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Standing before nearly 1,000 HBS alumni, faculty, and guests in a packed Shanghai hotel auditorium, HBS professor Warren McFarlan savored a moment a quarter century in the making. In 1979, he was part of the first, small HBS delegation to visit a newly opened China. “It was the single most important trip of our lives,” he recalled. He glimpsed the future, and it now has come to pass: China has emerged as an economic force of major global significance.

Fast forward 25 years to the School’s first Global Leadership Forum held in a mainland Chinese city. McFarlan, faculty cochair of the 2004 event, couldn’t help but feel that this was the culmination of a long journey for himself and for the School. The mid-June gathering at the Shanghai Grand Hyatt gave alumni a chance to see and experience China’s modernization firsthand. The conference itself took place in a high-rise-studded financial district that didn’t exist just a decade ago. And the event put a spotlight on the School’s deepening involvement with the world’s fastest-growing major economy.

McFarlan, a champion of Asian studies since that first visit to China, noted in his welcoming remarks that HBS opened its Asia-Pacific Research Center in Hong Kong in 1999, creating a launching pad for case writing and research from Indonesia to Korea. Since then, more than eighty case studies dealing with China have been written, and 99 Chinese students have received MBAs from HBS. Nearly one in six HBS faculty members lists China as a primary research interest.

China’s research potential is almost limitless. The country’s development over the past 25 years has been nothing short of remarkable. Economic reforms that began in 1978 have stoked annual growth in excess of 9 percent, three times that of the United States. Per capita income among the nation’s 1.3 billion inhabitants has more than quadrupled, surpassing $1,000 last year. Multinationals have rushed to take advantage of China’s low labor costs, transforming the country over the past decade into the world’s workshop. In 2003, China ranked as the world’s major recipient of foreign investment — nearly $53 billion. It is on pace this year to attract even more.

Long-term trends point to continued strong growth and tantalizing opportunities, tempered by substantial risks for businesses and investors looking to cash in on China’s economic renaissance. Over the course of the three-day Global Leadership Forum, twenty HBS faculty members and thirty U.S. and Chinese business leaders offered valuable insights, along with words of caution.

Reforms Set the Stage for Growth

When Deng Xiaoping came to power in 1978, he set China on a new course by making economic growth a top priority, even if that meant relinquishing state control over markets. It was the realpolitik thing to do, said Long Yongtu, who formerly served both as a Chinese deputy minister and as the country’s chief World Trade Organization (WTO) negotiator. After three decades of communist central planning, “China’s economy was on the brink of bankruptcy,” he told a first-day plenary session. Hardship and starvation were pervasive. As a university student in the 1960s, Long remembers eating lots of pumpkin — the only food readily available.

The early engines of growth were holdovers from the Maoist era: township and village enterprises (TVEs) rooted in China’s vast rural regions, and state-owned enterprises (SOEs). The TVEs were collectively owned and operated at the local level, and typically filled rural niches for consumer goods. At their peak in the early 1990s, an estimated 19 million TVEs operated across the country. By contrast, the SOEs were controlled by various government ministries at the central, provincial, and city level, and ranged from small firms to large capital-intensive enterprises, such as banking, telecommunications, mining, and transportation. By the late 1980s, many had developed a good deal of autonomy.

Twenty-five years of economic reform have changed the structure of ownership, said Long. By the mid-1990s, large numbers of local and state-owned enterprises had been privatized. Significantly, the Chinese constitution was amended in 1998 to describe the private sector as “an important component” of the economy, an about-face from communist tenets on state ownership. Long estimated that the private sector now produces one-third of China’s GDP. “In eight years,” he predicted, “I expect the private sector to contribute three-quarters of the GDP,” as the role of local and state-owned enterprises continues to fade.

Economic reforms already have given rise to a new and growing middle class. Long estimated that 10 percent of the population, 130 million people, have reached middle-class status, spawning a growing consumer-driven economy. Auto sales, for example, grew by 38 percent, to 964,700 units, during the first five months of this year compared with 2003, according to the China Association of Automobile Manufacturers.

