Why China Can’t Create Anything
16 minute read
Michael Schuman / Shanghai
November 18, 2013 12:00 AM EST
Is China an unbeatable industrial juggernaut that will steamroll the U.S., stealing our jobs and depressing our wages in its relentless quest for wealth and power?

Or is it the world’s biggest opportunity for U.S. corporations, a honeypot that will enrich our firms and make us more prosperous as a result? Those are arguably the two biggest questions in the global economy right now. With the U.S. growing at a sluggish 2.5% and Europe doing even worse, all eyes are on China as the world’s growth engine. In the mere 30 years since its communist leadership exchanged Maoist rhetoric for good old capitalism–or what it calls “socialism with Chinese characteristics”–China has become the world’s second largest economy and the chief rival of the U.S. for global dominance. China’s 1.3 billion upwardly mobile people are voracious consumers of everything from cars to smartphones to Kentucky Fried Chicken. Through its relentless exports, China has amassed a mountain of cash reserves and made itself Washington’s biggest foreign creditor.

However, the country that vacuumed up factories to become the Workshop of the World is fading into history. China is a victim of its own success. Decades of nonstop growth have forever altered its place in the global economy and changed how it must compete with rich nations like the U.S. and emerging economies like India. The tools that China has used to spark its economic miracle–government support, cheap labor, state-directed finance–cannot ensure its future. The country can no longer rely on just making lots of stuff; China has to invent things, design them, brand them and market them. Instead of following the leaders of global industry, China has to produce leaders of its own.

Such a transition is not easy. Few emerging nations in modern times have made the leap from assembler to inventor, copycat to innovator. For China, this would mean an overhaul of its economy. Many of the products China manufactures today aren’t really Chinese at all. Apple iPads might be exported from assembly lines based in China, but the Chinese themselves do little more than piece them together. The core technologies come from elsewhere, and even the factories are run by foreign firms (like Taiwan’s Foxconn). For Chinese companies to compete with the world’s best, they will have to create products of their own that have an impact similar to the iPad’s. That requires a set of skills and know-how they don’t yet possess and a level of managerial expertise they haven’t yet developed. Economist William Janeway, author of the book Doing Capitalism in the Innovation Economy, says what has gotten China this far won’t be enough for the next step: “It is hard to start the process of pushing the frontier with [such] practices and policies.”

Chinese policymakers fully realize that. The new leadership team in Beijing, ushered into office a year ago, has pledged to press ahead with free-market reforms–liberalizing finance, supporting private enterprise and cracking open protected sectors. “China’s modernization will not be accomplished without reform, nor will it be achieved without opening up,” Premier Li Keqiang recently conceded. So far, though, progress has been slow. Few meaningful initiatives have been introduced, and even headline-grabbing measures–like the September launch of a special zone in Shanghai to experiment with freer capital flows–have proved mere baby steps. Li and his mandarins must take on vested interests and rein in an overbearing bureaucracy, which will require formidable political will. China’s leadership “is not ready yet to deliver a comprehensive reform package with executable specifics and clear timetables,” Bank of America Merrill Lynch economists warned in October.

Whether China succeeds or fails will determine where everything from sneakers to cars to smartphones are manufactured, the brands that appear on them and who sells them. Failure could stall China’s economic miracle and dampen global growth with it. Here are five challenges China must address:

LABOR IS NO LONGER CHEAP.

In June, Chip Starnes made a fateful decision. The co-founder of Florida-based Specialty Medical Supplies, which makes alcohol pads, lancing devices and other health care products, decided to shift his plastics manufacturing from the company’s Beijing factory to India. As he finalized severance packages for the 34 workers he had to lay off, the remaining 110 employees revolted. First they demanded payouts of their own and blocked efforts to pack the equipment bound for India. Then, when a rumor spread that Starnes intended to close down the entire Beijing operation, the workers held the American hostage in his office for six days.

China’s workers may not like it, but what they faced at Starnes’ factory will become more common. China launched its economic ascent by tossing its giant, impoverished workforce into the global supply chain. Labor was so cheap and plentiful that few other countries could match it. But with the population aging rapidly, thanks to the government’s one-child policy the workforce is shrinking, and the abundance of opportunities in the fast-growing economy has made monotonous assembly-line work less appealing. As a result, wages are skyrocketing. Starnes says that over the past 10 years, the cost of a worker in his factory quintupled to $500 a month, and even with that increase, he couldn’t find enough staff to fill his needs. By contrast, in Mumbai, where his new facility is based, workers are 75% cheaper and far more plentiful.

The competition for talent is so fierce in China that all sorts of employees earn well above what their counterparts in other emerging economies receive. According to data collected on median salaries by consulting firm Mercer, a machine operator earns $6,405 and a skilled secretary $11,213 in Beijing, significantly more than the $4,817 and $7,809, respectively, in India. “Companies have gone to China to find cheap labor, but it isn’t there anymore,” Starnes says. “Now you are forced to look elsewhere.”

