William Overholt, a senior fellow at the Harvard University Asia Center, wrote a controversial book in 1993 entitled The Rise of China. In the book, which had started out as a series of speeches on the Tiananmen Square uprising, Overholt predicted that China would be the big winner in achieving market reform while the economies of Russia and many of the eastern European companies would fall apart under shock therapy policies advocated by the West.

Overholt feels the events of the last several years have vindicated his thesis. He continues to be bullish on the outlook for Chinese reform, especially in comparison to Japan’s recent unsuccessful efforts to stabilize its rapidly deteriorating economy. His viewpoint stems from a number of years spent in Asia, including three years from 1998 to 2001 as head of strategy and economics at Nomura’s regional headquarters in Hong Kong. Prior to that he was managing director and head of research at Bank Boston’s regional headquarters in Singapore. He also spent 18 years at Bankers Trust, managing a country risk team in New York from 1980 to 1984 and then serving as regional strategist and Asia research head based in Hong Kong.

On April 22, Overholt will speak at a conference on “The Future of Chinese Management,” to be held at Wharton’s new location in San Francisco, Wharton West. His topic: “Economic Reform in China and Japan: Does China Lead in Creating a Market Economy?”

Below, Knowledge at Wharton asked Overholt for his views on Chinese and Japanese efforts to reform their respective economies.

Knowledge at Wharton: How would you answer the question posed in the title of your upcoming speech? Does China in fact lead in creating a market economy?

Overholt: Japan provides an example of how not to bring about reform. China provides an example of how you can reform vigorously and still keep your economy growing.

China is addressing the problems created by the socialist banks, the state-owned enterprises and the dislocations caused by 55 million layoffs, and it is moving from an export-driven economy to a domestic-driven economy, something we have been urging on the Japanese since 1979 but which they have failed to do. The fact that China has done this means it can grow 7% a year while everyone else is in a recession. And it means the country has created a very entrepreneurial environment in what was once one of the most bureaucratic societies in the world.

China has also led in opening up its economy; trade is 44% of GDP while it is only 15% of Japan’s GDP. China has been less nationalistic and more open to foreign direct investment. In the 1990s Japan received $39 billion in foreign investment; China received $309 billion.

China has taken the lead in globalizing its elite education and its institutions. It is sending tens of thousands of students abroad, especially to the U.S. It is doing what Japan did in the early Meiji era – reaching out to foreign countries for models of success. It is reaching out to the U.S. for a model of how to run a central bank, to Hong Kong and Britain for models of securities regulations and to Taiwan for a model of how to regulate foreign portfolio investment. It is putting very experienced people from Hong Kong into senior positions running Chinese financial markets.

Having said all that, it’s important to remember that there are two issues to consider here. One is how deep a hole you are in and the other is how fast you dig yourself out of it. China is in about as deep a hole as anybody but it is digging itself out faster than anyone else. Your growth rate is a measure of how fast you are digging. So in China, yes, the state enterprises are extremely inefficient, the banks are still in worse shape than Japan’s, and the people are still quite poor. But when you combine the entrepreneurial non-state economy with attempts to reform state enterprises, you get rapid growth and progress towards a market economy.

Knowledge at Wharton: How do you define ‘market economy’?

Overholt: A market economy is one where the structure, and the winners and the losers, are primarily driven by market forces and where the institutions and attitudes are in place to make that possible. China does have major problems but the market in fact rules in a remarkably large portion of the Chinese economy. The state sector is actually quite small. The percentage of socialist ownership is less than one-third whereas it is up to half in some western European countries.

The Chinese and the Japanese both face the problem of overregulation of business in general. China, however, once had 10 administrative ministerial bureaus running the economy. It chopped that down to one. In Japan, that kind of change is almost impossible.

Knowledge at Wharton: What in your opinion are the major obstacles to reform in Japan?

Overholt: Japan’s biggest problems are government allocation of capital and the rigid labor market, which means that the country’s best labor and much of its capital are substantially wasted.

Japan’s economy is at war with itself. The country has a trillion dollars of capital tied up in dead companies and another trillion tied up in moribund companies. The government tells the banks not to allow these enterprises to go bankrupt, which means that capital is not available to modern successful entrepreneurial companies. So the whole capital allocation system, the banking system, is essentially dead.

On top of that you have workers bound up in lifetime employment which has become a prison for highly talented and skilled people. Even if they want to make a move, they can’t.

Another area in which China has moved ahead of Japan is the connection between business and government. China skeptics always said China would never be able to reform because the Communist Party depends for its power on the state enterprises. But the extraordinary reforms underway, including a decline of 55 million in state and collective enterprise employment, show that in fact the Communist party leaders realized that if they clung to old practices they would go the way of the Soviet party. In Japan, however, different parts of the Liberal Democratic Party are effectively owned by the construction, property, banking and retail sectors – they are referred to as ‘tribes’ – which do extremely well as long as their sectors are not reformed. There isn’t the kind of distance between politics and business that is required.

Japan has more wealth, a well-educated society, higher levels of technology and more connections to the global marketplace – all the things that you need to succeed. China in general doesn’t have these things. But China is managing itself better, so it grows even while the rest of the region is in recession.

