Silicon Hutong

China and the World of Business • China Business and the World

Silicon Hutong - China and the World of Business • China Business and the World

Bet the Farm, Or Settle for Table Scraps?

In China, Go for Broke or Accept that Less Is More
Franc Kaiser

Harvard Business Review
April 4, 2014

Nanjing Road pedestrian mall, perhaps the busi...

Nanjing Road pedestrian mall. (Photo credit: Wikipedia)

In this intriguing essay, Shanghai-based consultant Kaiser suggests that for foreign companies, the glory days are over, and the only two strategies left are to either fight for one of the top two positions in your industry (against what might be brutal competition) or accept that your market in China will be modest, picking up what others cannot.

I really enjoyed the essay, because I like contrarian thinking on business in China. But I have a couple of problems right out of the gate.

First, I find it hard to accept that all companies in all industries face such a stark, binary choice. Airlines and banks do not face the same challenges or opportunities as McDonald’s or Intel.

Second, Kaiser’s choices seem better suited to Fortune 500 multinationals with a single line of business. Many large companies will do very well being modest players in multiple markets or product lines without ever being a market leader or settling for modest returns, and many small- and medium-sized businesses will gorge themselves on a modest market position.

Third, the market is immense, and opens the door for a wide range of niche and multi-niche strategies that would be incredibly lucrative, especially for small- and medium-sized businesses from outside of China.

Finally, and perhaps most important, Kaiser implies that there is but a single motive that brings companies to China: profits from China operations. For many companies this is true, but for others, being in China offers other rewards. Companies in the mobile industry benefit from participating in the largest, most lucrative market in the world; other firms are in China so they can better defend against Chinese rivals elsewhere; still others could care less about profits, as China drives volume that supports lower unit costs in more lucrative markets.

One reason there are few good “China strategy” books out there is that there is no good, blanket approach for China that spans across a wide range of companies and industries over a modest span of time. Corporate strategy is bespoke, like the course for a ship. When we write books, we can talk about avoiding storms, rocks, and shoals, and we can talk about the processes that lead to great strategy or effective implementation. Everything else is situational.

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Setting the Stage for Chinese Innovation

Near People’s Square, Shanghai
Skyline in Silhouette 
0700 hrs. 

Walking the floor at both CES in Las Vegas and Electronica China in Shanghai within a ten-week space provides one with a clear view of how far Chinese enterprise has come, and, equally important, the degree to which international technology businesses have lost their former dominance in China.

One could conclude from these impressions that multinational tech companies are in a state of permanent decline in China: Beijing’s unstated but ongoing policy of import substitution has succeeded, and foreign companies are fighting a losing battle. You don’t need to go to trade shows for anecdotal evidence. Just look in purses and backpacks: ZTE, Huawei, TCL, Lenovo, and Yulong are five of the top ten mobile device brands, and they’re gaining on the global giants.

But if you dig a bit deeper, as you can at a show like Electronica, you find that the opportunities for foreign tech companies have not disappeared: they have evolved. To understand why and how, it is useful to start by looking back on how the tech business developed in China.

From Buy to Make

Since the beginning of reforming and opening in China in 1978, the nation has essentially gone through three phases of foreign involvement in technology-based industries.

The first phase was imports, when the government focused on bringing urgently-needed products like personal computers, telephone switches, automobiles, machine tools, and other technology-based products into China. The need for these products, most of which were essential to ease key bottlenecks in the development process, was so urgent that key ministries were permitted the use of precious foreign exchange to purchase those goods.

China’s leaders always expected, however, that the nation would begin producing these goods on its own, preferably in local companies, but realistically in joint ventures with global technology companies who would bring three essential ingredients: the products, with their component technologies; production know-how, with process technologies; and the capital to build the production facilities. This was the second phase: the shift to local production.

Fast Followers

By the mid-1990s, though, another shift began to take place. As the global tech giants ramped up production in China to a mass-scale, local firms began manufacturing their own technology goods. Local firms began to dominate production, using a “fast-follower” approach: “maybe we won’t be innovators, or even the first to market with a given innovation, but we will come to market so soon after the innovation leader that we will still reap our share of the market.”

By last year, the payoff of this shift had become apparent. Chinese high-tech companies were long past needing foreign manufacturers to teach them how to build high-tech products, to help them implement cutting-edge production processes, or even to finance the construction of factories. Those local firms unable to bootstrap their own capabilities and finance now had a vast stable of local and foreign companies ready to provide the necessary technology, and finance, thanks to cash flow and capital markets, was no longer a problem.

Innovation, however, remained a challenge. While a handful of local tech companies –  notably (but not limited to) Huawei, ZTE, Xiaomi, and Leovo – had begun to innovate, widespread innovation that would offer a more sustainable competitive advantage (and a larger share of profits) still seemed a ways off.

Enter the Innovation Platforms

And there it remains today.

This gap between efficient production and value-driven manufacturing is the heart of the next opportunity for foreign firms. While the days of foreign brands utterly dominating technology markets in China may be past, more than ever China’s manufacturers need a steady stream of innovations upon which they can base their own innovating.

Technologies that serve as the foundation that allows others to innovate are what we can call innovation platforms. Five factors make innovation platforms stand out from other technical advances:

Significant – The core innovation is a genuine advance that is both useful and relevant;

Substantial – There is a obvious, large, and diverse market for products based on the innovation that offer substantial profit potential, and the technology is easily commercialized;

Shared – The company promulgating the core advance is more interested in creating an ecosystem than a monopoly, i.e., it is content with focusing on supporting and enhancing the core technology and not getting into the business of its customers/licensees;

Stable – Any subsequent changes in the underlying technology are likely to be iterative, not major, for several generations of products. This makes it economically viable for companies to invest in R&D based on the innovation platform.

Supported - Rather than serving as a glorified patent troll, the companies that develop innovation platforms invest heavily in resources designed to assist product developers create viable commercial products, such as on-site engineering support, system validation labs, extensive documentation, or developer groups. In addition, the company continues to invest in improving the core technology.

