Myths and necessary adjustments in the “New China”

Guest Article by Dr. Timo Wiegmann (TMG China)

THE “NEW NORMAL” IN CHINA IS FORCING FOREIGN COMPANIES TO RETHINK AND ADAPT TO NOTICEABLY CHANGING CIRCUMSTANCES

Dr-Timo-Wiegmann

Dr. Timo Wiegmann

For companies in the manufacturing industry, China has become over the past three decades an increasingly important production footprint. Initially, the goal was purely to exploit the huge reservoir of cheap Chinese labor in order to produce cost-effectively for the world market. Today, entirely different topics are for most companies on their China-Agenda. The goal: to strengthen their own competitiveness in China and to be locally successful with products and services specially tailored to the Chinese market. With the announcement of the “Made in China 2025” strategy, the Chinese government has now set a clear indication of the future environment and the resultant requirements for the China-Engagement of foreign companies in the coming years: significantly reduced growth rates and an economy that shall be especially stimulate by domestic consumption, sustainability, innovation and a consistent high-tech orientation. For manufacturing companies, this realignment provides a multitude of new growth potential that should be exploited.
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Whenever the Media reports about the Chinese economy in recent weeks and months, it would usually be done in a way that the reader could almost inevitably get only one single impression: China is having serious problems.

It is correct, that the gross domestic product (GDP) of the second largest economy in the world is currently growing slower than it has been in the last 25 years. The country can today only fulfill contigently it’s in recent years determined role as the global growth engine. Foreign trade is weakening. The debt has reached a dimension with most recent 28 billion US dollars which corresponds to almost three times of its own economic performance. In addition to that, mid of 2015 turbulences on the stock market came on top with falling stock prices up to 40 percent within a few weeks – with the result that a market value worth about four billion US dollars have been lost.

Well, should we be genuinely worried about the second largest economy in the world?

In our view, definitely not. Most of what is being commonly spread to the public about the Chinese economy and its future outlook is based on a number of prejudices:

Myth 1: The prospects of the Chinese economy are gloomy and the country is facing a longer period of stagnation.

It is true that China has abandoned the double-digit growth rates of the past. The overall economic performance shall probably rise this year by nearly seven percent. For the upcoming years, economic growth in a range between five and seven percent is expected from today’s perspective. Designating this development as “a long period of stagnation” is absurd, at least on totally unsubstantiated grounds especially if one considers the growth rates we talk about in Germany, Europe and the US.

Today’s growth of around seven percent generate a higher economic output than the fourteen percent from the year 20071 because the economic performance is today many times higher than at that time. This is pure mathematics. It is also interesting to note in this context, that the current decline in overall economic growth rate is accompanied by an increase in the growth rate in the service sector by more than eight percent (8.4 percent). Private consumption lay in the first half of 2015 by more than 10 percent (10.4).2 Perspectively, this is mainly a good sign.

In 2013, the Chinese per capita income (calculated at the official market exchange rates) amounted to the equivalent of almost 7,000 US dollars to just 13 percent of the US per capita income (53,000 US dollars). The disposable income was not sufficient for excessive consumption. For about five years now, this has begun to change more and more. Income has been continuing to rise for years (see Figure 1).

The population in China is becoming increasingly richer, even though the potential for income growth in the household sector is still very large: In 2010, only eight percent of the Chinese population belonged to the middle-class (defined as a category with an annual income between 15,000 and 33,000 US dollars). According to forecasts, by 2020, nearly 60 percent of the population would belong to this group. The foreseeable or expected trend in personal income may be considered a reliable indication that the economic outlook for China shall be anything but gloomy.