Having said that, however, it is important to add that the Chinese are in such a deep hole that the minimum standard of survival is heroic leadership. If they go even a couple of years without dramatic reform they are in serious trouble. So there are still risks. They are certainly not out of the woods. But the current leadership in China is probably as good in the economic arena as any we have seen anywhere in the world in the last century. There is a management change coming at the end of this year, with the prime minister and president planning to step down and new leaders being announced by early 2003. Their attitudes seem to be reformist, and in general the younger leaders are much more reformist than the older ones. But we will have to see whether they have the authority and the courage to continue with such painful political reforms.

Knowledge at Wharton: What about the resistance to change that one hears about among Chinese who are heavily invested in the current system?

Overholt: Yes, there is resistance but that is true in all economies. In China the difference is that top management is determined to bring about change. And that means that some people lose out. But even those who have lost their jobs are benefiting from a more entrepreneurial society. The government is being cut in half, from eight million workers to four million. At the central government level it’s hard to find people who haven’t come out ahead after losing their jobs. With the exception of less skilled workers at the provincial and lower government levels, most people seem to be making more money than before. The layoffs have made possible big wage increases for the remaining government employees.

Knowledge at Wharton: Are they making more money legitimately or are they engaging in the widespread corruption that one reads about in China?

Overholt: Corruption is certainly a big concern of Western companies doing business in China. And it is shocking how omnipresent it is. It’s even shocking to the Chinese students who return home after studying in the U.S. They become idealistic here and then they go back and find that if you are going to do business you must do a lot of it under the table.

But what has saved China so far is two things. First, the very top leaders have been honest, including Mao Tse-tung, Deng Xiaoping, Zhu Rongji and Jiang Zemin. They have acted in the national interest as they saw it, albeit from a very misguided view in the case of Mao. Their primary concern has been to go down in the history books in a positive way rather than to make a lot of money. That is very different from the pattern in the Philippines or most of Latin America, where the central purpose of seeking high political office is usually to get rich. Second, the leaders have continually created more and more competition and that has increased efficiency and decreased margins available for corruption. So for example, you go from one regional airline in China to 31. They compete at the margins, and every one of the 31 is much better and more efficient than the original one.

Knowledge at Wharton: What are China’s strongest industries?

Overholt: Certainly consumer products would be one. Basically it’s the labor intensive industries where China has the competitive advantage and the highest degree of foreign investment and foreign management. Nobody can compete with them in clothing, bicycles, toys, even appliances. China could pretty much clothe the whole human race, at good prices. Haier now produces half of the number of appliances that GE produces.

Knowledge at Wharton: What will be the impact of China’s recent accession into the World Trade Organization?

Overholt: Clearly no other country in the world would have accepted the kinds of conditions that China has accepted in order to be a WTO member. And certainly there is no other country in the world that is aspiring to meet those conditions in such a short time. But for all the rigor, it won’t require as rapid change as the country has experienced in the last five years. So it’s a question of whether the momentum can be sustained. The current leaders have been trying to lock in a set of commitments that will force their successors to continue the pace of reform. WTO is the primary mechanism for that. Again, success or failure comes down to the qualities of the new leadership.

Knowledge at Wharton: One of the concerns voiced by foreign companies interested in doing business with China is the rampant piracy of software, videos, designer labels, etc. that seems to occur without attempts by the Chinese government to stop it. How serious is this?

Overholt: Piracy is a huge problem. And it will be huge for the indefinite future. The good news is that the Chinese government has accepted the idea of intellectual property in a way that places like Thailand and India have not. This is because China has a lot of intellectual property of its own, most notably in herbal medicines, mountain waters, local brews and so forth, but increasingly in widgets and software as well. The country now registers substantially more trademarks every year than anyone else in the world. An example: The government recently decided to stop using pirated software because they realized that the whole Chinese software industry would go from big losses to significant profits if the government bought the industry’s own products. As in other areas, China is in a deep hole, but has accepted the need to dig itself out and is digging more vigorously than its neighbors.

Knowledge at Wharton: How does the large number of family-owned businesses affect the economic climate in China? Is there such a thing as corporate governance?

Overholt: Family businesses in China are both good and bad. Because the Chinese system tends to be very family oriented, it is also very fractious. This can make it hard to create large, impersonal institutions but it leads to a highly competitive economy of the kind that Americans understand very well. In many ways, the Chinese system – where you are dealing with a family business – is much closer to the Western system, in which businesses frequently start out under family control and then evolve, than it is with the Japanese system where much more of the economy is dominated by vast keiretsu and by government administrative guidance.

Corporate governance is a huge issue in all of Asia. I was at a forum recently where some participants discussed the results of a survey on corporate governance and specifically the independence of boards of directors. The U.S. got 6.5 points out of 10. Germany and France got 3 or 4. Japan got zero. China wasn’t scored but I’m confident that China would have been zero also. Japan is actually far ahead of China in this area, so China should probably have a negative number.

The ‘personalism’ of both China’s corporate governance and its government governance is one of China’s greatest weaknesses. Your taxes depend on whether the tax bureau chief likes you. Judges interpret the law very personally and often can’t enforce their judgments. The government holds a majority share in most listed companies and therefore a lot more attention is paid to political whims than to shareholder interests. Beijing knows it has to fix this, but efforts are still just beginning.

Knowledge at Wharton: Did President Bush’s trip to China earlier this month result in any new understanding or new initiatives that you feel will hasten China’s efforts at market reform?

Overholt: Bush’s visit to China focused almost exclusively on security issues, including the terrorist war. Only in Japan did he focus on economic reform. In retrospect it is interesting that he didn’t feel it was necessary to harangue the Chinese about economic reform and WTO compliance.