What conclusions about China can an American professor draw who has closely watched the country grow and prosper in recent years? One is that China has largely completed the first transition from a command to a market economy and is now inching toward a second transition, which involves building national rather than regional markets. In a recent speech during a tour to celebrate Wharton’s 125th anniversary, Wharton management professor Marshall Meyer shared his insights on China’s economy. Among other topics, he examined China’s beer industry and container business, and offered advice to Chinese companies that are building domestic markets on the way to going global. He offered suggestions for Chinese policy makers as well.
An edited version of his speech appears below.
The title of my speech is China’s second economic transition …. The transition from regional to national markets, I believe, is imperative so that firms capable of competing nationally and ultimately developing into global players can emerge. This second transition may prove more challenging than the first because localism is deeply engrained in China. However, I believe that the success of this second transition will be critical to China’s long-term economic vitality. Today China is one country but many economies. Witness the difficulty the central government has had moderating economic growth. Going forward, the capacity of Chinese firms to compete globally will depend on creating a single market and a single economy at home.
China decentralized much of its economy save for pillar enterprises by the early 1980s. Under the policy of administrative decentralization, control — though not ownership — of the great majority of state enterprises was transferred to provincial and local authorities and in some instances to enterprise managers. The decentralization of the economy gave China an enormous advantage in the 1990s because it allowed economic reform to proceed swiftly on the local level.
Local governments rather than the central government initiated most reforms. Reform initiatives were experimental. What worked was adopted by the central government as national policy and what didn’t work was abandoned. The decentralized and experimental approach to reform was in sharp contrast to the “big bang” or “shock therapy” approach taken in the former Soviet Union that promised instant reform but produced mainly asset-stripping, concentration of control of the economy in a handful of oligarchs, and a sharp economic downturn.
The downside of administrative decentralization and, later, decentralized reform of enterprises, was that China evolved into several regional economies rather than one. The Pearl River delta (eastern Guangdong Province), The Yangtze River delta (Shanghai, southern Jiangsu Province, Zhejiang Province), and the Bohai Bay region (extending in an arc from Qingdao to Dalian, including Tianjin and, of course, Beijing) became the hot spots of the Chinese economy. Provinces competed for GDP growth and erected barriers to inter-provincial trade. Shanghai, for example, practiced import substitution. Automotive components manufactured outside of Shanghai were treated as foreign-made and taxed as imports.
The combination of local GDP targets and local protectionism meant that the provinces replicated each others’ economies, miniaturizing firms and sacrificing comparative advantage. During the Mao era, when China felt surrounded by enemies, local self-sufficiency was a matter of national security. Today, national security is less of a motif but economic fragmentation persists and, perhaps, has accelerated.
Several econometric studies confirm that fragmentation of the Chinese economy increased during the 1990s. For example, Alwyn Young, an economics professor at the University of Chicago Graduate School of Business, found a convergence in the proportions of provincial GDP accounted for by industry, agriculture and services, and a divergence in labor productivity and prices across provinces from the late 1970s to the mid-1990s. Young’s results are exactly the opposite of what would be expected if national economic integration and regional specialization had occurred and are most likely due to an exacerbation of internal trade barriers.
Sandra Poncet’s comparison of domestic with international trade flows of Chinese provinces from 1987 to 1997 came to a further and somewhat surprising conclusion: As Chinese provinces became more integrated with the rest of the world, they became less integrated with each other. “Chinese provinces’ international integration has gone together with domestic market disintegration.” The implication is that Chinese firms look to foreign markets because of the difficulty of doing business domestically. Poncet is an economics professor at the Panthéon-Sorbonne-Economie and Paris School of Economics, Université Paris 1. James Kynge, former Beijing bureau chief for the Financial Times, in his new book China Shakes the World argues just that. According to Kynge, “Chinese manufacturers (the energy and resources companies are in a separate category) are being pushed overseas through weakness rather than strength.”