Early Innovation Platforms

Many innovation platforms take the form of acknowledged industry standards. Examples like Wi-Fi, Bluetooth, and USB could be considered a form of innovation platforms, in that their technologies enabled the creation of products and even companies.

But when we talk of innovation platforms, we are really looking at products and technologies that spawn not only products, but companies and entire industries. Some illustrative examples:

The Xerographic Process: Invented by Chester Carlson and later commercialized by Haloid/Xerox, which begat the photocopier, the laser printer, desktop publishing, and many specialized sectors;

The Intel 8000 microprocessor family, that together enabled the creation of the personal computers, stand-alone video games, and a half-dozen major industries;

Qualcomm’s CDMA: CDMA enabled the commercialization of the internet, created the telematics industry, and is on its way to recreating the automotive, trucking, and healthcare industries, among others.

Each of these companies took an indirect lesson from the failure of Thomas Edison’s Motion Picture Patents Company, an industrial trust that tried to control the film business as well as the manufacture of cameras and film stock. It was, arguably, Edison’s greatest failure. By exercising a modicum of control over the core technology, supporting it, advancing it, and making it available on reasonable terms, Xerox, Intel, and Qualcomm each fostered the creation of immense economic value.

Platforms for the Future

In a world where industrial and engineering capability is a scarce quantity, the easiest way to make a return on a major innovation is to create a vertical industry around it, building the components, creating the product or system, and distributing it under your own brand. The Bell System did this for nearly a century with telephones, and IBM and a handful of other companies did this for the first three decades of the computer industry.

But when the ability to design, engineer, and industrialize complex products is widely distributed, as it is today, robust companies are built on either using innovation to enable industries, or in building on innovation to create industries.

For the time being, Chinese companies are (generally) comparatively better at building industries based on key innovations, and European and particularly US companies are (generally) comparatively better at consistently creating core innovations that can serve as the platforms for those industries. This does not mean that no core innovations will come out of China, or that the US is no longer capable of product development and commercialization.

But it does suggest that the richest opportunities in China for foreign companies, particularly those in science, engineering, and technology-based industries, lies in licensing and enabling Chinese manufacturers, rather than competing with them.

The question facing tech companies, then, is whether and how to make use of the company’s innovations – or an ongoing stream of them – in order to serve as a profitable and indispensable platform for Chinese innovation. And for those of us who watch this market, the pressing question is “in which industries will the next round of innovation platforms emerge?

I leave the first question to the companies themselves. For the second question, my early research points to transportation, healthcare and biosciences, construction, energy, and the environment. I know: I have my chips on a lot of spots on the roulette table. In the coming months, I look forward to sharing with you why I think things are going that way.

Five Predictions: China’s Business Environment in 2014

Hutong West
Sunday Afternoon Countdown to Morning in Beijing
1526 hrs. 

Much ink and focus has been given of late to understanding China’s political evolution. Too little, on the other hand, has been given to what it will all mean to those of us who must decide what role China will play in our business plans in the next two to three years.

Futurism is alchemy in the best of circumstances, and nowhere more so than in the case of China. Nonetheless, if we extrapolate from current events, it appears that China has embarked on a course of commercial nationalism, if not outright mercantilism.

In the spirit of the season, then, we offer our five predictions for 2014:

1. China will build a more protected environment at home for its state-owned, state-coopted, and “accidental champion” enterprises through an increase in the use of soft protectionism.

2. Those enterprises will thrive at home, but increasingly will be pushed abroad, seeking prestige, less competition, and faster growth.

3. Trade and industrial policy will test the absolute limits of what China can get away with under the WTO, and Beijing will conduct a propaganda campaign to try and undermine the Trans-Pacific Partnership.

4. Foreign brands will find it more difficult to gain share in China. In addition to soft protectionism, they will face the continued relative decline in the prestige of foreign goods/brands in a growing number of sectors.

5. In 2014 we will see the beginnings of a new crop of Chinese entrepreneurs, more of whom will be starting their companies from second, third, and fourth tier cities, or even overseas. The cost and complexity of doing business in China’s first tier cities – along with the declining quality of life – will shift focus away from Beijing and Shanghai.

I’ll be addressing these more in the coming year.

Is Apple Going (China) Mobile?

Hutong West
Two hours sleep, three cups coffee
1039 hrs. 

 

China Mobile

China Mobile (Photo credit: Wikipedia)

The Wall Street Journal has lit up the net with an article proclaiming that the ink is drying on a deal between Apple and China Mobile for the carrier to (finally) (officially) offer iPhones on its network. Nothing has been confirmed by either Apple or China Mobile, but that has not stopped the speculation.

My take on the deal has not changed from when I wrote this piece in September: the value of this deal is far from clear. As such, it might be time to add a few more points to the debate to provide some perspective:

1. There have been 89 million iPhone 5 handsets sold thus far.

2. There are already 42 million iPhones using the China Mobile network. These are people with iPhones and a China Mobile account.

3. Optimistic analysts expect another 20 million iPhones will be sold next year in the event of an China Mobile deal, around 1.5 million phones a month.

4. Said analysis suggests that just under 3% of China Mobile’s subscribers will buy iPhones in the first year, and presumably a percentage of those will be replacements, given that your average Chinese smartphone user replaces his/her device every 15-18 months.

5. If Apple did sell an additional 20 million iPhones in the first year of its business with China Mobile, at, say, $400 revenue per unit, that would be $8 billion. A very nice chunk of change, and it would deliver a respectable jump in iPhone sales worldwide.

6. Putting that in perspective, Apple’s revenues for the 52 weeks prior the end of last quarter were over $170 billion. Therefore, even a very successful debut with China Mobile would give Apple a 5% revenue bump.

None of this is to say that this will be a bad deal for Apple. Even if Apple sold only an additional 10 million units, selling 10 million units of anything in the mobile business counts as a win, even for Apple. At the same time, it is important to keep in perspective exactly what a China Mobile deal would mean – and, more important, what it would not mean – for the company.

Six Principles of Entrepreneurial IPR Protection in China

Hutong Forward
Somewhere in San Francisco
0930 hrs. 

