ENTREPRENEUR

Introduction

Until now, all of my posts on China have been rehashes of what I learned during my time at the Guanghua School of Management in Beijing.  I’ve discussed the research and theories of some of the leading experts in the fields of finance and economics.  But I think it’s important for people to form their own informed opinions about a topic, so to close out my series of articles on doing business in China, I’m going to throw in my two cents on the country.  Keep in mind that what you read here is based solely on observations gained in three weeks of visiting, and two weeks of studying, in the country, so you’d be wise to take it with a grain of salt.

Now, what do I think about this whole China phenomenon?

It’s pretty impressive, but let’s not lose our heads over it.

China spent the past thirty years growing faster than a baseball player on steroids.  It experienced double digit GDP growth every year for decades on end.  That’s unheard of.  It become the second largest economy in the world.  Incredible.  And recently, it overtook the US as the largest manufacturing country in the history of the world.  No one can deny that they’ve done a great job of managing and encouraging growth.

But guess what?  The Chinese are still poor, at least in terms of average income per person (per capita income).

Quality of Living

Sure, China may grow to become the world’s largest economy some day in the foreseeable future (more on this later).  But you know what?  It should be!  It has the largest population of any country in the world.  By a lot.  It would actually be a bit ludicrous for it to not be the largest economy some day.  In fact, speaking from a humanitarian point of view, I think that its economy should even be much larger than it is now.  In terms of total economic output, my problem with China isn’t that it’s too large.  My problem is that it’s not large enough.

China has the second largest economy in the world.  That economy is breaking its back trying to support the largest population in the world.  Despite how large the economy truly is, it just can’t keep up with China’s gargantuan population.  When you break it all down, a large portion of Chinese people are getting by on very little money.  Average income in China is around $4,000 per year¹.  Can you imagine living on that?  I can’t.

China’s economy should actually be 4 to 5 times larger than it is now to even approach some form of quality of life that most us would consider tolerable.  And I don’t see that happening any time soon.

To date, China has epitomized the Asian model of growth – make stuff for cheap and sell it all to Westerners.  China’s economy relies heavily on external trade.  It’s true that its domestic consumption rate is growing extremely quickly, but consumer spending in China comprises slightly more than a third of overall GDP.  In the US, that number is more than twice as large.  The huge Chinese consumer market that everyone talks about isn’t really buying that much.  Most people just can’t afford to spend a lot, even though they try to give off the impression that they’re rich and powerful.  And unlike in the US, the wealthiest portion of the population can’t spend enough to make up for the low rate of spending from the rest of the country.

Changes to economic sectors

We’re also beginning to see signs that manufacturers are now moving their production facilities to new countries, countries where the labor practices and wage rates are even more depressed than those in China.  Countries like Vietnam, Indonesia, and the Philippines are quickly becoming the new manufacturing powerhouses of the world.  We’re even beginning to see some manufacturing come back to the Western world, especially here in the United States.

If China’s economy is to challenge that of the United States’, it needs to see foster significant industrial diversification and an increased level of spending from its own consumers to make up for the eventual loss of its dominance in manufacturing (if you think that this can’t happen, just take a look at what happened to the other “unstoppable” economies of Asia back in the ’90s).  Right now, we don’t see that diversity.  China’s service sector is nearly non-existent.  What’s going to happen if, and when, all of the factories leave?

Before industries such as service and R&D can even begin to develop in China, there would need to be a series of infrastructural changes at the social, political, and legal levels of Chinese society.  China would have to start caring about IP protection.  The courts would have to become proficient in all forms of corporate law.  Property rights would have to improve.  There would need to be new incentives for firms to innovate.  Such changes would be massively disruptive to the Chinese way of life, and as we’ve mentioned before, disruption is not the Chinese way.

I believe these changes will eventually come around, but it will take a lot of time.  One of China’s main advantages in the past few decades has been its ability to slowly enact change – try new things, see what works, implement that which does and discard that which doesn’t.  However, this slow and cautious approach, vital as it may be to maintain social order, also places a ceiling on how quickly the Chinese economy can adapt to a changing economic environment.

New reforms and how they’ll affect Chinese economy

As these reforms come about, the Chinese will have to deal with new challenges that they’ve never experienced before.  A more significant stock market will require more efficient oversight and better flows of information.  Without them, the Chinese economy could experience significant setbacks based on market volatility alone.  A privatized banking sector (which, I truly believe will be required for sustainable Chinese growth) could lead to the same banking crises that we saw in South Korea and Hong Kong.  And perhaps most notably, the makings of what could be a housing bubble could lead to a crash that could completely wipe out economic growth, a la Japanese housing crisis.