China and the World Trade Organization

Within this context of quickening economic change, China was admitted to the WTO in December 2001, culminating fifteen years of on-again, off-again negotiations. It was a watershed moment in the country’s progress toward a market economy, said HBS assistant professor Regina Abrami, who led the breakout session “China in the WTO: Two Years In.”

The United States and other developed nations welcomed the required lowering of tariff and nontariff trade barriers, and the gradual opening of China’s vast consumer market to global competition. For their part, Chinese reformers who negotiated the terms of the WTO agreement made a calculated gamble that it would provide the necessary leverage to force policy changes necessary for homegrown businesses — including SOEs and TVEs — to adapt and compete in a global marketplace. Long, the government’s point man at the negotiating table, offered this assessment: “The WTO agreement has been very useful leverage for the Chinese government to advance economic change and to change mindsets,” he explained, calling it “a classic case of using a trade agreement to facilitate market reform.”

His matter-of-fact acknowledgment of the government’s intentions surprised Abrami. “Before China’s accession such a comment may very well have jettisoned domestic political support for the WTO,” she commented afterward. “Everyone knew that domestic political and economic change was a goal, but it wasn’t always openly talked about for fear of upsetting more conservative elements.”

The envisioned reforms, not the least of which include further privatizations and increased layoffs, will cause considerable strain on the Chinese system if carried out too hastily, explained Abrami. Historically, provincial leaders used a variety of measures, including tolls, to shelter local enterprises from competition. They are motivated by the need to protect the local tax base. Without it, local officials stand to lose a major source of revenue needed to pay their own salaries and fund local social services and welfare programs.

“Local governments already are running deficits, and they are getting worse,” said Abrami. Foreign competition that further weakens local enterprises and erodes the tax base could trigger a WTO backlash at the provincial level, she warned. Already, local retailers have expressed concern about the arrival of large multinational competitors such as Wal-Mart and Carrefour.

The SOEs in particular are feeling threatened. Of the 100,000 that remain, experts maintain that many are near bankruptcy and not prepared to compete head-to-head with multinationals. Under WTO rules, however, most foreign firms no longer are required to partner with a Chinese firm to gain market access.

The country’s communist leaders clearly must balance WTO requirements for market reform against the need to maintain domestic economic and political stability. They can’t afford to move too far, too fast. Nor can they turn back. “This historic reform process will not stop,” Long observed.

Advice for Business and Investors

The rapid pace of change not only creates new opportunities, it shapes new ways of doing business. In a session titled “Modes of Competition in China’s Markets: Economics and Politics,” HBS associate professor Felix Oberholzer-Gee drew on recent World Bank survey data on 3,899 Chinese firms. He and HBS professor Tarun Khanna have analyzed the data to find predictive indicators for business success and guides for investors to pick winning enterprises. The preliminary findings challenge two widely held beliefs.

First, conventional wisdom holds that the country’s coastal region is the best place to find successful businesses, said Oberholzer-Gee. In fact, for two decades the government officially encouraged foreign investment in coastal regions while diverting it from the country’s interior. But no more. Since China was admitted to the WTO, many favorable trade policies have been extended to the interior of the country, Oberholzer-Gee explained.

Moreover, the data analysis “does not allow you to predict a company’s success based on geography,” he said. “Location of firms explains very little of the variation in sales growth and margins.” Accordingly, Oberholzer-Gee advised that “it is a not a good idea to dismiss a company’s investment potential because it is in the interior of the country.”

Second, the importance of relationships in Chinese culture extends to the business world, where a simple phrase speaks volumes: “No guanxi — no business.” Translation: No relationships — no business. Relationships take on added importance in China because they tend to make up for weak legal and regulatory institutions, noted Oberholzer-Gee. But do companies with enduring relationships with bankers, customers, and suppliers necessarily do better?