The issue of intellectual property rights and their protection continues to bedevil the agenda between China and the rest of the world. Do Chinese companies cheat? Certainly many do. Does China have on the books a comprehensive set of intellectual property protection laws? Without doubt. Does the government act to protect the IPR of foreign companies? Not as much as they could. All indications are that this situation will continue for at least the foreseeable future.

For that reason, it is perhaps past time to start drawing bigger lessons from this situation. It is time we started approaching IPR less as inventors and their attorneys, and more as businesspeople.

To that end, I propose six principles of what I call “entrepreneurial” IPR protection in China. Lawyers and the like are essential to the IPR protection process, but experience in China has proven that legal protection is insufficient. In addition to having legal eagles at your side, you need to take your own steps to protect yourself.

1. Start by protecting the rights of others. Remember that if it is all about you or a small subgroup, you are going to lose in the name of the greater good. The more protection benefits everyone, the more it benefits you.

2. Make it about citizenship. Actively support the creation of an IPR protection system that serves the interests of all parties, including the public at large.

3. Look inside before looking outside. Do all you can in your internal processes to protect your rights. For example, if you are walking around with a laptop that is not using disk-level encryption, but you pay for a high-power IPR attorney, you are doing this all backwards.

4. Don’t be an IPR troll. Protect only what you must. License what you can. Give away as much as possible.

5. Be a wellspring, not a storehouse. People will support your IPR if they depend on you as a source of innovation more than they depend on the innovations themselves. Remember that the well is more valuable than a bucket of water.

6. Talk about what you are doing. When you are being smart about protecting your IPR outside the court system, talk about it. Each of the steps above will brand you as smart, forward-thinking, and the kind of company people will respect. If nothing else, all of that reputation capital will serve you well when you are forced to take the nuclear option and drag some beloved Chinese company into court, as it strengthens your case politically (and make no mistake – court decisions in China are political.)

In the case of many companies, there are even more steps you can take that are specific to your industry or situation. This list, however, represents a set of general prescriptions and a place to start in rethinking your approach to protecting your IPR in China.

Qualcomm: Cometh the Reaper?

Hutong Forward
Learning not to eat fish 400 miles from the ocean
1840 hrs. local time

LinuxTag 2011 - Qualcomm

LinuxTag 2011 – Qualcomm (Photo credit: LinuxTag)

Two days ago, QUALCOMM (QCOM) announced that its chipset business was the subject of an investigation by China’s powerful National Development and Reform Commission. Details are sketchy, as the company has been instructed to keep the details to itself. It appears, however, that the issue is whether QCOM’s chipset business, QUALCOMM CDMA Technologies, is an effective monopoly in China.

Yesterday I got a note from Edmond Lococo at Bloomberg, who was curious about the degree to which QCOM’s critical China business will take a hit as a result. (Full disclosure: QCOM was a client from 2000 to 2004, but I have had no direct interaction with the company for nine years.)

As I told Edmond, reports of QCOM’s monopoly are exaggerated, to say the least. Apple makes their own chips, as does Huawei, and MicroTek and local upstart Spreadtrum been supplying China’s smartphone market for years. To suggest that Qualcomm has anything approaching a monopoly defies the facts: one need only check the specs on the 10 most popular phones in China to ascertain as much.

Impact on QUALOMM

At this point, though, it is hard to say what impact this will have on QCOM’s sales in China, which represents some 49% of the company’s revenues. There have been no specific accusations made, and few handset manufacturers who are committed to the QCOM architecture are likely to change on the basis of an unspecified investigation, particularly for those devices well along in the development cycle.

Where this may impact QCOM will be in the case of companies who are not committed to the architecture for devices in development, but who are looking to make a decision on chipsets in the coming months. This means that the longer this goes on, or if there are accusations of a specific nature levied at QCOM, there may be a meaningful impact. In the meantime, however, I expect many manufacturers to take a “wait-and-see” attitude.

Why Qualcomm, and Why Now?

There could be any number of reasons behind this: it could be concern about Snowden’s allegations; retaliation for Huawei’s treatment in the US; a growing nationalist discomfort with the success some foreign companies have enjoyed in China; or, indeed, a specific issue with QCOM. But suggesting any or all of these reasons at this time is little more than speculation.

As this all plays out, I expect we will learn more, and that we will soon know whether this is aimed at a single company, or whether all foreign enterprises in China should be concerned.

In the meantime, the wise course for any company would be to assume that “the bell is tolling for thee,” and address the specter of a changing business climate head-on.

Bill Bishop on Apple: We Need More Mojo

Temporary Hutong, Wangjing
K-Pop O.D.
1307 hrs. 

Sinocism editor Bill Bishop wrote a thoughtful piece about Apple (“Apple Needs China Mobile Deal to Regain Smartphone Mojo”)  that ran in USAToday late last week. Reading between the lines, Bill’s motive for writing the article is to give context to the excitement that rumors of a China Mobile deal are stoking among Apple shareholders. Since even before the iPhone was officially introduced in China in late 2008, speculation has been rife about whether, when, and how China Mobile (CMMC), the nation’s largest carrier in number of subscribers, would offer the phone to its users.

Five years later, the speculation continues. Yet while Apple fans talk up the company’s stock with visions of a Yangtze-sized cataract of money that flow into Cupertino’s coffers, questions persist about exactly how big of a win it would be for the company.

Tim’s Empty Quiver

First, as Bishop points out, Apple lacks leverage with China Mobile. At this point, Tim Cook’s company needs CMMC more than the carrier needs Apple. The iPhone has a shrinking share of an increasingly competitive market, and the company has made no secret of the extent to which its profits depend on China. China Mobile would almost certainly have used those facts as leverage in negotiations.

Arguably, China Mobile does suffer for not having the iPhone in its display cases, but the company has managed to do quite well without Apple, especially as the selection of devices that run on its unique TD-SCDMA 3G network and its new TD-LTE fourth-generation network. For this reason, it is possible, if not likely, that Apple made commercial concessions to get China Mobile to offer the phone. China Mobile is unlikely to be prepared to subsidize sales of the phone, especially given its keen watch on cost management over the past years. Apple may not be able to expect the high returns it once enjoyed on the device, especially if China Mobile agrees to put a bunch of advertising dollars behind the introduction.