Figure 1: Development of the per capita income in China over the past ten years

Myth 2: China’s economic miracle is based on extensive planning by the state and not on the performance of the private sector

It is true that the state and state-owned enterprises together account for around a third of China’s total investment expenditures3. In highly developed industrial nations, this proportion amounts to less than 5 percent. However, the private sector in China is nowadays already responsible for two thirds of the economic performance. The Chinese economic miracle is therefore not majority based on government investment programs. Furthermore: The efficiency of investment in the private sector is significant higher than that of state enterprises. All of the approximately 250 million additional jobs created in China since 1980 were created in the private sector. And also, in the end, the private sector draws predominant responsibility for export. Myth 2 is therefore likewise not able to withstand a fact check. Lastly it remains myth three:

Myth 3: Chinese companies are good at copying, but not at generating their own substantial innovations4

In Chinese culture, to copy something is imposed as a particial expression of mutual recognition, like a homage to something good. Copying has therefore been a long tradition in China. The annoying problem of piracy is thereby not alleviated; it will be greatly enhanced by a good knowledge why imitating in many sectors within China is part of typical business practice.

This impression overlook, that China has always been a center of innovation. Whether paper, silk, the compass, printing with movable characters, gunpowder or the melting of iron: Many inventions of global importance have their roots in ancient China.

But even today, managers should have China on the radar for their ability to innovate: manufacturing simple products in large quantities and cheaply selling them all over the world – the political leadership of the country has this strategy long past. By 2025, they rather intend to have achieved the transformation from low-cost producers to a high-tech country. But that is not enough: Upon the 100th anniversary in 2049, the People’s Republic should ascend to being the leading “industrial superpower”.5

And that is only possible through innovation. One of the cornerstones of the “Made in China 2025” strategy, which was personally presented by Premier Li Keqiang during the People’s Congress in March 2015, is also the promotion of innovation. China already invested around 200 billion US dollars per year toward innovation. The volume has quadrupled in ten years and is roughly equivalent to two percent of the gross domestic product. Furthermore: Companies are consistently and devotedly supported by the government – by its own admission – due to their innovation activities. According to the future strategy, the aerospace, mobile communications, data processing, e-commerce, biotechnology, high-speed trains and renewable energy fields shall be particularly encouraged in the future6.

That means: China shall no longer only be the workbench of the world but shall seek salvation in selected fields of high technology. The government has recognized that the wage and labor cost increases in recent years no longer quite fit the existing business model of its economy, which produces preferably cheap mass-produced goods. The “Made in China” brand should mainly stand for innovation, quality and efficiency in the future.7 The second-largest economy shall therefore to play a leading role the near future with pioneering technologies and innovations and create additional business opportunities. In some areas such as telecommunications or consumer electronics, this has already been attained. And also: The country has been the world leader in patent applications for years now.

Figure 2: Patent applications in major countries

Figure 3: Trend of patent applications with the five major global patent offices

Even though the quantity and rapid rise in patent applications still does not provide information on the quality of underlying innovations – the bias of a technologically backward China as always referred to this context by western industries should be quickly adopted. As the Mercator Institute for Chinese Studies, one of the world’s largest institutions for research and knowledge about the current China, recently put it in a nutshell: “If China succeeds in implementing its plans, then the country will be on equal footing a competitor with Germany in the field of leading-edge technology”.8

ON THE PATH TO A HIGH-TECH LOCATION

On the path to become a top leading economic power that not only plays a dominant role because of its sheer size and huge domestic market, but also wants to be play at the forefront in innovation and in the high technology, China still has to do some homework. The “Made in China 2025” strategy describes the roadmap to modernize the country and transform the economy from the former low-wage country to a high-tech location. In the course of the planning the Chinese government normally considers an average growth in the gross domestic product of five to seven percent per year. From the political leadership, this dimension has been called the “new normal”. At least 30 to 50 percent of the projected growth shall come from improved factor productivity or from higher automation. This means: in the future, China will more develop better jobs while the supply of cheap labor shall continue to decline. Foreign companies can instead expect a larger number of higher educated and skilled workers. Nearly one in five of the world’s “Technical Graduates” is toady a Chinese nationality.

