Understanding the way China is governed, and why.

The Alipay Warning

Hutong West
Watching the Overcast Burn
1120 hrs.

Sometimes, when the Chinese government is considering or planning a policy change, they will make some sort of formal announcement in advance. But not always: often, they will signal their intentions more subtly. That is the kind of behavior that keeps policy analysts in business, and that keeps all of us watching for statements and remarks that may signal a warning of an impending change.

VIE another day?

Xinhua may have issued such a warning to foreign investors in Chinese online companies a few weeks ago. In an article examining the Yahoo!-Alipay dispute, Xinhua suggested that the structure Yahoo! used to invest in Alibaba – and that is used my a number of overseas investors to circumvent laws restricting foreign investment in the Internet – may no longer escape government scrutiny.

The structure, called a variable interest entity, or “VIE,” is essentially a set of technical service agreements between a foreign entity and an internet company in China, allowing a foreign company to be paid for its “services” based on the performance of the Chinese company. One hard look at how these deals actually work would reveal them to be what my mentor Jeanne-Marie Gescher calls “functional equivalents,” in that they are the functional equivalent of an investment. While keeping within the letter of the law, they stray outside its intent.

And that is the problem. As Xinhua notes:

Fang Xingdong, founder of blog provider bokee.com, said that there is tendency among Internet companies and foreign investors to gamble on whether the government will actually enforce its rules.

The Alipay case shows that the VIE structure may not be safe for foreign investors anymore and it is hurting the credibility of Chinese regulators, according to Fang.

Remembering Zhong Zhongwai

Those who are skeptical that the government would step in this way would do well to recall (or look up) what happened in the case of another functional-equivalent structure used during the 1990s to siphon foreign investment into the restricted Chinese telecommunications sector. That structure, called a “sino-sino-foreign” (SSF) arrangement, circumvented the letter of the law by creating an onshore equity joint venture between a local company and a foreign investor. The joint venture, ostensibly a Chinese company, would then make the investment in the local telco.

After ignoring them for several years the government pulled the plug on those entities in 1998, declaring them to be illegal under the law restricting foreign investment in Chinese telcos. The government required the local companies to buy out the foreign investors, most of whom were large global players like Deutsche Telekom, and rode roughshod on the process to make sure it happened. The denouement of SSF was ugly, a distraction for all involved, and an unequivocal warning from the Beijing aparatchiks: you may sneak around the law, but eventually we’ll catch up.

When Will the Bell Toll?

The bell will probably ring at some point for the VIEs, and it might be soon: the Alipay case could serve as a first warning shot, and it need not require some sweeping, high profile legal or policy change to end the validity of these arrangements, just a small change in the administrative rules of a single ministry. In the Alipay case, according to Xinhua:

The central bank created a rule last September that requires all payment-service companies in the country to obtain a specific type of business license, which can only be granted to Chinese-owned entities.

For online entities, the axe could fall from any of a number of directions: the Ministry of Commerce (MofCom), the State Administration for Radio, Film, and Television (SARFT), the Ministry of Industry and Information Technology (MIIT), or a player to be named later. If history is any guide, the only real question is “when?”

Right Soon, Probably

For many companies, operating in the gap between law and enforcement is the only available way to participate in the market, and when your competitors are doing the same thin, it is hard to resist the opportunity. Many of us have done it, and it is more common that any of us would care to admit. But that is no justification for complacency.

There are varying degrees of regulatory risk in China, but when you count on either lax enforcement of the law or enforcement limited to the letter of the law, you place your money at the mercy of bureaucratic whim. Regulators tend to get very jumpy during times of political change, looking for ways to clean up their patch to show the new leadership that they are on the case. As we approach 2013 and the handover to a new generation of national leaders, we are on the cusp of such a change in China.

So the Alipay case and Xinhua’s response to it should be construed as a warning. Companies depending on a VIE for an investment in China or for a local business operation need to start thinking about those two magic words: “exit strategy.”