More Users, or Same Old Users?

Second, and more important, we do not know the extent to which China Unicom and China Telecom have slurped up everyone in China who wanted an iPhone. Because a phone number change is mandatory when upgrading to a smartphone, many people took the leap with China Unicom, whose once anemic network has improved radically in recent years. As such, most of those who really wanted an iPhone may well have gone ahead and jumped to China Unicom or China Telecom.

Granted, China Mobile does have 130 million 3G users who don’t have an iPhone, and you can bet if China Mobile cuts a deal with Apple both companies will put big marketing dollars behind the device. But most of those users were added to CMMC’s 3G rolls after China Unicom introduced the iPhone, so you have to wonder whether those users are really going to care.

Finally, while a deal with China Mobile is a necessary step for the iPhone to regain its market share and “mojo” in China, it is not likely to be sufficient. As even Bishop admits, the iPhone is not “cool” anymore. Making it available to a whole lot more people is not going to help the cool factor much, and is likely to sandblast off whatever remains of the iPhone’s snob appeal. It will become, in the words of a good friend of mine, like “wallpaper:” ubiquitous and unremarkable. And that, for Apple investors, means that the premium will be eroded.

More than just Distribution

Facing a steroidal Samsung, plucky HTC, and local favorites Xiaomi, Huawei, ZTE, and Lenovo, all running some form of the increasingly impressive Android operating system, the iPhone needs more than a larger addressable market: it needs to get sexy again.

That’s a tall order. Chinese mobile users swarm to and discard phone manufacturers periodically, never to return in the same masses again. This happened to Ericsson and Nokia in China. Within three years of getting dumped by Chinese users, Ericsson was groping for a partner to save its bacon in the devices business. Nokia lost its luster three years ago, and today its mobile phone business on its way to becoming part of Microsoft.

I’m not ready to suggest that Apple is entering a similar tailspin. But what it does over the next six months will determine whether it regains its seat at the head of China’s mobile phone table, or whether it gets shoved further and further down the ranks in a very robust market.

Big Pharma, Bad Medicine, and What GSK Can Teach MNCs in China

Hutong West
Watching Louis Malle films
0813 hrs

I’m a little late to the bar with my take on this, but here it is, in three parts. Experienced China hands – go straight to the third section below.

When I first joined a global PR firm in China in 2000, I spent one day in my first week reviewing potential clients with my new boss. While my beat at the time was technology companies, I suggested we also look at pursuing some healthcare clients, maybe the big pharmaceutical companies. Surely, I thought, growing prosperity would send the demand for medicines skyrocketing, but local challengers would bring increasingly heated competition. A high-profit industry vulnerable to local competition sounded like the ideal client for us.

My boss gave a derisive snort and told me to forget big pharma. Seeing my confusion and taking pity upon the ignorant, she softened, and then gave me an eye-opening education in the ways of the pharmaceutical business in China. I won’t recount the details, but the gist was that pharmaceutical firms didn’t need public relations, because, allegedly, they marketed their wares in a rather more straightforward manner: they simply spiffed hospitals and physicians for prescribing the drugs.

Why spend money on PR, the thinking went, if what you needed was sacks of cash? I promptly forgot about Big Pharma in China until two weeks ago. Now it is clear that the plight of GSK and its cohorts is something none of us should forget.

The China operation of GSK stands accused of price fixing, of bribing doctors and hospitals by funneling those funds through travel agencies, hiding the bribes as travel costs and thus engaging in fraudulent financial accounting, and of conducting an internal investigation that failed to turn up any of these actions – actions the company now acknowledges were perpetrated by at least some employees.

This is an ugly litany, but it is not a new one. For over a decade it has been something of an open secret that some major pharmaceutical firms have been pursuing some variant of the pay-for-prescribe model. Doubtless, over the years many of those companies were counseled to cease such practices by employees and advisers. (There is some speculation as to why GSK was singled out as the monkey that would kill the chicken, but I’ll leave that to others.)

But one wonders whether, under the circumstances, GSK had a choice. It is a China business truism is that once a company has been through the market entry obstacle course and has begun generating (often spectacular) profits here, the pressure to sustain and grow that flow of cash is enormous. News about a company’s business in China moves the share price, and the prospects for business in the PRC is a key topic at a growing number of quarterly earnings calls. And the question is never “how” a company is doing business in China, but “how much.”

Capital, like justice, is willfully blind.

In a market where doctors make a pittance, where hospitals are overwhelmed yet constrained from charging reasonable rates for  care, the medical profession aches for streams of revenue that will keep the wheels on, if not line the otherwise threadbare pockets of underpaid physicians and administrators. Pharmaceutical companies foreign and domestic offer a ready source of cash, inciting a practice so pervasive that any drug firm unwilling to pony-up is simply not in the game. Add those pressures together, and a company could find itself fairly pushed down a slippery slope.

Having invested heavily for years in people and facilities and immersed in an industry where “everyone does it” and apparently gets away with it, it is easy to see why a company like GSK might be tempted – nay, compelled – to engage in behavior considered unethical or illegal elsewhere. At that point, the only alternative was to pack up and leave. This, it seems, was never an option.

And that is precisely the point.

GSK and several other multinational pharmaceutical firms look set to undergo a public revelation of the ugliest parts of their China businesses. That these revelations will damage the companies prospects in the world’s largest market is a given. All that remains to be seen is how far the Chinese government is prepared to go in sanctioning these companies for their past behavior.

Those events will take their own course. What must concern us now is a more urgent question: what other industries in China hide similar practices?

Already in the past week the Chinese government has taken to task the handful of international firms supplying infant formula to the Chinese market. The charge: price-fixing. Never mind that local companies in the same industry, by taking production shortcuts, have earned a reputation for sickening and killing children with their product, and that parents able to afford it in desperation have taken to buying imported formula often smuggled from abroad.

In so doing the government has sent a powerful message not once, but twice: no industry or company, however vital to the well-being of the Chinese people, will be allowed to engage in illegal and unethical business practices, and the foreign firms will be punished first and with greatest vigor.