“It was a big surprise to us to find that companies with long-standing relationships don’t necessarily do better,” said Oberholzer-Gee. In fact, Chinese firms that had foreign partners reported lower growth than those without such partners. “To say that you don’t need relationships would be jumping the gun,” he continued. “Everyone has relationships because they are very important. But you should not conclude that relationships give you a competitive advantage.”

Challenges Ahead

After nearly three years in the WTO, Chinese officials show no signs of changing course and backing away from further market reforms. But external criticism of the country’s uneven progress in implementing the trade agreement has grown stronger in recent months.

U.S. manufacturers complain of massive job losses to Chinese competitors at a time when Chinese imports are flooding the domestic market. China recorded a $124 billion trade surplus with the United States last year, the biggest bilateral trade imbalance in history. Trade friction escalated late last year when the U.S. government slapped Chinese television manufacturers with high tariffs for dumping cheap sets in the U.S. market. The U.S. government also curtailed Chinese textile imports on grounds that their rapid increase constituted a “surge.”

Critics blame the import flood on the undervalued Chinese yuan, pegged at 8.27 to the dollar since 1994. Chinese officials have steadfastly maintained that they will not yield to international pressure to stop fixing the yuan’s value to the dollar. And they have filed their own trade complaint against U.S. optical-fiber maker Corning Inc., alleging that the company hurt Chinese producers by selling optical fiber at unjustifiably low prices. Corning denies the accusations.

With U.S. presidential campaigns now under way, trade has emerged as a hot topic. Democratic nominee John Kerry of Massachusetts has accused the Chinese of “predatory currency manipulation” that is costing U.S. factory jobs. President George W. Bush (MBA ’75) has been more circumspect in his statements, but in June he dispatched officials to Beijing to make the case for trade concessions.

Transparency also remains an important issue. Long Yongtu, China’s former chief WTO negotiator, explained how the concept requires a new way of thinking. “There’s an old Chinese saying: ‘If the water is too clear, there will be no fish.’ We have to change that mindset,” he explained.

Protection of intellectual property also poses a major challenge and is one area where China “overcommitted” in the WTO agreement, added Long. Although the central government has enacted a number of intellectual property laws and set up a criminal court to prosecute violators, violations are difficult to police, especially when local governments openly support businesses that illegally copy foreign products, he explained.

At least one major issue remains under the radar screen of the business community, HBS assistant professor Abrami said in an interview. The Chinese built their economy on a system of dual-class citizenship, one that designated any individual living away from his or her place of permanent registration to be a “temporary resident,” she explained. For people moving from rural provinces to work in coastal-region factories, this status translated into officially sanctioned lower wages and poorly monitored working conditions.

This system is now under assault by the AFL-CIO, which regards “temporary” worker classification as an unfair trade practice that artificially lowers wages. In March 2004, the AFL-CIO filed a trade-dispute petition seeking U.S. government action to pressure the Chinese to abolish the dual-class citizenship system.

Given the growing attention to corporate social responsibility in China, the system has been especially problematic for multinationals. Their concerns have caused Beijing to begin to deal with the problems this system creates. As part of its efforts to build the “rule of law,” the government now supports a number of legal-aid programs for “temporary” workers. Not satisfied, international organized labor and nongovernmental organizations will continue their pressure to abolish the dual-class citizenship system.

What Lies Ahead?

“Over the long haul, there’s reason to be optimistic about China’s development,” said Abrami. The WTO agreement holds the promise of unprecedented access for foreign firms entering the Chinese market. The central government is firmly committed to a steady pace of gradual change toward a more open, market-oriented economy, she said.

In the near term, expect more trade friction with the United States. But don’t let heated rhetoric obscure an important fact, advised Brigadier General George Yong-Boon Yeo (MBA ’85), Minister for Trade and Industry for the Republic of Singapore. Speaking to a luncheon audience, Yeo assured the group that “there’s a font of goodwill between China and the United States.” Just remember, he added, “Chinese ministers may criticize the United States, but they send their children to study at U.S. universities.” No doubt, HBS will land its share.

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