Primer on China’s Leadership Transition (via Patrick Chovanec)

In the Hutong
Reading Heavily
1841 hrs.

I have never reposted other bloggers here on Silicon Hutong, but after reading this piece I decided it was time to start a new tradition. Professor Chovanec offers what is without doubt one of the most concise yet complete overviews ever of a political event in China, and it is worth reading and absorbing:

Primer on China's Leadership Transition Over the past few months, several people have written asking me to offer a short “primer” on China’s upcoming leadership transition, which begins next year.  The handover to a new president and premier has generated plenty of speculation in the press, about who the leaders are and what is will all mean, but sometimes it’s useful to go back and fill in the very basics, since China has a unique and in some ways quite confusing political system. The … Read More

via Patrick Chovanec

Is Film Finance in China About to Change?

In the Hutong
Break time
1120 hrs.

Since China began the reforming and opening process in the late 1970s, a small number of industries have been held outside the reforms that most other sectors have enjoyed. One of those industries has been the national defense complex, and the other has been media.

The media and entertainment sector in the world’s largest and most entertainment-hungry market has been kept in the hands of government at the insistence of the Party. This has meant that the government has rebuffed not only attempts by foreign investors to buy into domestic traditional media properties, but similar attempts by powerful local companies as well.

The result has been the anemic development of the domestic media industry, forced as it is to rely on its revenues, the government, and ingenuity to support its efforts. This has been particularly challenging for the film and music businesses in China, making it difficult for those businesses not only to finance new projects, but to make long-term capital investments and to attract and retain talent.

Not so constrained have been new media companies, in particular the online video websites, the largest of which are taking foreign venture capital investments, conducting offshore IPOs, and starting to produce their own television/video programming. This contradiction is a latent problem in Chinese policy, one that is frustrating to the leaders of China’s state-owned traditional media, and it becomes more severe as the online video sites grow in revenue and production capacity.

The government will have to level he playing field at some point. They can do so either by forcing the online video sites to buy out their foreign investors (not so easy after an IPO,) or by allowing traditional media companies to seek outside investment. The latter would mark a radical shift for Chinese policy makers, and one fraught with risk. The implicit belief in Beijing is that once private interests control media, the Party loses control. In China’s system, this risk is nigh unacceptable.

But there are some signs that the party is willing to experiment with a degree of private ownership in traditional media. South Africa’s NASPERS has long held an interest in Beijing Media Corporation, a marketing and advertising vehicle for print media in Beijing, and a joint venture with Anhui Daily Newspaper Group. These deals took place with the implicit approval of the Party, and it appears they are being watched with great care.

That degree of experimentation appears to have now extended to film. Last week, Beijing Xiangqiao International Media, a film and animation production company and subsidiary of state-owned Hunan Broadcasting, went private in a management buy-out, and there are apparent plans for a domestic IPO at some point in the future.

This will be an important development to watch. If this is allowed to go forward, this marks a limited but key precedent for wider privatization – and private finance – in China’s growing film industry.

This could also be a watershed moment for online video providers like Youku (YOKU) and Ku6 (KUTV). If regulators are prepared to allow domestic production houses outside investment, it could mean that they are also prepared to allow Youku, Tudou, Ku6 and others to continue their evolution toward becoming integrated media companies.

Handicapping Little Sheep

little (fat) sheep
Image by conbon33 via Flickr

In the Hutong
I hate writing about food before dinner
1721 hrs

Tom Orlick, who does the Heard on the Street pieces for China at the Wall Street Journal, did a short but excellent rundown of some of the commercial challenges Chinese hot-pot chain Little Sheep faces as global fast-food monster YUM (owner of KFC, Pizza Hut, and Taco Bell) sets out to acquire the company. There are other bogeymen in the basement of this deal, however, and the largest of those is the Chinese government.