The planned transformation of the economy and the implementation of the “2025” strategy should be considered against the background of some basic trend developments that shall shape the further progress of the country to a large extent:

Trend 1: Urbanization

China’s society was characterized as traditionally rural. In the course of reform and economic opening, more and more residents were then attracted from the countryside to the cities. Such strong migratory pressures which will particularly acute in tier 2 and tier 3 cities in western China. Following example shall show the expected dimension in the urbanization: Every year, 18 million people are attracted to the cities. It means, that every eight years a new Japan is created. For foreign companies, these cities are becoming more attractive – also and especially in view of the improved infrastructure and the availability of higher qualified potential employees.

Trend 2: Efficiency

In the past, China was the factory of the world and of course will keep this meaning in the future. However, in the next years, we will see a much higher degree of automation in production in Chinese companies. Thus leads to substantial positive economies of scale. Already, 80 percent of air conditioning units, 90 percent of global PCs, 75 percent of solar panels and 60 percent of all shoes are produced today in China. This will not change. But, we shall see in other industries that Chinese companies will exploit the the economies of scale in mass production and will threaten the global market – often on a competitive technological level.

Since labour supply in the face of the imminent decline in working age population and at the same time, the income of workers is continuously increasing, the trend toward higher technicalization and automation in production is logical. This is also officially expressed with the “Made in China 2025” strategy. The political leadership bases its automation and digitization efforts to a large extent on the German “Industry 4.0” approach. And even if the country still has a long way to go: companies should assume that the automation process shall proceed quickly. A patent analysis of the Fraunhofer IAO from March 2015 shows that China especially is a nose ahead in basic technologies for Industry 4.0. Even with the number of patent applications, the country is well ahead of the USA and Germany.9 China is leading not only in terms of the number of patents, but, according to the IAO analysis, also in some highly innovative developments, especially in the fields of energy efficient wireless sensor networks and network structures.

Today, the Middle Kingdom is also the largest market for robotics – one of the most important business regions of foreign suppliers such as Kuka and ABB Robotics. As part of the further spread of robots and other technologies, more and more jobs for simple routines shall disappear. At the same time, there shall be a noticeable increase in higher-value jobs.

Trend 3: Consumption

An increasing number of Chinese people can afford more and more consumption. Today, there are around 300 million consumers in the “Middle Class” with an annual income between 15,000 and 33,000 US dollars. Another 250 million are on the way there. In 2025, according to planning by the political leadership of the country, already 60 percent of the population has reached this income level. Furthermore: Since almost five years, a trend for consumption in China is quite clearly being recognized. This means: More and more Chinese people can not only afford, but they also want to consume more. How the consumer behaviour shall evolve in the future, it is currently not possible to forecast seriously. The fact is, however, that a total of far more income – and hence income for consumption purposes – shall be available. But even if a growing number of people become consumers on the market, it does not mean that sales shall be simple: The Chinese are very selective and very difficult to assess in their individual consumer behavior.

Trend 4: Financial Power

In China, an enormous amount of money is in bank accounts – of companies and of individuals: 15 billion US dollars in the form of bank deposits and in capital accounts. These funds could increasingly flow in future investments. In China, it is already not particularly difficult for investors to come across financial resources. They are plentiful. The challenge for consumers is rather that potential investors are unsure of what to do with their wealth and exactly where to be involved financially. Innovative foreign companies here offer very interesting options to acquire capital and to benefit from the enormous financial power of China. For this purpose, however, they must succeed in order for it to distinguish itself as an attractive potential partner.

Trend 5: Tremendous Availability of Qualified Talents

With more than one billion people, it is only logical that a number of well-trained talents can be found within. There are many things to accuse the Chinese education system, but for sure not of it being without strictness and rigor. Whoever manages to get through it with good grades is highly qualified and smart.

Meanwhile, a growing number of qualified young people from universities are pushing into the market. This year, there were already 17.5 million graduates who left Chinese universities with successful results.10 This growing pool of qualified young academics offers foreign companies interesting opportunities in order to take some of the sting out of the shortage of skilled labor and the associated “competition for highly qualified heads” mainly among mathematicians, scientists, computer specialists and people of related disciplines. Foreign companies, however, should keep in mind that despite the increasing number of qualified young people in individual disciplines, the competition when recruiting shall become harder and also the retention of qualified professionals to their own companies – depending on industry and location – shall remain an ongoing challenge: In China, the targeted headhunting of key personnel belongs to the recruitment culture.