In fact, that last point is so important that it deserves a bit more attention.  Living in major cities in the eastern part of China is incredibly expensive.  Real estate values are rising like crazy.  Now, one could say that what we’re seeing isn’t truly a bubble, since there is some semblance of market demand for housing, and they might be right.  There is quite a bit of demand for real estate in China.  But I’ve seen too much in the past 15 years to believe that prices that are going this high this fast are sustainable.  Growth cannot continue inevitably.  If Newton was an economist, I guarantee this would have been one of his new “laws of economic motion.”  So I think there might be a bubble, even if it is slight.  And we’ve all seen what a real estate bubble can do to a country’s economy.

We’re also seeing growth in the technology and luxury sectors, but again, only a relatively small portion of the population is buying into it all.  There may be a middle class, and, in absolute values, it may be huge, but eventually these sectors will reach market saturation (even if it does take a few decades), and I’m not convinced that this area of the economy will be large enough to compensate for other, more languished areas in the future.

To top it all off, China’s rapid economic growth will soon be overshadowed by smaller, faster growing economies that will capture the attention of popular economic media.  Emerging markets, particularly those that are beginning to recover from war (Sri Lanka), those that are stabilizing in Africa (Ghana), and those that control energy and natural resources (Qatar, Eritrea) are projected to grow nearly twice as fast as China.  China’s growth was incredible inasmuch as it was a developing economy.  It’s true that it is the fastest growing major economy, but when it comes to absolute rate of growth, it probably won’t be able to compare to other parts of the world, those that are currently more destitute but have a lot of room for improvement.

Conclusion

Ultimately, I think China still has a lot of room to grow.  The manufacturing industry is alive and well, and even if some companies are currently taking their production facilities elsewhere, China has solidified its place as the center of the manufacturing world.  But rapid, exponential growth can’t continue forever.

So I do think that Chinese growth will eventually stall.  It’ll probably take a while – it could be 5 years, it could be 50.  My guess is that right around the time the size of the Chinese economy reaches that of the US, it will experience some major setbacks.  I can’t predict whether or not the Chinese economy will surpass that of the US – my gut tells me that it won’t; my head tells me that it will (and I think that even if it does, it won’t be by a significant amount).  But in any case, it doesn’t really matter.

China may gain some bragging rights, but the only measure of a country’s economy that actually has any real world significance is how well the average citizen is able to live.  I would be much more impressed by a smaller economy in which every citizen owns a house and a yacht than an enormous economy in which extreme levels of pollution, congestion, and horrible standards of living are the norm.  In that sense, China won’t be able to compete for a long, long time.  Though, sadly enough, neither will the US.  The citizens of Qatar are living it up as the wealthiest people in the world.  Though, we’ll see if the latest innovators in clean energy have anything to say about that.

Zàijiàn for now, gromer.

It’s no secret that Chinese culture is vastly different from our own.  Everything from their phonetically-based language to their education methods to their fashion sense screams “we’re not you”.  So when a Western business is looking to break in to the Chinese market, it’s vitally important for them to have some clue of how they can appeal to the Chinese consumer.  That’s why it’s vitally important to truly understand the value system and behavioral drivers behind Chinese consuming habits.

The Chinese consumer is a lot like the American consumer of the ’50s.  Obviously the environment and political backgrounds differ, but the socio-economic drivers are still very much the same.  The Chinese are quickly gaining wealth.  Though there is still a big gap between the rich and the poor, the middle class is up-and-coming, quickly.  And they’re looking to spend.  Traditionally, China has been known to be a net saver.  Most Chinese, at least in the past, used to save more than they spent (contrast that with the average American that actually spends about 2% more than they make).  But that’s quickly changing.

The younger Chinese generation is quick to break out its credit card, sometimes, even when they don’t have the money.  They care about image.  They care about brand.  For many Chinese consumers, material goods are status symbols.  They’re ways to say “hey, look at me, I made it.”  Interestingly enough, this isn’t a new phenomenon.  It actually originated with the older generation.

For the past few centuries, China has been under constant threat from outsiders.  The British, French, Japanese, and even Americans have all carved up parts of China and influenced its people.  The Chinese quickly saw how little they had in comparison to their outside aggressors and quickly began to feel a sense of deprivation, and possibly even a little jealousy.  This feeling of inferiority, combined with the innate desire for respect from one’s social circle and the concept of maintaining “face,” led the older generation to value material goods as a way of proving that they are no longer oppressed, and that they have finally become successful.  This will oftentimes lead them to contribute to their children’s lavish lifestyle.  They may even finance the purchase of high quality luxury items when their kids don’t have the money to pay them off themselves.