The government has regularly demonstrated (but not often communicated) its policy on foreign companies buying local firms, a topic I last covered in the wake of Coca-Cola’s failure to acquire Chinese juice giant Huiyuan. Put simply, while the government is comfortable allowing foreigners to acquire struggling or failing Chinese companies, they object to healthy, growing local companies winding up in foreign portfolios.

Regulators especially object to budding local brands like Little Sheep falling into non-Chinese hands. Chinese regulators may see Little Sheep c. 2011 as McDonalds c. 1960, and would be in no hurry to see that brand captured so young and turned into an American global franchise operation.

Worse, regulators get very squeamish when a local brand is being acquired by a foreign company already dominant in the sectors. The PRC restaurant industry is incredibly fragmented, but there is arguably no company with a wider collective brand presence in mainland eateries than YUM.

There are enough parallels between the YUM/Little Sheep deal and the Coke/Huiyuan deal, then, to suggest that regulatory review is going to be a major hurdle, if not a deal killer.

YUM has one hope for success, and that is an astute and persuasive communications full-court press to build local support for the purchase among both regulators and the public at large. That campaign needs to start yesterday.

If, however, YUM skimps on the effort to build support for its efforts among any and all groups in China that could raise reasonable objections (and there are plenty of those, beginning with Little Sheep’s competition), this will turn out to be a long, expensive, and ultimately fruitless effort.

In the west, we are used to using acquisitions as a tool. Deciding to buy a company is a straightforward mathematical exercise: would it be cheaper to replicate what you want to build in a given market, or to simply go out and buy it? In China, though, the analysis is undermined by the calculus of a Party bent on nurturing and building its own global brands. Just ask Coke. Or Carlyle.

Having spent a quarter century building two successful businesses in China (KFC and Pizza Hut) and having failed in China with two others (Taco Bell and A&W), YUM can be forgiven for wanting to take a shortcut to its next success in the PRC. Unless it undertakes a brilliant charm offensive, YUM may wind up wondering if it wouldn’t have been easier to cook its own mutton.

An Old China Hand and China’s New Foreign Policy Factory

In the Hutong
New Year Day Five
1718 hrs.

Ross Terrill of the Fairbank Center is an old China Hand, and he writes incisively about a range of topics on China, most notably the nation’s foreign policy.

Recently, he contributed a brilliant article to the Wilson Quarterly entitled “The Case for Selective Failure“, in which he argues for and posits several scenarios where China would stumble just enough to provoke positive and meaningful reform but without experiencing complete systemic breakdown. Undoubtedly we could talk all day about the likelihood of such an event occurring and argue ourselves to a standstill: there is just no way of knowing until after it happened, but the uncertainties are enough that you’d never want to purposely try to provoke such an outcome.

What interested me most, though, was Terrill’s view of China’s foreign policy-making process, revealed in this bit of the article.

There are wise heads in Beijing who understand the latent power of American nationalism and other dangers facing a Chinese rush to the top. They urge their leaders to stick with Deng’s maxim of “hide our strength and bide our time.” These cautious folk in well-connected think tanks and even government ministries do not believe the public mantra that the United States is “holding China back.” Rather, they see clearly that the United States is a force fueling China’s rebirth—by buying Chinese exports and supplying technology for Chinese industry, among many other ways.

There are indeed wise and cool heads in Beijing, but Terrill’s view of how foreign policy is formulated in China comes across as a tad outdated. As I wrote in “The Case for a New Public Diplomacy in China” both here and in AdAge China in 2008, the “cautious folk in well-connected think tanks and even government ministries” are no longer the sole nexus for the creation of policy. As we have seen evinced all too clearly in the past several months, there are a lot of chefs in China’s foreign policy kitchen, and two of the most important new entrants to the process are the PLA and popular opinion.

Over time, these two players will the formulation and execution of foreign policy a complex, slow, and highly politicized process that threatens to retard the conduct of diplomacy in China. To depend on the realists and ignore the idealists, irredentists, and nationalists in Chinese foreign policy would be like ignoring the progressives and the Tea Party in the United States.

