China’s Great Leap OutwardPublished: March 21, 2000 in Knowledge@Wharton
However troublesome relations between the U.S. and China have been over the past decade, it's clear that the trade pact signed on November 15 is heady stuff.
By partially clearing the way for China to enter the World Trade Organization (WTO), the U.S. has offered domestic industries their best opportunity ever to tap into a marketplace of 1.25 billion consumers.
Should the trade accord be approved by the U.S. Congress and by major trading partners such as the European Union - the U.S. will benefit from lower tariffs on its exports to China while China will gain new jobs, new technology, new foreign investment and perhaps most important, new respect as a member of the global trading community.
That's the good side. The agreement also comes with its predictable losers, among them the U.S. textile industry, Chinese farmers and many of China's state-owned enterprises. "In China it is estimated that 30,000 state-owned enterprises have been running deficits for the last 15 years," says Ming-Jer Chen, founding director of Wharton's Global Chinese Business Initiative and author of an upcoming book entitled, Inside Chinese Business: A Practical Guide to Doing Business with the Chinese Worldwide (Harvard Business School Press.). "These enterprises will be forced to restructure or they will die out." And when they do restructure, unemployment is likely to go up dramatically. "At this point approximately 10% of China's population is affected by unemployment," Chen notes. "After the WTO agreement takes effect, that number will likely be higher."
While welcoming the accord as a "truly win-win situation, on the macro level, for all parties in the long term," Chen also cautions that "the pace of change may not be as fast as western companies and countries are used to. Because of local resistance within China there will be many mechanisms in place for slowing down the process. And it's important to remember that it took 13 years for this particular negotiation to be completed. The Chinese have a very different time perspective; they can wait another 13 years to fully execute it." The signing of the treaty is one thing, Chen adds. "But execution is all that counts."
In addition, there is the WTO itself, whose dispute resolution system depends on "good political relations between member countries," says Wharton legal studies professor G. Richard Shell, author of a Duke Law Journal article entitled, Trade Legalism and International Relations Theory: An Analysis of the World Trade Organization. "We've seen instances where if a particular trade matter turns out to have a strong constituency in one country or another, then the dispute system doesn't work well," Shell says. "Examples include the U.S. defying the WTO system in its argument with Japan over auto parts, and the European Union defying the WTO in its dispute with America over bananas. We can predict that Chinese relations with both Europe and America will have rocky moments."
But for now, the focus is on opportunity and nowhere is that more apparent to U.S. business interests than in the services industries, including banking, telecommunications and insurance.
The agreement, for example, allows foreign banks to offer services from managing deposits to making loans - in local currency to Chinese companies and individuals. (The central bank will continue to set deposit and loan rates.) The agreement also allows for joint ownership of money-management ventures.
How these provisions will actually play out, however, remains a question mark. "I don't think anybody has gotten to the fine print behind all this," says Wharton finance professor Richard Herring. "In the meantime, I have some concerns that relate to the current state of the Chinese banking system. Many people think the mother of all banking crises is looming in China, but that the crisis has been constrained because the currency is not convertible and because the Chinese have had little choice as to where they put their money.
"Opening up the system to foreign financial institutions could de-stabilize it," Herring says. "The problem is further complicated because the Chinese have been using their banking system as an off-balance-sheet way of funding state-owned enterprises. These enterprises are generally very inefficient and lose lots of money. The Chinese government must find a way to either make them more efficient or privatize them. That in turn gets into complicated questions of whether the economy is resilient enough to absorb the unemployed workers who will be released by the restructuring."
At the moment four state-owned banks control 90% of all banking in China and their main customers are state-owned enterprises, Herring notes. "These banks are in a very precarious position. Foreign competition and transfer of technology and training would ultimately strengthen the Chinese financial system but the government has a major adjustment problem to work through first. So far they have been able to keep the system propped up by making sure their citizens don't have ready alternatives for placing bank deposits."
"Clearly for foreign banks entering this system it will be very easy to pick off the attractive business in China," Herring says. "While it is not a very wealthy country, its population is huge. Even if only 2% of the Chinese economy has a high level of income, that can be a very attractive market for upscale retail services - much larger than most industrial countries."