Rising costs are even making China less competitive compared with the U.S. The decision to offshore production to China was once almost automatic for American executives–high costs in the U.S. made staying almost impossible. But that is no longer true. Boston Consulting Group (BCG) figures that, taking into account rising wages, labor productivity and other factors, the cost of manufacturing in China will roughly equal that in the U.S. by 2015. No wonder a BCG survey of large U.S. manufacturers, released in September, showed that 21% of the respondents were either actively bringing production back to America from China–a process known as reshoring–or planning to do so over the next two years.

Michael Araten, president of toymaker K’NEX, began reshoring in 2009 to preserve jobs at his Hatfield, Pa., factory during the Great Recession. Examining the operations, Araten came to realize that manufacturing in China was not as efficient as the firm had believed. There was what he calls the China handicap–the added burden of large inventories, inflexible supply chains and missed market opportunities caused by long-distance production. By investing in automation, K’NEX has been able to return almost all of its parts production and most of its finished-product assembly back to Hatfield while maintaining profitability. “China is at an inflection point,” says Araten. “The world inverted over the past 30 years and China benefited. Now it is inverting again, and America is the beneficiary.”

Not just foreign companies are looking to ship out. Last year, footwear maker Huajian, based in the southern industrial town of Dongguan, invested $15 million for a factory in Ethiopia, attracted by wages one-eighth of those in its Chinese plants. Over the next five years, Huajian plans to expand its workforce in the African nation from 2,800 employees to 30,000. Huajian chairman Zhang Huarong believes Chinese shoemakers need to do more than compete on cost to ensure China’s future in the industry–they must focus on R&D and improving productivity. “Before, the model was to follow the cheap labor, but now Chinese companies should change their attitude,” he says.

COMPANIES LAG BEHIND IN TECHNOLOGY.

Some Chinese companies, most notably telecom-equipment maker Huawei, are globally competitive. But they are rare. Most lag behind in critical technology. Ask Li Shufu, founder of Hangzhou-based Geely. In 2006, Geely made history by becoming the first Chinese automaker to display a model at the North American International Auto Show in Detroit. Back then, the hard-charging Li had a grand plan to export his small sedans to U.S. consumers. That never happened. Li wisely decided his cars simply weren’t ready to compete in the tough American market. “Geely needs to improve in many aspects: skills, quality, maintenance, management,” he admits.

Li could be speaking for his entire industry. China has dreams of becoming a rival to the U.S. and Japan in car manufacturing, but despite bottomless investment and state protection, the country’s carmakers have not been able to compete head-to-head with foreign players. At home, international brands like Chevy, Volkswagen and Hyundai dominate 70% of the passenger-car market, according to research firm LMC Automotive. Overseas, Chinese exports are often driven by price-conscious consumers in poor nations. Geely and other Chinese carmakers have desperately been trying to improve by investing heavily in R&D and automation, and they are making progress. But the most recent quality survey from the market-research firm J.D. Power shows Chinese-branded cars still suffer 49% more initial defects and other problems than international ones sold in China. “Putting together long-lasting, world-tested products–it takes years,” says Kevin Wale, former president of GM in China. Chinese carmakers “are still going through a learning phase.”

Even when Chinese firms work hard to catch up, they find their foreign rivals haven’t stood still waiting for them. Shipbuilding, an industry targeted by the state as strategic, added tremendous capacity over the past decade, and China overtook South Korea as the world’s largest producer of vessels. But Chinese yards generally export ships of older, simpler design that command lower prices, while the Koreans have advanced into more expensive, technologically superior products like supersize container ships and sophisticated drilling vessels for the energy industry. “The Koreans are much more mature in R&D and quality,” says Natalie Burrows, an analyst at London-based Clarksons Research. “They are streaks ahead” of the Chinese.

INNOVATION DOESN’T COME EASY.

There are clearly innovative firms in China. Shenzhen-based Tencent is well known for its creative Internet and mobile services, typified by its wildly popular messaging system, WeChat. Xiaomi has become a competitor to Apple in China with its low-cost smartphones–even though it is a mere three years old. However, the innovation that takes place in China tends to build upon existing technology, not generate revolutionary ideas. In a recent KPMG report, 37% of the technology executives surveyed believed that the U.S. holds the most promise for producing disruptive technologies over the next four years, while only 24% thought China does. China hasn’t developed the track record or financial networks to support the sort of speculative research that can spawn big-time innovation but often takes years to bear fruit. Jeff Richards, a partner at GGV Capital, a venture-capital firm with operations in both Shanghai and Menlo Park, Calif., says Silicon Valley has a clear edge: “It has an advantage in that it has an ecosystem to make big breakthroughs.”

While Silicon Valley is unique–many countries, from Malaysia to Russia, are trying to create their own, with limited success–China will at least need to come close to matching American innovative prowess if it intends to compete with the U.S. in the decades to come. That will require intensive reform of its financial system, so it more effectively supports private enterprise; of its regulatory environment, to better protect intellectual property; and of its exam-obsessed education system. China’s schools may excel at infusing students with strong skills, but they have been widely criticized for failing to foster the creative thinking crucial to innovative research. Even former Premier Wen Jiabao complained that “students don’t only need knowledge; they have to learn how to act, to use their brains.”