You can see that brand and image are extremely important to the Chinese consumer and why it’s so vital for Western companies to spend time and effort in crafting a message that will strike the right chords in the average Chinese purchaser.  That’s one of the reasons that luxury brands are flocking to China.  Not only is the overall market huge, but the individuals that compose the market are looking specifically to flaunt what they’ve got.  I can just imagine what the boardroom must be like at companies like Louis Vuitton and Coach.

To take an example, I’d like to go over Audi’s success in China.  Audi is known as a relatively luxurious brand across the world, but in China it enjoys unmatched popularity.  They’re the quintessential example of a company that understood the Chinese market and capitalized on their knowledge.

Audi’s success started at the top.  They recognized that if they appealed to government officials, they would be able to build their status as a car for the successful elite (even more so than in the US, Chinese government officials are widely respected and lauded).  So they struck a deal with local and national officials to provide black, tinted Audis, probably at a discount, to government officials.  When these officials started driving around their new cars, successful businessmen and other elite citizens took notice.  Suddenly, they started buying Audis to showcase their wealth and prestige.  Soon, more and more Chinese citizens began buying Audi – specifically, tinted black Audis – and now, the A4 and A7 have come to symbolize wealth and luxury in Chinese culture, while simultaneously generating significant revenue for the company.

Audi’s story is one of a company that truly understood the Chinese consumer’s value system and capitalized on it.  They realized that status and image mean much more in China than in the Western world (hard to believe, I know).  They then capitalized on their status as a luxury carmaker to organically grow their brand in “the world’s largest market.”

On a final word, it’s important to note that, though the Chinese consumer cares about brand and image, they often care just as much about value.  Many Chinese consumers will make the extra effort to find a product that will save them money, without sacrificing quality.  Thus, value is as important to them as image.  So it’s important to note that, as a high quality brand, it’s not advisable to charge huge amounts of money for a product.  The middle class is quickly growing but is still shadowed by the large amount of poor and impoverished people in the country.  Regardless of location, it’s never smart to alienate your customer.

In his teachings, Confucius proclaimed the virtues of the five main human relationships: ruler to ruled, father to son, husband to wife, elder brother to younger brother, and friend to friend.  It’s easy to see that structured relationships form a key part of Chinese culture.  These structures are the source of one of the most important concepts in Chinese culture – that of hierarchy.

During my nearly three weeks in China, I found a large number of instances in which the Chinese proclivity for defined hierarchy came to the forefront of discussion.  One of the most interesting of these instances was in how the Chinese rank their cities in “tiers.”  Particularly in class, discussion around the Chinese economy was often specified in terms of the first and second tier cities in China.

No one gave a definition of what constitues a first-tier or second-tier city, but somehow, everyone knows.  Beijing, Shanghai, and Guangzho are clearly first-tier cities.  Second-tier cities are those that still have some growing to do.  Third-tier cities are likely those in the western part of the country and encompasses those that have seen relatively low economic development and widespread poverty.

For me, it was very interesting to see the Chinese classify their cities into “tiers,” as if some were better than others.  They could have easily differentiated their cities based on economic development, or population size, or a variety of other factors.  But the fact that they choose to distinguish between the different “tiers” of cities in their country is a tribute to the great need for general, over-arching hierarchy in Chinese culture.

In the same way that the Chinese classify cities into tiers, they similarly differentiate between the different ranks of universities, politicians, companies, and everything else in Chinese culture using a “tiered” or ranking system.  One of the interesting consequences of this ranking lies in the educational system in China.  Recently, China Central Television (the government-controlled news program) aired an interview with the Richard Levin, the president of Yale University, on the topic of improving education in China.  During the interview, they asked him how China can improve its educational system.  His response was very interesting.

He commented that the Chinese need to begin encouraging their students to think more critically in class, rather than take everything that their professors say as dogma.  He noted how universities in the US are much more comfortable with students actively questioning their professors and taking part in classrom discussions than their Chinese counterparts.  He noted that this practice can be traced back to the traditional practice of “respect for one’s superiors.”  Much as the ruled should respect their ruler, and a son should respect his father, students should respect their professors by not questioning what they say.  Thus, the hierarchy that I talked about earlier in this post eminates itself in the classroom.

Unfortunately, this may stifle Chinese learning.  One of the biggest advantages that students in western universities have is their ability to think critically, to take a hypothesis and analyze its underlying assumptions and the arguments in favor and against its validity.  This ability to think critically leads to innovation, invention, and the ability to develop creative solutions to problems.  The Chinese, on the other hand, lack this skill.  They are very good at taking instructions and executing them effectively, but when it comes to true innovation, they need to “think outside the box.”  This truly starts in the schools and universities that mold the minds of the younger generation.  As China progresses, there is no doubt that this practice will slowly become more prevalent in class, yet, whether or not it permeates into the larger culture remains to be seen.