Terrill “hopes” that events will see these players in Chinese foreign policy marginalized. But hope is not a method, and it is a poor approach to the conduct of international relations. Wise heads in Washington, DC, Tokyo, Brussels, London, and elsewhere need to adjust their efforts, strategies, and toolkits to incorporate the full set of foreign policy influencers in China, not just the ones who play by the old rules.

The above aside, the article is superb, especially the barbs he tosses at Nouveau Sinologists like Niall Ferguson and American Declinistas. Give it a read.

Why Hu Jintao is not a Lame Duck

Hu Jintao
Image via Wikipedia

In the Hutong
Keeping warm
1434 hrs.

Last Friday I had an interesting conversation with Newsweek’s Isaac Stone Fish. Among other things, we talked about the growing meme among China observers that as Hu Jintao takes his trip to the United States, given that he only has two years left in his 10 year term, he is somehow a “lame duck”.

As I told Isaac, Hu is nobody’s idea of a handicapped waterfowl. The importance of Mr. Hu being in the “home stretch” of his administration is at best overstated, and at worst completely misunderstood, for two reasons.

Peak Power

Most observers calling Hu a “lame duck” are looking at the situation in China through a filter formed by years of watching Western politics. In the West, when leaders are elected to office, they begin their administrations by selecting a slate of their own senior bureaucrats and political appointees, allowing them to place their stamp on government and put into place a group of officials prepared to take the President’s direction.

This system, commonly known as “to the victor goes the spoils,” ensures that when a new leader comes office, they not only bring an electoral mandate, they come to office with a tremendous amount of power and at the very least control over their own administrations.

By contrast, when the Communist Party of China selects a leader to take the highest position in the country, that individual’s ascent is the result of debates and compromises at the highest levels of the Party, and the new leader must govern with a team of bureaucrats and political appointees selected for him by the Party’s Organization Department. What this means is that many if not most of the individuals working for this new president are not beholden to him for their political fortunes to the same degree as their Western counterparts, and some, as the result of the compromises that brought the leader to office, may even be members of a rival faction.

After the leader takes office, though, he is able to gradually extend his influence as the Party and the government evolve, as official retire, and as circumstances permit. As such, China’s leaders thus build and consolidate their power over their time in office. This explains in part how Jiang Zemin was able to muster the support to retain his chairmanship over the Central Military Commission for a year after he handed the reins to the Party and Government to Hu Jintao.

Indeed, you could argue that every Chinese leader since Deng Xiaoping left office at the peak of his power. Hu Jintao is unlikely to be any different.

Consensus Rules

The other reason Hu is not a “lame duck” lies in a misconception about the ebb and flow of Chinese government policy that is also rooted in a western view of politics. Leadership changes in western countries, even those where leaders are of the same party, are usually harbingers of policy change, sometimes quite radical (in rhetoric, at least.) This is because those policies are a reflection of the leader and his/her values and priorities.

In China, however, policies are formed over time in response to a wider set of considerations, and decision-making is more consensus-driven, especially foreign policy. China’s leaders are now “first among equals,” and thus less likely to impose their personal imprint on policy. Those policies are not just made by government functionaries, but by the Party, the PLA, and a growing host of domestic special interest groups to which China’s leaders are increasingly beholden.

If Obama makes a deal with Hu today, in other words, he is not making a deal with an administration that is on its way out the door, but with a governing apparatus that will change only incrementally when the new administration takes office. In other words, all other things being equal, Xi Jinping will be as obligated to adhere to the policies and agreements of his predecessor as Hu Jintao is today.

The Lame Duck Problem

This is more than a matter of semantics. The west generally and America specifically cannot afford to put off substantive progress in relations with China until 2013. The problems that plague the bilateral relationships need to be addressed now, and addressed with the understanding that waiting until Xi ascends and consolidates his power, we will have lost as much as five years in the effort.

The time to engage with China is now, and, at the moment, Hu is the man.