In so doing, the government accomplishes three aims: it slows or stops practices likely to enrage the populace; it sends an unequivocal warning to its own local industry; and it cripples or eliminates foreign competition for its own local firms.

To every other multinational company in every other industry in China, ask not for whom the bell tolls. Xi Jinping’s administration has put the world on notice that no matter what local firms do, unethical and illegal business practices on the part of multinationals in China will no longer be tolerated, and in fact they’re coming for the foreigners first.

It is time for an immediate and thorough self-examination for the kinds of business practices that will not withstand government or public scrutiny. The time to clean up is right now, even if it cost contracts, relationships, and hard-won business. Failure to do so only puts off the reckoning and ensures that the cost will be much higher when that reckoning comes.

And there is one more lesson for the leaders and directors of any company that does or would do business in China, perhaps the most important of all.

A company entering the China market may well decide how much it is willing to spend in time, resources, and capital to attempt success there. No board worth its name would underwrite a leap into the PRC with a blank check: at some point, the cost is higher than it is worth. There would be no shame in such a decision, if for no other reason than the list of companies who have given up on China after finding no long-term payoff is long and distinguished.

But it is rare to find a company that has set an explicit limit on how far it is willing to go ethically to succeed in China, to say “here are the things we will absolutely not do in order to win in this market,” and gain board and shareholder support for that initiative. The readiness to define how much a company is willing to invest in the pursuit of success in China, but the failure to define how far it is willing to go to do so is what ensnares good companies like GSK in a web of worst practices.

And that is the lesson for all of us: if we do not draw a line in the ethical sand, stating in advance that our success in China will not be won at the cost of our ethical bottom line, we are effectively licensing the people building and operating our offices and operations in the PRC to do anything in the pursuit of financial gain.

Whatever your ethics, the Chinese government is now making clear the practical costs of pursuing such a path. If there is a future for foreign enterprise in the PRC, it belongs to companies who are prepared to live and die by a better standard of behavior, not to those who follow the lead of the meanest actors in the market.

China and Soft Protectionism

In the Hutong
What, cold again?
2142 hrs.

Protest in Hong-Kong against WTO on december 2005

(Photo credit: Wikipedia)

Though we may not be talking about it much, those of us who watch China for a living are looking forward with a mixture of dread and anticipation to the upcoming “two meetings,” the annual sessions of the National People’s Congress and the China People’s Political Consultative Committee. Even though the die of China’s future leadership was cast at the Party Congress in November, the coming NPC is the juncture where the reins of government are handed over to the new leadership, and the retiring members of the Hu Jintao/Wen Jiabao entourage graduate to the status of “elder statesmen.” For that reason, this is the point at which we will all be watching for some indication of how Xi Jinping and Li Keqiang will run the show a little differently.

While some will be looking for signs of political reform, my eyes will be cast elsewhere, namely to trade. What I want to find out is whether and how the new administration plans to play by the rules it signed up for when it acceeded to the WTO eleven years ago. Or, indeed, how it intends not to do so.

Since at least the early days of the Hu Jintao administration it was clear that the so-called Fourth Generation of leaders was somewhat less enthusiastic about playing the globalization game, and much more interested in just keeping a lid on the place. Stability was the name of the game, and the spirit of we-can-take-whatever-free-trade-can-dish-out that exuded from Zhu Rongji like a heavy cologne was blown out the window when Zhu left the building in 2003. In its place came a series of policies that I term collectively “Soft Protectionism (软保护主义),” a series of measures and behaviors that allow China to circumvent the intent of the global free trade regime almost at will.

Soft Protectionism, as I see it, consists of several pieces.

National Standards. We see this most blatantly when it comes to technology. The government establishes a standard based on a technology that is locally developed, and by so doing secures all or at least part of the market for Chinese output. The TD-SCDMA standard for third-generation mobile phones is a great example, as is the WAPI wireless LAN standard that was supposed to supplant Wi-Fi. China has learned that this policy is best conducted when it is done within the parameters of global standards-making bodies like the International Telecommunications Union (ITU) and the Institute for Electrical and Electronic Engineers (IEEE.) Through organizational activism, horse-trading, and the occasional theatrical tantrum, China is able to gain acceptance for standards that are, in some cases, little more than laboratory experiments. Using this global legitimacy, the standards ploy becomes legitimate. And lest you accuse me of being biased, let me make clear that we Americans all but invented this game, and we perfected it with our bull-headed nationalist behavior when it came to standards for digital televisions and the first digital phones. China is simply turning the tables.

Creative Use of Non-Tariff Barriers. Despite the openness promulgated by the WTO, there are still back doors that will allow governments to selectively protect industries. The first and favorite of these is the so-called National Security Exemption from the World Trade Agreements. The key phrase is “Nothing in this Agreement shall be construed . . . (b) to prevent any contracting party from taking any action which it considers necessary for the protection of its essential security interests”

That exemption gives wide latitude to any government willing to interpret it liberally, and China can and does do so, especially when it comes to information products and software. Other countries use this exemption to ensure that they have access to weapons production in the event of international isolation. The U.S. uses it, for example, to ensure its ships, tanks, and warplanes are all made by factories on US soil, but it does not use it to stop the import of foreign merchant hulls, diesel trucks, or civil aircraft. China, according to Nathaniel Ahrens at the Center for Strategic and International Studies, is comfortable crossing that line.

China also manages to restrict the free trade in publications, television, film, and music by stretching the WTO’s Cultural exemption (introduced by France in 1993) beyond the breaking point. Under the guise of protecting its vulnerable culture, China requires specific approval for any publication, recording, video, or film coming into the country. Keep in mind that we are talking about the culture that for nearly two thousand years has managed to assimilate every culture and nation that tried to subjugate it. Nonetheless, the exemption is used at every juncture.

Passive resistance to WTO Rulings. Rather than submit to WTO rulings it does not like, China conducts a passive-aggressive policy of resistance, even at the risk of undermining the institution. Dan Harris of China Law Blog fame put it like this:

“China still intends to remain within the WTO so as to be able to obtain certain trade benefits. Rather than openly disregard the minerals decision, China will resort to “procedural games” (游戏规则) to render any response against China ineffective as a practical matter. China is proud of how it has  used “procedural games” to avoid its responsibilities to respond to adverse WTO decisions and it openly states that it will continue to use this approach in these “national interest” cases. In fact, the term “procedural game” has become a standard feature of the China’s trade policy vocabulary.”