That forces corporate managers to lure Chinese engineers out of their shells. When Rameshbabu Songukrishnasamy became general manager of Honeywell’s R&D centers in Shanghai and Beijing in 2011, he was surprised to find his engineers weren’t tinkering on their own projects. “They were happy just doing what they were asked to do,” he says. The problem, he determined, was that they were too worried the company would be angry if their experiments flopped. “A fear of failure is part of the culture,” he says. To change that, Songukrishnasamy instituted a program in which he provides funding for personal initiatives while making it clear there is no pressure to transform them into business results. He also started workshops with role-playing and other methods to try to enhance their critical thinking. The tactics worked: his 1,500 researchers are generating more patents. Some Chinese engineers “tend to shy away from critical questioning,” says Songukrishnasamy, but that process “is fundamental to R&D. The reason they are able to make so much innovation in Silicon Valley is that people question the status quo and find alternative ways.”

THERE ARE TOO FEW GLOBAL BRANDS.

Though the Chinese manufacture a lot of stuff, only a handful of firms–PC giant Lenovo, and perhaps appliance maker Haier–have internationally recognized consumer brands. Those bold enough to try have sometimes struggled. Chinese sportswear maker Li Ning, for instance, has spent heavily to promote its brand and challenge behemoths Nike and Adidas, even hiring NBA superstar Dwyane Wade last year to market a line of sneakers and apparel. But the Beijing firm has failed to lure international shoppers. Sales in the first six months of 2013 plunged nearly 25%. Li Ning’s problem, as with other Chinese firms, is that its management “has just gone through the motions of their competitors,” says P.T. Black, a consumer strategist in Shanghai. Chinese executives are too fixated on their production and not enough on their customers to make progress on branding, he says. “There is a general weakness in what I call the humanities–an honest, committed interest in other people,” he says. “If you don’t consider your customer as the reason for doing things, you’re in trouble when building a brand.”

Zhou Chengjian, founder of Shanghai-based apparel retailer Meters/bonwe, is trying to learn from his compatriots’ mistakes. The former tailor has constructed a retailing empire in China of about 5,000 stores selling casual jeans and shirts. But even though he has taken stabs at introducing his brand to a global audience–placing a Meters/bonwe T-shirt on Shia LaBeouf’s character in the last Transformers movie–he hasn’t rushed to expand outside the country. The reason, he says, is that his brand isn’t strong enough yet. “Having money and being audacious doesn’t make you ready to compete in the international market,” Zhou says. He is experimenting now with refashioning his brand from simply a label on basic clothes to a name that encapsulates a lifestyle steeped in Chinese tradition. To promote the new image, Meters/bonwe is launching a chain of redesigned flagship stores around the country–one, in Hangzhou, has been crafted to look like an old Chinese train station. After honing the concept in China, Zhou plans to go global, opening stores in New York City, London and Tokyo over the next three years. “By combining a Chinese way of life with international methods, we can be unique and competitive,” he says.

That will be a tall order. Even at home, Meters/bonwe and other Chinese retailers are being seriously tested in major cities by rapidly expanding foreign competitors like Zara, H&M and Uniqlo. Says Zhou: “Chinese people look up to the international brands because they think they are better than the local brands.”

GOOD MANAGERS ARE HARD TO FIND.

Fixing all these problems will take some nimble corporate management. Though there are some exceptional entrepreneurs and executives in China, finding talent to fill the needs of all the rapidly expanding businesses in the country has become a major headache. A recent survey conducted by the European Chamber of Commerce in China found that the scarcity of qualified workers is the No. 1 human-resource challenge facing its members. Those few who are qualified can command juicy paychecks. The median salary for an upper-middle manager in Beijing rose to over $105,000 in 2012, already more than two-thirds the level in the U.S., according to Mercer.

The dearth of capable managers, says Bob Boyce, CEO of Shanghai-based Blue Horizon Hospitality Group, “is the biggest thing holding our business back.” Since almost none of his 800 employees had relevant experience when they joined the restaurant chain, Boyce has had to train his managers from scratch, intensively immersing promising staffers in different aspects of the business and carefully moving them up into more senior positions. Some, he says, turn into top-notch managers. But he has had to implement measures that probably wouldn’t be necessary in the U.S. Responsibilities are broken up into narrowly defined slivers among numerous managers–one monitors the kitchen, another oversees the waiters, yet another the facilities. Boyce has designed detailed checklists and procedures on everything from how a waiter should interact with customers to personal hygiene to food preparation, all carefully monitored by a general manager. To compensate for such green management, Boyce staffs his restaurants with some 30% more people than a similar one in the U.S. “Without proper managers, everything has to be overengineered,” Boyce says.

Despite these challenges, don’t count China out. It has routinely silenced naysayers and defied gloom-and-doom predictions. The economy, even amid a current slowdown, has remained enviably robust, expanding by 7.8% in the third quarter. And a major slate of reforms may be unveiled at a Communist Party plenum in November. Yet transforming a fractious developing country of such gargantuan size into an economically advanced nation has simply never been done before. “You’ve got 50 years of business innovation in the U.S. trying to happen here in 10 years,” says GGV’s Richards. That may be too much to ask of any country, even China.