One particular fall evening, many hundreds of years ago, an emperor of China was walking through his palacial gardens with one of his most trusted ministers.  In fact, this particular minister had even been employed by this emperor’s father, making him one of the longest standing members of the royal court.  During the course of the walk, the emperor took out a fan with the minister’s name written on it and handed it to the minister.  The minister accepted the fan, examined it, and the two continued their walk silently forward.

The next day, the minister stood up in front of the entire court and emphatically announced, “emperor, I feel I have served this court well and to the best of my abilities.  I served your father, and I served you.  Now I am getting old, and I ask your permission to retire so that I may spend the last of my days with my family in my home town.”  The emperor immediately agreed, allowing the minister to retire in peace.

As a Westerner, one could read this story and wonder what the heck is going on.  The emperor gave a thoughtful gift to his oldest confidant and mentor and the very next day he retires?  It doesn’t make sense.

Here, as in all of China, the devil is in the details.  The key thing to note is that the emperor gave his minister a fan, with the minister’s name on it, in the fall.  The weather was cool, and a fan was unnecessary.  Because the fan had the minister’s name on it, the emperor was implying that, like the fan, the minister was also unnecessary.  But instead of firing him flat out, the emperor gave the minister a chance to “save face”, a very important aspect of Chinese culture, by allowing him to retire.

This anecdote actually illustrates many of the key nuances of Chinese culture that I’ve been exposed to during my time here in China.  Over the past two weeks, I’ve been taking part in lectures, classes, presentations, corporate visits, and, of course, the requisite tourism, all as part of Stern’s “Doing Business In China” program.

Over the course of the next few weeks, I hope to write several posts on a variety of topics that I’ve learned about while on this trip.  This first one corresponds to the first lecture I received on Chinese culture.  It was given by professor Li Ma, who is part of the Department of Organizational Management at Peking University, China’s premier educational institution.

During the course of his lecture, he discussed the value systems and incentive structures that Chinese workers, and the Chinese population as a whole, live by.  One of the key concepts was that of saving face, which relates to the more general concept of living in a harmonious, de-individualized, respect-based culture.  The Chinese are very group-oriented.  They thrive on having high social status within their immediate social, professional, and familial lives.  They value having close relationships and value relationships within their immediate circle, almost at the expense of relationships with those that are farther away.

For example, the Chinese will do almost anything for close friends, and usually consider them honorary family members.  However, they’ll readily bump, shove, and push their way past other Chinese people that they see on the street.  Similarly, they’re more favorable to giving jobs, favors, and money to those that they’re close to at the expense of strangers.  This reliance on close relationships is known as “guanxi”, and is a common force in everyday business in China.

Many businesses here will leverage their guanxi with government and private sector officials to increase their customer base, find new clients, develop exclusive sales contracts, and hire employees.  In fact, at some points, it begins to border on what Westerners would call corruption and bribery.  But to the Chinese, guanxi is anything but.  It’s a way of life.  It is the epiphone of what Chinese culture is all about – extremely strong close relationships and much weaker relationships with those outside of one’s “circle of trust.”

This leads to a very interesting way of life in Chinese culture.  Oftentimes, Chinese people will do anything to maintain harmony, even when this could lead to potential problems down the road.  For insance, one of the examples that professor Li gave us was that a spoken “yes” by a Chinese person can mean “yes”, “maybe”, “I don’t know”, “if you say so”, or “I hope I have said this unenthusiastically enough for you to understand that I mean no.”

As you can guess, this leads to a culture that is very high context, where details matter, and where what’s spoken is hardly what’s meant.  When it comes to business, this still plays a role, but is slowly changing.  Chinese workers will usually do what their boss tells them with no hesitation.  Managers will often exert significant influence over those below them, but will usually not provide any push back to their own bosses.  They’ll often seek to please others at their own expense, and at the expense of productivity and, possibly, good business.  Interpersonal relationships, perceptions of fairness, and social standing all play a huge part in Chinese business.

This is slowly changing, as new Chinese employees are much more materialistic than previous generations.  They’ll usually spend more than their parents, and they work hard to one up their friends and colleagues with the newest products.  With that said, they’re still Chinese, and the concepts of harmony and social order are still important to them.

In general, the average Chinese person will work very hard to please others around them.  They’ll bend over backwards to make life easier for their friends, family, and guests, often to the point of inefficiency and inconvenience for the very same people they try to please.  Understanding this, and being respectful of it, is the first step in doing business in Chinese culture.  So the next time you’re in China, trying to close a multi-million dollar deal, and your hosts spend all of their time trying to wine and dine you and none of their time in the meeting room, take it as a good sign.  You’re building guanxi with them, and once you start negotiating, it will be a much more smooth operation.