American banks that want to enter the Chinese market will be strong competitors, Herring adds. "Our banks, including investment banks, do well in the world economy. We compete head on with European and Japanese banks, and we tend to dominate the underwriting of securities. And because banking often follows direct investment, U.S. banks may be especially well-placed because a number of their clients are major direct investors in China." At the same time, Herring says, because banking is so heavily regulated all over the world, "there are many opportunities to obstruct the implementation of any agreement. That's one reason it will be important to read the fine print of the final agreement."
In the telecommunications area, under the guidelines worked out last week, U.S. and other foreign companies can own up to 49% of Chinese telecom firms and Internet companies in the first year after China joins the WTO, and up to 50% in the second year. That's good, maybe.
"The Chinese market is so big that even owning a piece of it would be significant to a lot of telecoms," notes Wharton operations and information management professor G. Anandalingam. "On the other hand, China in particular has been a difficult trading partner. The Chinese drive a very hard bargain. So if you don't have majority control of a company, you are at their mercy. That is the trade off: Owning a piece of a large and expanding market vs. not having the kind of control most American companies would like to have." What is needed, Anandalingam adds, are "innovative ways of entering the market and also retaining some degree of control."
Even assuming American companies successfully navigate the legal and cultural barriers to entry in China, they face serious competition from other foreign companies, Anandalingam says. "The biggest and most lucrative market in China will probably be wireless. U.S. companies are a little behind European ones in that area. Nokia in particular has been doing business successfully in various parts of Asia. Also, the cellular technology used by the U.S. is different from that used by the rest of the world, which is based on the GSM (Global System for Mobile Communications) network. Chances are the Chinese will probably use the same system, which would put U.S. companies at somewhat of a disadvantage compared to European ones.
"In addition, for British telecom and other companies, Asia has always been a primary target for expansion. They would be able to compete vigorously with any U.S. firms trying to enter the Asian market."
That said, notes Anandalingam, the U.S. does have a strong presence in Asia. Companies like AT&T, MCI, Lucent, Cisco Systems and others are already there." And at some level, he adds, "everybody manufactures goods in every country and sells in every other country. Toys sold in the U.S. are frequently made in China, as are automobile parts, suitcases, clothing, footwear and other goods. So in one sense what this trade accord really does is formalize branded equipment and services flowing from the U.S. to China and vice versa. That will be advantageous to both countries."
Within the insurance industry, the prospects for doing business with the Chinese appear equally upbeat, partly because China up until now has successfully kept out most foreign insurance companies. (Foreign insurers currently can be licensed only in Shanghai and Guangzhou.) "It's been difficult to get into that market," notes Neil A. Doherty, Wharton professor of insurance and risk management. "Companies, especially American International Group (AIG), have been trying to make the initial investment. But China, in this market like all the others, has played the game of keeping everyone out while expecting trade agreements that allow them to sell elsewhere."
Insurers hope that China's swing to a more open market will spur demand for everything from auto and homeowners insurance to fire and liability insurance. "Given the amount of industrial building going on, the whole commercial property market will be a big one," notes Doherty. "It's there for the taking."
China's "massive catastrophic risk problem" poses another opportunity for insurers, he says. "Flooding of the Yellow River occurs periodically and there are other natural disasters as well. That is one set of issues. A whole other set of issues involves life insurance. The propensity to save and accumulate is high in China. With the right sort of marketing opportunity and given China's large population, it's a big open marketplace."
An interesting footnote, Doherty adds, is "the degree of bargaining power held by the outside world. For a domestic insurance company to be financially solid, it needs access to foreign reinsurance. That gives some bargaining leverage to outsiders who are willing to use it."
Meanwhile, says Ming-Jer Chen, one question that all outsiders must ask themselves is "whether they are ready for a deeper integration with the Chinese … How much do westerners, for example, understand the Chinese ways of doing business as well as the social, political and cultural issues that come into play? It is truly time for western companies to do some serious homework and pay greater attention to China's domestic policy making, especially such social issues as unemployment, because that will greatly affect the pace of this whole restructuring and execution."
National interests, adds Shell, "will still be the driving force in trade policy. But what this agreement does is help pro-WTO Chinese officials in their domestic disputes on this issue. By joining the WTO there is a certain amount of policy momentum that gives the internationalists some leverage against those in China who are more isolationist." Chen agrees. "Short-term, this trade accord ensures economic reform and also provides timely and most needed political support for the reformers. It very much sets the stage for more effective global integration of the Chinese economy."