Trend 6: Internet as Economic Factor

Of the approximately 1.37 billion inhabitants of China, almost half are connected to the Internet. China has therefore more than twice as many Internet users than, for example, in the US. One in five Internet users worldwide comes from the Middle Kingdom.11

To whoever takes the metro in China, for example, it immediately becomes apparent: Everyone is somehow involved with his or her smartphone. And the Chinese using the Internet not just for fun, figures from Electronic Commerce showing: The number of online shoppers has already exceeded 300 million. Sales on the Internet are extremely high. The Commerce Department estimates that transactions worth 3 trillion RMB (around 430 billion euros) were made via Internet platforms in 2015. That makes a total of more than 10 percent of the total trade turnover of the vast nation.12

Whoever wants to be successful in business as a company in China needs a convincing web presence. The Internet is a real economic factor in China – especially for businesses that sell to end users. Here, a professionally designed, functioning Online-Shop is now one of the fundamental success factors. Every business in China is therefore required to consider how it can use the Internet in the best possible way as part of its business strategy implementation.

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Figure 4: Number of online buyers in China and their proportion to the entirety of all buyers

With the political leadership classifying the Internet and the continued development of the Chinese industry to be of eminent importance, it made the presentation of the “Internet Plus” action plan apparent in July of this year. It foresees the application of advanced online technologies – mobile Internet, cloud computing, Big Data and the Internet of Things – in traditional industries.13 The action plan elaborates the development objectives as well as supporting measures for a more efficient use of the Internet in selected key sectors. Namely it includes the agriculture, energy, finance, public utilities, logistics, e-commerce, transport, biology and artificial intelligence. As it seems, the government’s aim is the integration of the Internet in the economic and social sectors to further strengthen and make new industry methods as from 2018 for a main driving force of growth.

The pictures of crisis on the state of the Chinese economy that are particularly drawn in Western media are, in our view, appear badly exaggerated in part. To speak of a crisis or even an economic crash is entirely unfounded with growth of around six to seven percent. China’s economy shall also take a leading role in the global economy with a deceleration in growth – though on the basis of changing industrial structures and as part of a “new” normal.

Manufacturing companies need to rethink their China strategy:

Innovative product and service portfolios combined with an effective sustainability strategy determine future success with increasingly nascent sophisticated Chinese consumers

Partnership conditions ensured for financing and mobilizing capital in the implementation of innovative products and services

The significant increase in the degree of automation and the adjustment of production structures enable a cost-effective provision of services with wages that continue to rise mainly in coastal industrial centers

The continual balancing of the operations network or production footprint to compensate regional factor cost differences between East and West China increases and secures future income in and outside China

Long-term strategy and business model hedging is primarily determined by the willingness and ability to inspire, bind and promote Chinese talents

Only those who are really laying a foundation can successfully act in China in the future, thus ensuring growth and profitability.
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Sources:

1 Source: “The Economist”, 9/12/2015

2 Source for both figures: GIGA Institute of Asian Studies, 7/9/2015

3 “The Economist”, 9/12/2015

4 On the importance of China as a center for R&D and innovation, also see the interview on page 26: “Choosing the right R & D location is critical to success in China”

5 The challenge to Germany, Die Zeit/Online 5/27/2015

6 Source: Handelsblatt/Reuters 5/19/2015

7 The Mercator Institute for Chinese Studies: How does China’s innovation policy prepare for the future, September 2015

8 http://www.zeit.de/wirtschaft/2015-05/china-industrie-technologie-innovation

9 “Industry 4.0: China in the fast lane”, IAO Press Release, 3/30/2015

10 By comparison: in 1998, there were just 1 million university graduates in China

11 http://www.internetlivestats.com/internet-users-by-country/

12 Source: Hong Kong Trade Development Council, March 2014

13 Innovation News DIHK, August 2015/Consulate General of the People’s Republic of China in Munich