Government Catch-up initiatives. These are the micro-level great leaps that the government attempts to engineer over time in order to substitute domestically-made products and technology for locally-made equivalents. The past thirty years has seen China-government sponsored initiatives succeed in “catching up” in several industries, including shipbuilding, digital telephone switches, heavy trucks, wind-power generators, and solar power, and it is attempting to do so in automobiles, commmercial aircraft, microprocessors, and encryption software. The end result is the same: serviceable and appropriate products from overseas are gradually pushed out by government programs designed to deny them access to the market.

Government encouraged SOE support. This comes in many forms, but the most prevalent is outright cash payments. By offering low-interest or permanently rolled-over loans for state owned enterprises through state-managed policy banks at either the national or local level, China creates effective trade subsidies that are not counted according to international standards. A senior Obama administration official confided in me on the sidelines of the Strategic Economic Dialogue in Beijing last year that China’s export loans dwarfed even the U.S.’s generous programs through the Export Import Bank.

There is not much that the US, the EU, or any grouping of governments can do about any of this, short of an all-out trade war, if China chooses to continue with these policies. What this means is that even as a full-fleged WTO member, China is still capable of providing a protected environment for its firms, and has proven willing to do so.

Such policies will help companies beat foreign interlopers at home, but at what cost? At some point China will confront the other edge of that sword, whether in the form of having its behavior mirrored by other countries with tit-for-tat trade measures within the scope of the WTO; or by discovering that the companies it protected at home were weak and unprepared when venturing abroad.

For Xi Jinping, the choice in the coming months is whether to continue to use Soft Protectionism as the nation’s de-facto trade policy, or whether he will instead switch off the pumps and force Chinese companies to build the resilience necessary to beat global competition away from home. For the companies themselves, as Sunzi said, “Enemies strengthen. Allies weaken.” The wise Chinese company will seek to step out from under Beijing’s umbrella as early as possible to learn to compete on a globalized playing field, rather than a nationalized one.

The Business of China is NOT Business

In the Hutong
Bandwidth-starved
0842 hrs.

Last week I had a chance to talk with Carlos Tejada at The Wall Street Journal about how Google services have become all-but-inaccessible for users in many parts of China, and how this all seems to have gotten worse over the last several weeks. What is worse, access to virtual private networks (VPNs,) most of which require offshore payment to access and upon which many business are dependent, has been all but severed.

The Hobbled Headquarters

I made the point to Carlos that there are a growing number of businesses who depend on cloud access – not just foreign firms, but organizations based in China who actively collaborate with groups overseas to conduct research and development as well as commerce. To these companies, access constriction is a man-made disaster that is in some aspects worse than a natural one: at least with natural disasters, even one like Superstorm Sandy, there are ways to fix or work around problems of data disruption. With access constriction like this imposed by an unaccountable, unseen human entity, there is no telling when it will end, and the work-arounds are cut off as well.

The longer this goes, the more it will force businesses to re-examine the wisdom of locating headquarters or back-office operations in China:

“If China insists in the medium and long term of creating another Great Firewall between the China cloud and the rest of the world, China will be an increasingly untenable place to do business.”

Anyone who wants to do business in China is well-advised to have a presence here. But China has long made it a goal to get foreign companies to locate their Asia-Pacific headquarters in places like Shanghai and Beijing rather than, say, Hong Kong and Singapore. How many companies are likely to consider that option with a sword of Damocles hovering over their links to data and the outside world?

A Lesson in Chinese Political Economy

There is a wider issue here than just the risk and inconvenience of having to do international business through an increasingly impermeable data force-field. The past two weeks have been a rude reminder that the government and the Party place social stability and continued Party control far above commerce; that they see commerce as serving the interests of the government and the Party rather than the other way around; and that the implicit conflict between the interests of the Party and the interests of business (especially SMBs and foreign-invested businesses) are more fundamental and closer to the surface than we might wish to think.

Let us not kid ourselves, then, and suggest that when you scratch a Chinese official you will find a capitalist not far under his Communist skin. There will ever be opportunists in positions of power, but in the end all business in China remains subject to the whim of the central government’s leadership. Thirty-five years after Deng Xiaoping declared China’s reforming and opening to the outside world, political risk for every company operating in the PRC remains as real and immediate as ever.

And it shouldn’t take an internet outage to remind us of that fact.

 

Silicon Hutong 3.0: The Merchant and the Dragon

In the Hutong
Where have I been lately?
0740 hrs.

If this forum has been silent for the past month, we* have had good reason. It is now evident to anyone watching that China is on the cusp of change so large that its own leaders likely still do not grasp it. We’ve spent the last month trying to do so, and we’ve realized it is time to make some changes.

The End of Harmony

The particulars have been summed up at great length and eloquence elsewhere. In short, China has enjoyed 35 years of relative harmony enabled by acquiescence at home, accommodation abroad, and consensus within the Party. The past five weeks have made clear that this period of harmony is now at an end.

In fact, China is entering a period of great disharmony. The implicit promise of growing, shared prosperity looks increasingly difficult for the Party to keep, just as revelations emerge that suggest widespread malfeasance among the Party’s highest ranks. The willingness of Chongqing’s citizenry to accept Bo Xilai’s microwaved Maoism hints at a national mood that continues to sour. Suggesting that China is on the verge of a new revolution would be hyperbole, but the days of acquiescence are over, and the days of a more vocal, demanding populace are here.

The consensus-building approach that has characterized Party decision-making for the past 25 years appears to have reached its limits as well, and for good reason. When the way ahead was sustaining the status quo, consensus was easy to establish. The way forward is now unclear, and different political end economic visions are battling for precedence. Building general agreement among all leaders, even within the Politburo Standing Committee, will become difficult if not impossible.  The choice will be between paralysis and the end of the consensus-based system. Either direction will have vast repercussions.

