.
Currently, foreign-invested companies account for more than 50 percent of China’s exports and 60 percent of its imports. But that will change as China’s national champions grow and become more technologically sophisticated and many of the existing foreign firms are purchased for their distribution networks or forced aside. There will come a time when China will no longer need them.China’s Price Advantage
China’s economy has developed to the point that it has a price advantage over foreign competitors in virtually every product it makes in almost every market in the world. In 2006, the Paul Merage School of Business at the University of California– Irvine released an important study titled A Report of “The China Price Project.” Professor Peter Navarro identified eight factors that gave China a price advantage in global competition and calculated their relative contributions to that advantage.
1. Low wages for high-quality work:
Chinese wages are not the lowest in the world, but the country’s workers are very productive and do high-quality work. Adjusting China’s wages to account for the productivity of Chinese workers, Navarro found that the cost of an hour’s work by a Chinese employee is about 18 percent that of a comparable American worker. What this means, of course, is that a company can hire five Chinese workers for the same price as one American. In all, low wages constituted 39.4 percent of China’s price advantage.
2. Piracy and Counterfeiting:
China is the center of world piracy and counterfeiting. As I documented in my book Hot Property
(2005), almost every commercial item for sale in the world, including patented, trademarked, and copyrighted materials, has been copied and sold by Chinese pirates and counterfeiters. The government regularly promises to stop such activities but makes only a token effort. Since its accession to the World Trade Organization, China has created an elaborate judicial system to deal with violations of intellectual property rights and model laws. But the system does not work well, if at all. Sophisticated Western investors realize that if they take their technology to China it will be ripped off. Japan has asked its leading technology corporations to keep their most advanced work inside Japan and not even patent it out of fear that the patent applications themselves might give away that nation’s most vital technological secrets. Navarro calculates that more than 8.6 percent of the Chinese price advantage can be attributed to the piracy and counterfeiting factor.
3. Minimal worker health and safety regulations:
The World Health Organization and International Labor Organization jointly report a growth of workplace accidents in China. Their most recent data show that more than 90,000 Chinese workers died in 2001 because of work-related accidents and 69 million were so badly injured they were absent from work for three or more days. One of the attractions to foreign investors is the fact that they can eliminate investments in occupational safety equipment and training in Chinese factories and escape virtually any obligation when workers are killed or injured. Laws exist but are not enforced. Silicosis, brown-lung disease, cancer, and toxic poisoning are common sicknesses among Chinese workers. Navarro estimates that factory owners in China spend a third of what their counterparts in the United States do on health and safety. This contributes 2.4 percent to the China price advantage.
4. Lax environmental regulations and enforcement:
China is the world’s top polluter. More than 70 percent of its rivers are badly contaminated. Two thirds of its cities fail to meet even the minimal standards for air quality. More than 400,000 Chinese die annually because of air pollution–related diseases. At the same time, more than 25 percent of the Chinese population is drinking unclean water. Companies that operate in China are not required to meet the environmental obligations they are in Japan and the West. Navarro calculates the absence of environmental regulations makes up 2.4 percent of the price advantage.
5. Export subsidies:
The government, as well as provincial and local regimes, heavily subsidizes both domestic and foreign-based corporations in a variety of ways. The China Development Bank and the Export-Import Bank of China provide Chinese enterprises massive credit lines for global expansion.
The Export-Import Bank, for instance, provided TCL, now the world’s largest television set maker, funds it needed to take over and operate the TV production of Thomson and the mobile phone business of Alcatel. It also finances the export operations of Huawei Technology, a telecom network equipment maker, and the Haier Group, which makes a variety of technology goods.
6. Industrial network clustering:
Think of River Rouge, where between 1917 and 1928 Henry Ford built an automobile factory in Dearborn, Michigan, on a thousand-acre site that grew to contain ninetythree buildings, docks, a hundred miles of internal railroads, an electricity plant, a glass factory, and a steel mill. Raw materials arrived on the docks, and ultimately finished automobiles were driven out of the factory. By the 1930s, more than 100,000 people worked on this large, integrated site, which contained most of its supply chain inside the complex or close by. China has built similar complexes that specialize in the production of specific items. Huizon makes DVDs and laser diodes. Ingrid produces computers. Leila turns out bicycles. Yanbun manufactures underwear. Dozens of these clusters, involving millions of workers, now exist, and great efficiencies are achieved. Navarro estimates that such clustering adds 16 points to the China price advantage, almost as much as government subsidies do.
7. Foreign direct investment:
China is the world's principal destination for foreign direct investment (FDI). Unlike foreign investment in the United States, where almost 96 percent of such funds are used to buy existing assets such as stocks, almost all the foreign money going into China is invested in new production facilities. Foreign technology, managerial expertise, and global distribution networks accompany these funds. Navarro concludes that FDI adds a bit more than 3 points to China's price advantage.
8. Undervalued currency:
In The Trap,
Sir James Goldsmith illustrated how the value of a nation's money can be manipulated to make its products cheaper in the global market and thus create an economic advantage. In 1981, he wrote, one U.S. dollar was worth 4.25 French francs; but by 1985, the dollar had risen sharply and was worth 10 francs. Consider a product, such as a chair, that in 1981 cost the same to make in either nation. By 1985, it was twice as expensive in America as in France, simply because of the value of the currency. Then, in 1992, the dollar's value fell again to 4.8 francs, making the price of the same chair once again competitive on open markets. In 1994, China pegged the value of its currency at eight yuan to one dollar, where it has stayed ever since. By keeping the yuan at roughly eight to one, the Chinese government makes that nation's exports far less expensive and imports far more expensive than they otherwise would be. Ironically, if China suddenly allowed the yuan to trade at five to one, the U.S. cost of living would soar with a jump in prices of the Chinese imports upon which the nation now depends. Making a trip to Wal-Mart would be like going to Neiman Marcus now. Congress and many trade associations have been concerned since the early years of this decade about the undervaluation of the Chinese currency. Navarro, taking a very conservative approach in his calculations, estimates that the Chinese currency is undervalued by only 20 percent. Even then, the currency factor contributes 11.4 percent to the China price advantage. A quick way to understand how China's price advantage has changed.From the Hardcover edition.
Excerpted from Dangerous Business by Pat Choate. Copyright © 2008 by Pat Choate. Excerpted by permission of Knopf, a division of Random House, Inc. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.