Government policy favors companies that look large. However, looking large and acting like a large, integrated firm are different things. Some of the largest SOEs in China that remain 100% state-owned and retain 100% ownership of their subsidiaries continue to have difficulty controlling, much less coordinating, their subsidiaries. I know of one group corporation where a proposal to consolidate several 100% group-owned subsidiaries triggered a worker “incident” – a riot — following which top management backed off. Worker recalcitrance arises from the peculiar definition of state ownership, “ownership by the whole people,” which leaves property rights ambiguous.
A Look at the Chinese Beer Industry
Domestic M&A also remains challenging. On July 26, 2001, I met with Tsingtao Beer senior economist, vice chairman and general manager Peng Zouyi. Peng outlined his strategy for consolidation of the Chinese beer industry. Financed by secondary offerings, Tsingtao acquired 45 subsidiaries and raised its domestic market share from 5% in 1999 to 13% in 2001 to become the top selling beer in China. Within three to five years, Peng predicted, Tsingtao would make more acquisitions and consolidate the domestic beer market with 30% to 40% market share. Tragically, Peng died five days later. Within a year, Anheuser-Busch raised its stake in Tsingtao from 4.5% to 27%. Despite the additional Anheuser-Busch investment in Tsingtao, Tsingtao’s market share has stalled at 13% to 14%. Last month, SABMiller, which holds a 49% interest in China Resources Breweries announced that its CR Snow brand captured 14.9% of the Chinese market in the first half of 2006, fractionally ahead of Tsingtao.
It is possible that new regulations governing on cross-border M&A will have the indirect consequence of stimulating domestic M&A by creating local demand for M&A consultants. The amended cross-border M&A regulations, which took effect September 6, 2006, require foreign acquirers to engage a PRC registered M&A consultant, which will conduct due diligence on the foreign shares and issue a consulting report for review and examination by the approval authorities. The regulations add further complexity by requiring national economic security to be considered and imposing restrictions on “round-tripping.”
While the Chinese beer industry remains fragmented nationally, it is highly concentrated locally. According to John Slocum and his colleagues in a recent Organizational Dynamics article — aptly titled, “Fermentation in the China Beer Industry” — the top three brands in Shanghai, Beijing, and Guangdong province command 56, 77, and 73% market shares respectively. The number one brand in most localities is a local brand, e.g., Yanjing in Beijing, Tsingtao in Shandong province, Zhujiang in Guangdong province. The exception is Shanghai, where Suntory appears to be the leader.
National fragmentation in conjunction with local concentration is a near certain indication that Chinese markets are local rather than national, reminiscent of the U.S. beer industry in the 1950s and the U.S. supermarket industry in the mid-1980s. The localism of Chinese markets is captured in an October 23 Wall Street Journal story about Walmart’s acquisition of Trustmart. The headline reads, “Retail’s One-China Problem.” “Nobody has a national footprint yet” according to Euromonitor retail analyst Yang Fan. Wumart founder Zhang Wenchong put it even more bluntly: “There is no one China market.”
Fragmentation of domestic markets is of concern because of its impact on the globalization potential of Chinese firms. Put somewhat differently, can China launch firms strong enough to withstand global competition from relatively small domestic platforms? Our received theories of internationalization suggest that this will be difficult. Generally, internationalization is a large-firm phenomenon. National champions are almost always large firms that have integrated and consolidated their industries in preparation for going abroad. MITI, for example, encouraged domestic competition but then forced industry consolidation before permitting Japanese firms to invest abroad. A similar model has also appealed to France, which has applied it to firms like EDF, France Telecom, Total, Elf, EADS.
Government support, however, is not necessary for industry consolidation and internationalization. Product pioneers like Microsoft enjoy scale economies in R&D, manufacturing, and distribution; entry barriers created by a panoply of patents, trademarks, and brand names; and managerial capabilities smaller rivals are unable to duplicate. By contrast, the thin margins characteristic of highly competitive industries usually cannot sustain the costs of international operations. Moreover, the kinds of market imperfections allowing firms to extend their operations abroad are usually mitigated by intense competition.
The Container Shipping Industry and CIMC
Some Chinese firms have been able to leapfrog fragmented domestic markets and grow into global competitors. A case on point is China International Marine Container or CIMC, a Shenzhen-based manufacturer of shipping containers and semi-trailers. CIMC as far as I know — an important qualification — is the only sizeable Chinese firm to have achieved global dominance in its industry. CIMC manufactures more than half of the shipping containers in the world. And CIMC will soon achieve dominant market share of the Chinese semi-trailer business, though whether they can achieve global dominance in semi-trailers is still an open question. CIMC has very capable management. But CIMC also happened to be in the right industry at the right time.