Buy Olive Futures?

Olive oil from Imperia in Liguria, Italy.
Image via Wikipedia

In the Hutong
Burning up the Keyboard
1500 hrs.

In The Wall Street Journal China RealTime Blog, James Areddy  writes a brilliant article about the role oils play in the Chinese diet, and the challenge this presents Chinese policymakers when the prices of oils rise quickly. What intrigued me most, however, was a throwaway comment about two thirds the way down the page.

To counter the oil shock, Beijing is urging consumers to diversify their tastes and consider their health. According to the Xinhua news agency, “Chefs say olive oil complements Chinese cuisine and you don’t have to worry about sacrificing great taste.

If the central government, via Xinhua, is extolling the virtues of olive oil, what happens when hundreds of millions of Chinese start paying attention? What happens to the price of all of oil, especially the extra-virgin varieties, when hundreds of millions of Chinese families decide to start cooking with olive oil?

Can China become an olive oil producing nation?  Or can the rest of the world ramp up production sufficiently to meet the needs not only of health-conscious Americans and Europeans, but of increasingly prosperous and very hungry Chinese?

Matching the Dragon

In the Hutong
Watching the Skies
1512 hrs.

Robert Gates, a longstanding opponent to big-budget weapons systems like the F-35 Joint Strike Fighter, a man who has made it his mission (rightly, in my opinion) to bring to heel the Fighter/Bomber mafia that has been running the U.S. Air Force since 1947, is singing a very different tune this week, all thanks to our friends in Chinese Aerospace. From Elizabeth Bumiller’s piece in The New York Times:

The American weapons that Mr. Gates was referring to included investments in a new long-range nuclear-capable bomber aircraft, which the Pentagon had stopped developing in 2009, as well as a new generation of electronic jammers for the Navy that are designed to thwart a missile from finding and hitting a target. At a Pentagon briefing on Thursday, Mr. Gates said that the jammers would improve the Navy’s ability to “fight and survive” in waters where it is challenged.

Mr. Gates was also referring to continued investment in the Joint Strike Fighter, the Pentagon’s newest radar-evading fighter jet.

The Pentagon provided no estimate on Saturday of the total cost of the three programs or others meant to counter the Chinese buildup in the Pacific.

If a skeptic like Bob Gates is changing his mind about these programs, China may well have pushed the U.S. past a critical tipping point in the nation’s perceptions of China’s intentions. Despite protests to the contrary today (“no, really, Mr. Gates, this is not about YOU. We just want to feel safe,”) these seem to be systems designed if not to defeat the U.S. military in actual combat, then to carve out a sphere of influence into which the U.S. could no longer comfortably project its influence.

What is Beijing Thinking?

In which case, you have to wonder what the Chinese were thinking by showing off two disruptive weapons systems in the space of three months. One school of thought would say that they are doing this for domestic reasons that have nothing to do with the U.S. That’s possible.

Another school would say that the Chinese wanted to give the Americans pause, but gave no consideration to the fact that doing so would fundamentally alter the way the PLA is perceived by fence-sitters in the U.S.

But a third school would suggest that the Chinese new precisely what they were doing, that they knew this would provoke some instant anti-Chinese sentiment on Capital Hill, bolster the Panda-Sluggers in the Pentagon, and cause America to start pumping cash into weapons systems designed to combat a “near-peer” power. In this case, the theory goes, the Chinese want to provoke the U.S. into an orgy of weapons acquisitions that effectively derail the U.S. economic recovery (or at least slash the investments the Obama administration wants to make into rebuilding infrastructure), undermining long-term competitiveness and leaving  the country even more dependent on Chinese financial support.

The last one seems a tad far-fetched. But the more I think about it, the more it seems like a stratagem straight out of Sun Tzu. After all, isn’t this how America ostensibly won the Cold War? By making the Soviets spend way more than they could afford on matching NATO all while having to pour more money into Afghanistan?