As China takes its place among the leading nations of the world, especially in the wake of the Global Financial Crisis, the nation’s leaders have begun to address the world based on two implicit assumptions. First, that as an emerging world power China is entitled to change the rules of the global system to suit its needs, or ignore those rules if they obstruct China’s goals. Second, that the rest of the world will – or should – continue to accommodate China’s growing international assertiveness, even to the point of appeasement. That such assumptions place China at loggerheads with the rest of the world is of little concern. Japan, Europe, and the U.S. are too saddled with domestic troubles to effectively oppose China’s ambitions.

The Tale of the Merchant and the Dragon

If you watch China, none of the above should come as a surprise. And unless we’re living under a rock, we have to take notice. And we have. As we have done occasionally over Silicon Hutong’s decade in publication, we have taken a strategic pause in order to assess how we need to evolve this forum in light of China’s development. You will begin to see the results immediately.

First, you will see an evolution in our focus. Following the direction of my clients, this space has been moving beyond the original confines of technology, media, and public relations for some time now. We will now take the next step. Whether you do business in China or not, China will alter your playing field, and understanding why that is the case and what to do about it will be essential to everyone’s success. Our focus will become that why and the what. To that end, our five major topic areas will be:

  1. China’s Breakout: The emergence of China, Inc., and its role in global industry;
  2. China Rules: The effort by Beijing, Chinese companies, and Chinese executives to alter business norms, practices, and regulator behavior to favor Chinese firms;
  3. China Goggles: The globalization of China’s media industry and how that will enhance China’s economic and political influence;
  4. China Rewires: China’s consumers are going to alter the world’s business landscape, both for companies and consumers;
  5. Strategy, Action, Behavior, and Communications: Ideas and approaches to help executives and entrepreneurs deal with challenges of China’s rise.

Some of this, especially the last, is a recognition of the direction we have been taking for some time. The other four themes match the major directions I’ve taken in my own research and advising since 2008. It is now time to start delivering those insights.

Discussions about China’s national security, politics, arts, culture, history, and international relations will shift to The Peking Review, and will be delivered in the context of reviews of books, articles, and scholarly works about those topics.

There are more changes as well, but this post is long enough. Expect periodic updates in the coming weeks.

In the meantime, thanks for reading, and keep the feedback and comments coming.

Best,

David

* When I use “we” here, I do so not in the sense of the “royal ‘we,’” which would be a nauseating affectation, but “we” in the sense of myself and my wife and partner. While she does no writing for this forum, she is and has always been my sounding board and editorial adviser. Also, my time is our asset, so any expenditure of that asset needs sign-off. Finally, she has become a deep supporter of this forum (and The Peking Review). For those reasons, any major decision is ours, not mine alone.

The Return of News Corporation

The Speaker Lounge, Digital Matters 2012
Charging the Devices
1025 hrs.

In an excellent post in the Company Town blog over at The Los Angeles Times, Jonathan Landreth describes News Corporation’s announcement that it is purchasing just under 20% of Beijing-based Bona Film Group. (“News Corp. buys stake in Chinese film studio”)

The deal is interesting for several reasons. First, it marks a strategic departure for News Corp., which has in the past preferred to own larger stakes in its China ventures. It is also the first major investment News Corp. has made in traditional media since 2006, when CEO Rupert Murdoch told a meeting of industry executives in New York that he’d hit “a brick wall” in China.

Second, it is interesting because News Corp. is now leading from behind in China, preferring to play a fast second rather than trying to beat the rest of the industry. Similar linkages between Legendary Pictures and Orange Sky Golden Harvest, DreamWorks Animation and Shanghai Media Group, and Walt Disney and the Ministry of Culture/Tencent have been announced over the last year.

Despite some secrecy around specifics of the deal and Murdoch’s real intentions behind it, the move represents a wiser China strategy than News Corp.’s previous, dingo-in-the-butcher-shop approach. The history of foreign business in China has been dominated by a preference for speed over calculation: if we don’t get in early/first/biggest, the thinking went, we have no chance of success. It now seems that Murdoch has learned from costly experience the fallacy of such thinking, and now that Legendary, DreamWorks, and Disney have paved the way, he has followed.

Neither News Corp. nor its CEO have been idle these past six years, either. A quiet charm offensive has apparently been underway for at least the past two years, a period during which I think News Corp. has done a lot of listening and learning, understanding what is possible and permissible for a foreign media company here, and calibrating its ambitions accordingly. Many whom have dealt with the News kraken or one of its tentacles can attest that this is an uncharacteristic approach: normally it is News that defines what is possible in a given market.

I suspect, therefore, that this is a first step for News with Bona, and that we can expect the relationship to mature and expand based on the signals that come from the Party and the market in the next several years.

This is without doubt a deal to watch.

US Listed Chinese Companies: The Clock is Ticking

U.S. Regulators Push Chinese to Resume Auditor-Inspection Talks – Businessweek.

The U.S. is ratcheting up the rhetoric in the battle to improve the quality of auditing being done on Chinese firms listing or listed on U.S. stock exchanges.  The Securities and Exchange Commission and the Public Company Accounting Oversight Board (PCOAB) are trying to get the China Securities Regulatory Commission to require joint inspections of auditors from both the US and China for Chinese firms listed in the US.

The Chinese, claiming concerns over the revelation of “state secrets” are having none of it, seeing the US request as a violation of Chinese sovereignty.

PCOAB Chairman James Doty is apparently getting frustrated with his Chinese counterparts, who have abruptly cancelled bilateral discussions on the issue.

‘We can’t simply pretend that China is different,; he said. ‘You can’t come sell your securities here and ignore the fact that the law requires and people want to know that the auditor’s been inspected.’

Doty is not a paper-tiger bureaucrat that the Chinese can afford to just ignore:

The [PCOAB], which was created by the Sarbanes-Oxley Act of 2002 after accounting scandals contributed to the collapses of Enron Corp. and WorldCom Inc., has authority to de-register China-based auditors, which could start a chain reaction leading to companies being unable to list on U.S. exchanges.