There are two new books on container shipping, both published by university presses in the U.S. One is Marc Levinson’s The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger; the other is Brian Cudahy’s Box Boats: How Container Ships Changed the World. I take away three main points from these books. First, the cost of ocean shipping plunged by more than half from the late 1970s to the mid-1980s due to containerization, opening the floodgates of global trade. Second, China is the chief beneficiary of cheap shipping. In 2003, for example, 42.9 million TEUs (twenty-foot equivalent units) of containers passed through China’s three largest container ports, Hong Kong, Shanghai, and Shenzhen. The three major U.S. container ports, Los Angeles, Long Beach, and New York, by contrast, processed 15.1 TEUs in 2003. Third, despite the efficiencies of containerization, it took more than a decade, from the mid-1950s until almost 1970, for the International Standards Association and, subsequently, the shipping industry, to establish 20- and 40-foot containers as global standards.
CIMC entered the container business in the 1990s with three distinct advantages. One was industry standardization. There were no local tastes in containers, making container manufacturing a global industry from the outset. The second was a large domestic market. China was the global hub of container shipping and hence the largest market for shipping containers. The third advantage was logistics. Mai Boliang, CIMC’s president, understood that by integrating container manufacturing along the Chinese coast, from Dalian in the north to Xinhui in the south, he could deliver containers to customers when and where they needed them at costs substantially below competitors manufacturing in a single location.
CIMC’s dominance of the shipping container industry raises the question of whether the same formula — standardization, a large domestic market, and favorable logistics costs — would strengthen other industries in China. To return to the case of CIMC briefly, would not national standards for semi-trailers aid CIMC’s efforts to consolidate the semi-trailer business domestically and, ultimately, internationally? Would not concerted efforts to reduce logistics costs — now 18.5% of GDP in comparison with about 10% in the U.S. — promote growth and consolidation and hence internationalization of many Chinese industries? Karl Marx and John D. Rockefeller agreed on one thing: Fragmented, hypercompetitive markets are not sustainable. Marx called this “the anarchy of production.” Rockefeller complained about “ruinous competition.” Both had a point, even though the cures they proposed – that Rockefeller actually imposed on the petroleum industry — were quite different.
Advice for Firms and Policy Makers
What can firms do to build domestic markets and hence their globalization potential? The most important step, I believe, is to ask what investors want. Most of all, investors want to see a business plan answering some fundamental questions rather than a plan full of lofty aspirations. For example: Do you have a strategy to build a national brand, not just a sales plan? Do you have a strategy to build a domestic platform strong enough to support internationalization? Remember that that whether or not received internationalization theory — you must occupy domestic space before going out — is true, your investors believe it is true. Do you have a strategy for corporate governance that will focus the firm on sustainable competitive advantage rather than short-term profitability?
There will also be some challenges for the government, both domestic and international. The domestic challenge will be to take measures promoting national standards, national markets and reduced logistics costs. Many such measures can be imagined ranging from nationwide trucking licenses to elimination of official tax receipts to a Chinese counterpart to the Commerce Clause of the U.S. Constitution, which specifically reserves to the federal government — rather than the states — the power to regulate interstate commerce. Fundamentally, I’m talking about changing the rules of the game rather than building more highways and ports, about software rather than hardware engineering.
Such software engineering should proceed carefully, however. As Douglass North pointed out in his 1994 Nobel address, changing the rules — altering institutions — is not easy because formal rules, informal norms, and enforcement mechanisms must move in tandem, which is not characteristic of a system as complicated and decentralized as China. As a consequence, “transferring the formal political and economic rules of successful Western market economies to third-world and Eastern European economies is not a sufficient condition for good economic performance. Privatization is not a panacea.” What is important is flexibility, the capacity to learn, what North calls adaptive as distinct from allocative efficiency.
The international challenge will be to persuade the global community that a strong Chinese do