Although China continues to open its market in compliance with its WTO obligations, it is also putting new barriers in place. Underlying the new protectionism are leaders’ concerns that the economy is caught in a low value-added manufacturing trap.
Most sectors are plagued by surplus capacity and low margins, which has seen small firms squeezed between rising commodity prices and powerful downstream brand owners. To reverse this trend, Beijing is adopting a new policy framework to make Chinese firms more competitive, but this framework will make life more difficult for foreign investors.
There are three stages: consolidation through forced mergers while increasing R&D budgets and technology transfers from abroad; the tilting of regulations to benefit domestic firms over foreign rivals; and bringing local governments in line with Beijing’s policy objectives.
China’s economic reforms have produced spectacular results – an average of 9% annual growth over the past 20 years has catapulted the nation’s competitiveness ranking from 77th in 1988 to 32nd in 2004. But industry is still dominated by low-margin manufacturing and, because support has largely come from local level powers, this has given rise to a proliferation of small firms in most non-strategic sectors.
Meanwhile, regulatory uncertainty has compelled Chinese firms to focus on imitation and low-cost production over technological innovation, allowing foreign firms to dominate many non-strategic sectors and control most intellectual property.
Rise of the champions
In response, Beijing is making efforts to promote "national champions" in strategic sectors. The most recent major breakthrough was creating the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) in 2003 and granting it control over all national-level SOEs.
SASAC aims to reduce the 179 firms under its control to just 40, primarily through mergers and acquisitions, with a view to creating a handful of firms capable of competing directly with foreign multinationals both at home and abroad.
Plans are also in place to increase government investment in research, countering a structure that has traditionally focused on capacity expansion and cultivating relations with government officials over technological innovation. Most notably, authorities have pledged to invest US$5 billion to create a domestic aerospace industry and US$2 billion for engineering and shipping firms.
State-led investment is far from sufficient, however, to close the technology gap, which is why Chinese authorities and SOEs will continue to work together to induce foreign investors to transfer technology in exchange for market access.
China’s evolving regulatory framework is also tilted toward supporting domestic firms at the cost of foreign competitors. The long anticipated anti-monopoly law, slated to be adopted in 2006, will likely target foreign firms with a dominant market share, such as Microsoft and Intel.
Authorities have also sought to set standards in information technology to support domestic firms over foreign competition. China’s initial efforts to mandate WAPI – a new wireless LAN stardard – over the widely used Wi-Fi in 2003 and 2004 underscored this strategy. Although WAPI has failed to gain traction in the marketplace, authorities have since drafted almost two dozen industry and national standards in other sectors, two of which have been approved as international standards (Chaoji VCD video disk and TD-SCDMA mobile phone technologies).
A major obstacle to China’s national champion strategy is local government obstruction. Accordingly, Beijing is launching new initiatives to compel local officials to comply with its directives. Elite turnover at the provincial level and below has picked up in recent years, as President Hu Jintao appoints trusted bureaucrats to regional posts to ensure local compliance with central government policies.
The Communist Party is also revising its criteria for local promotions, shifting the current emphasis from GDP growth to criteria such as accountability for industrial disasters and environmental damage.
Changing incentives
Most importantly, however, the central government is changing the local government incentive structure through administrative and monetary control measures. Revisions will be made to the "approved project list" for foreign investment, signaling Beijing’s determination to crack down on low-value added, high-energy consuming investments. It will also promulgate new regulations in 2006 to establish direct legal accountability for local officials who contravene central government initiatives.
Together, these initiatives will create a more challenging investment environment for foreign firms in China, but they will also bring new opportunities.
Chinese officials, working together with SOEs, will leverage the lure of China’s growing domestic market to extract technology transfers from foreign investors. In return, firms such as Motorola and Siemens are in a position to benefit from TD-SCDMA mobile technology standards.
But Beijing’s desire to support domestic firms by adopting indigenous technology standards will come into conflict with global technology leaders seeking to enter China’s market and possibly some third country markets. And, perhaps most ominously, foreign firms with dominant market share could come under anti-monopoly probes by Chinese prosecutors, which will reverberate throughout the global investment community.
Erik Tollefson is an associate in the Asia Practice at political risk consultancy Eurasia Group, where he covers China