Doty, SEC Chairman Mary Schapiro, and Senator Chuck Schumer all seem to believe that this tough talk will compel China to give in, believing that China is more afraid of losing access to the capital in US markets than they are of giving auditors a glimpse at the dirty laundry of Chinese state-owned enterprises, or even of China’s actual level of defense spending.

They may be right. But many Chinese policymakers, offered the choice of putting state secrets at risk or funding Chinese firms outside of U.S. equity markets, will be motivated to take the latter course. As I noted in an earlier post, the growing complexity of listing Chinese companies in the US and the maturation of China’s own equity markets make the repatriation of offshore listings an increasingly tempting option both for regulators and companies.

Don’t get me wrong: I think that whatever else might be motivating them, Doty, Schapiro, and Schumer are right to be trying to protect the interests of investors. At the same time, though, they have to recognize two hard truths.

First, it is still unclear whether U.S.-based auditing firms operating in China are passing PCOAB inspections. Not only should the PCOAB attend to that task first, it should make the results of those inspections public. Failing to do so makes US regulators look hypocritical.

Second, the long-term outcome of this effort is less likely going to be a major improvement in corporate transparency in China than to hasten the shift of Chinese equities out of the U.S. and into Chinese exchanges. While US bourses boast far greater liquidity than China, the Shanghai and Shenzhen exchanges have access to a large, relatively undemanding pool of capital hungry for hot new listings. PRC exchanges could easily absorb a steady, modest stream of Chinese companies de-listing in the US and listing (or conducting new offerings) in China.

Doty et al are to be commended for their efforts. Sadly, corporate transparency in China will only improve when the Chinese government demands it in order to protect Chinese investors and/or the global position of Chinese markets.

Chinese TV: App to the Future

In the Hutong
Back from CASBAA
1307 hrs. 

China: The New Mobile App Dragon,” by Peter Farago, Flurry Analytics

If one conclusion stands out after all of the panels at the Cable and Satellite Broadcasters’ Association of Asia (CASBAA) conference this week, it is that all of the broadcasters in the region see the challenge posed by New Media (even China Central Television [CCTV]), and none of them are quite sure what to do about it. As one CCTV executive told me, “we all acknowledge now that new media, the Internet, and mobile are the future, and that we want to be a part of that. But the question is ‘how’?

Steve Garton of Synovate suggested in a well-attended breakfast meeting that part of the answer lies with apps. In his presentation, Steve made the case to the region’s broadcasters that they needed to get better at using mobile apps to distribute their content on smartphones and tablets. Specifically, Steve noted that his company’s research around the world had proven that the best way to get in front of users would be for a broadcaster to have its app pre-installed on phones when sold.

It is not hard to foresee an edict from the Central Government requiring all carriers selling smart phones to include a CCTV app on those devices, and the numbers suggest that the Party needs to start looking at mobile as a means to ensure that it is still reaching China’s post-90s generations. According to Flurry Analytics, China began 2011 ranked 10th in the world in the number of global app “sessions” on smartphones and tablets. Growing 870% in the first 10 months of this year, China has passed every country but the US and now ranks second worldwide in app use. And one of the top 10 must used apps? Youku, which, by the way, comes pre-installed on many of China’s handsets and tablets.

I’d wager CCTV and the other broadcasters will not long permit Youku exclusive rights to that space, but all of the terrestrial and cable broadcasters face the same problem: how to attract the user to their apps when those users do not watch the stations? And if they collaborate with Youku and Tudou to distribute their content, what value do the broadcasters add? And what happens to their brands?

We cannot yet rule out the possibility that the broadcasters will move to create a Hulu-type service and pull their content off of the other sites. But that still leaves them with a large back of programming all in one place, and the brutal challenge of getting people to actually use the service. And for all of their production and engineering prowess, Chinese broadcasters are not the bastions of marketing that their U.S. counterparts have been.

For these reasons, the question of how broadcasters will deal with apps and mobile seems to point toward the same eventual solution as do the tricky politics and economics of the broader online video sector: eventual mergers between the broadcasters and the major online video sites.

China’s Choice

As Number One, China To Face Hour Of Choice, by Richard Bush, YaleGlobal Online, June 30, 2011

Richard Bush, who is the director of the Center for Northeast Asian Policy Studies and a senior fellow at the Brookings Institution, offers alarmists in the West some perspective about China and its seemingly inevitable rise to economic leadership in this well-worded article in YaleGlobal.

One fascinating point Bush makes is that China faces a choice with its economic might: either build for domestic prosperity and harmony, letting the US “bear the burden of international leadership,” or it may use its treasure to expand its global influence and power. It is a fascinating point, but I would wager most Chinese would reject the choice. The US has (until recently) enjoyed global power and domestic prosperity, as have Britain, France, Spain, and the Netherlands before it. Why, the thinking will go, must China choose? Can it not have both?

The greatest challenge the world faces with China’s rise is the sense of national entitlement that seems to suffuse popular sentiment, in particular among the young. Being the world’s largest economy should come with the trimmings, they think.

Some Chinese believe that passing this milestone will have automatic consequences for international politics, giving China more international influence. In their view, other countries should then confer more deference on China and accommodate to it on issues that China regards as important, rather than China continuing to accommodate them. At some point, Beijing will likely insist that the head of the International Monetary Fund or World Bank be a Chinese.

Whether practical or not, the people of China will want both prosperity and power, and unless the government begins a campaign to manage those expectations rather soon, the Party will find that it has made a mighty rod for its own back. The government will be expected to deliver on both global power and local prosperity.

That challenge will form the primary driving force behind China’s international relations, whether in defense, diplomacy, economic relations, or commerce and trade. A China so pressured from behind will not sit politely in its seat at the table of global power and learn which fork to use. It will have to insist that the rules created to manage a world led by an Atlantic civilization be changed to address a shift to a world dominated by Pacific powers, including the US.

Rather than panic, which Bush suggests is uncalled-for, the time has come for us to determine which aspects of our global systems of security, diplomacy, economy, and commerce are – for us – non-negotiable, and why. We should try to guide China’s hand at the global table much as Britain guided ours, but we should hold true to our principles and our non-negotiables.

China’s choice has been made for it. The real choice belongs to the West.