The Myth Behind China's Miracle

George J. Gilboy

From Foreign Affairs, July/August 2004

Summary:  Washington need not worry about China's economic boom, much less respond with protectionism. Although China controls more of the world's exports than ever before, its high-return high-tech industries are dominated by foreign companies. And Chinese firms will not displace them any time soon: Beijing's one-party politics have bred a timid business culture that prevents domestic firms from developing key technologies and keeps them dependent on the West.

George J. Gilboy is a senior manager at a major multinational firm in Beijing, where he has been working since 1995, and a research affiliate at the Center for International Studies at the Massachusetts Institute of Technology.

As shown in the figure on the next page, the dominance of foreign firms in China is even more apparent in advanced industrial exports. While exports of industrial machinery grew twentyfold in real terms over the last decade (to $83 billion last year), the share of those exports produced by FFEs grew from 35 percent to 79 percent. Exports of computer equipment shot from $716 million in 1993 to $41 billion in 2003, with the FFEs' share rising from 74 percent to 92 percent. Likewise, China's electronics and telecom exports have grown sevenfold since 1993 (to $89 billion last year), with the FFEs' share of those exports growing from 45 percent to 74 percent over the same period. This pattern repeats itself in almost every advanced industrial sector in China.

The data featured in the figure highlight another trend that reinforces China's dependence on foreign investment and the growing gap between FFEs and domestic Chinese companies. In the 1990s, Beijing permitted a new FDI trend to develop: a shift away from joint ventures and toward wholly owned foreign enterprises (WOFEs). Today, WOFEs account for 65 percent of new FDI in China, and they dominate high-tech exports. But they are much less inclined to transfer technology to Chinese firms than are joint ventures. Unlike joint ventures, they are not contractually required to share knowledge with local partners. And they have strong incentives to protect their technology from both domestic and other foreign firms, in order to capture a greater share of China's domestic markets. As a result, according to the most recent Chinese government statistics for high-tech industries (pharmaceuticals, aircraft and aerospace, electronics, telecommunications, computers, and medical equipment), FFEs increased their total share of high-tech exports from 74 percent to 85 percent between 1998 and 2002. But perhaps more significant, in the same period, they increased their share of total domestic high-tech sales from 32 percent to 45 percent, while the share of that market held by China's most competitive industrial firms, SOEs, fell from 47 percent to 42 percent.

Finally, the data in the figure reveal that China's private firms are not yet significant global players. Despite more than two decades of economic reform, China's leading domestic industrial and technology companies are still primarily SOEs. Although they remain inefficient and dependent on government-subsidized loans, they account for the bulk of advanced industrial production in China, boast the country's best research and development (R&D) capability, and spend the most resources to develop and import technology. Their preferential access to markets and resources has blocked the rise of private industrial firms. Likewise, collective firms owned by provincial and local governments have failed to emerge as major players in China's advanced industrial and technology sectors.

PARTICULAR AND EXCEPTIONAL

One of the key reasons that state, collective, and private firms in China lag behind FFEs is that they have failed to invest in the type of long-term technological capabilities that their Japanese, South Korean, and Taiwanese predecessors built during the 1970s and 1980s.

Developing technology is a difficult and uncertain process. Neither large capital investments nor a significant stock of existing science and engineering capability can guarantee success. To create commercially viable products and services, firms must monitor and access new forms of knowledge, understand evolving market trends, and respond rapidly to changing customer demand. Firms that can develop strong links to research institutions, financiers, partners, suppliers, and customers have an advantage in acquiring, modifying, and then commercializing new technology. Such horizontal networks are essential conduits for knowledge, capital, products, and talent.

Yet China's unreformed political system suppresses such independent social organization and horizontal networking and instead reinforces vertical relationships. China remains a fragmented federal system, its fractious regions unified by a single political party. The CCP controls all aspects of organized life, including industry associations, leaving few avenues for firms to work together for legitimate common interests. This structure drives business leaders to focus on building relationships through CCP officials and the bureaucracy. Although market reforms have brought more rules to the Chinese economy, without institutional checks and balances or direct supervision, CCP officials still exercise wide discretion in defining and implementing those rules, especially at the local level. They can, and often do, manipulate economic policies to pursue particular local goals. Some engage in this "particularism" because they are corrupt, others because they directly own or operate firms. Most, however, do it because the political elite encourages them to: understanding that local economic growth promotes social and political order, the CCP tolerates, and even rewards, officials who use any means to produce local investment and employment. But this often results in fragmented national industries and wasteful overlapping investment.

Chinese business leaders at both public and private firms recognize that an economy dominated by particularism is a risky business environment. Markets are fragmented; rules constantly shift under manipulation by government officials; and political obstacles prevent firms from associating, sharing risk, and taking collective action. To cope with these uncertainties, Chinese business has developed a distinctive industrial strategic culture over the past two decades -- a set of values or guidelines about what strategies "work" in this environment. First, in response to the "particular" application of policy, Chinese firms routinely focus on obtaining "exceptional" treatment from key officials: special access to markets or resources, exemptions from rules and regulations, or protection against predation by other officials. Second, to maximize these exceptional benefits, as well as to avoid entanglements with other firms and their patrons, many Chinese companies shun collaboration within their industry, especially if such collaboration crosses regional or bureaucratic boundaries. Third, they generally favor short-term gains over long-term investments. Finally, Chinese firms tend to engage in excessive diversification in order to mitigate the potential damage of fratricidal price competition created by excess production capacity and overlapping investments.