Four Strategic Directions

The ball is now in America’s court. China and the world will be looking to see how the U.S. responds. And the smart thing to do is nothing…yet.

It would be foolhardy to be provoked into a spasm of military spending, especially if the grand strategy behind China’s hardware ante-upping may not be about goading America and its allies into a confrontation, but to drive us into a costly and ineffective military buildup that the Security Council powers can no longer afford. What greater triumph could the West hand China than an America doubly weakened by profligacy in consumer credit and arms procurement, lessened in stature, and compelled by domestic politics to retreat behind the dubious security of its coastlines?

Reverting to the postures and strategies of the Cold War would not bring the result America desires. No, this deserves a better, wiser response, one more suited to the strengths, weaknesses, desires, and vanities of a would-be challenger.

1. Calculate – Think Grand Strategy, Don’t React

Time to go back into the planning rooms and devise a grand strategy for addressing a rising Chinese military power, one that does not presume unlimited defense budgets, and one that takes the growth of four rival powers on the Eurasian content as a given (those being China, India, Russia, and the EU.) How does America’s perception of threats evolve? And what, precisely, are China’s true aims? Not the aims they claim, or those Fox News gives them, but what they really seek, what they’re willing to sacrifice to achieve those aims, and how and why those aims might change.

Until the leaders of the services have a better grasp on China’s strategic calculus, they cannot respond with any effect.

2. Educate – Admit America is China-Ignorant, and Start Doing Something About It

It is time to accept that the Chinese know a lot more about America than America knows about them. And that’s not a matter of bad intelligence, but a matter of misplaced priorities. It is time to change that, starting with the Pentagon. As Commander Tom Henderschedt and Lt. Colonel Chad Sbragia wrote in the Armed Forces Journal last September:

Conversely, while many U.S. maritime services personnel are dedicated to China, few currently on the “China account” have visited China, fewer still speak Chinese and nearly none have enjoyed direct, day-to-day experience with the PLAN and PLAN strategic initiatives. Disappointingly, no experts are placed to affect critical Navy Department planning and policy efforts. The deep understanding by the PLAN allows its officers to be extremely predictive on how the U.S. will act, react and negotiate. The inverse is also true — our superficial approach does not allow deep, predictive analysis of PLAN strategic initiatives.

I would venture that, while Henderschedt and Sbragia contain their comments to members of the maritime (i.e., Navy, Marine Corps, and Coast Guard) services, their comments apply to the Army and Air Force with equal or greater veracity. They counsel:

The most important near-term task is not establishing whether the PLAN is or is not a threat, but truly establishing a deep understanding of the PLA Navy, one that would rival the PLAN’s understanding of the U.S. Navy. Then, with clear penetration of Chinese maritime strategic thought, U.S. Navy “China hands” will be prepared to answer any call — from a PLAN threat or a PLAN partner.

China expertise can no longer reside solely among the China specialists in the U.S. armed forces. That knowledge needs to be disseminated, absorbed, debated, studied, and applied. Responding to a “Chinese threat” before truly understanding whether it is even a threat or whether it is something else entirely serves neither America nor China.

3. Rennovate – Don’t Prepare for Cold War II, Rebuild for The World As It Is.

Mr. Gates needs to make some radical changes to service leadership in the same way he took a fire hose to the Air Force. A few more warriors and fewer careerists atop the Pentagon would be a good start. But what really needs fixing is the military’s procurement system.

A list of prescriptions would be book-length, but it is clearly time to burn the old book, because things aren’t working. The focus has to return to a) superb research and development to keep the most recent innovations on tap, b) taking care of the people in uniform, getting them systems that enhance and protect them, and c) disrupting the capabilities of challengers in the most cost-effective way possible. Our challengers have learned to think asymmetrically about us. We need to start doing the same in return, rather than just buying more and bigger gold-plated systems.

We can argue about specifics, but America’s sword is not only tarnished, it is no longer the right weapon. Time for a rethink.

4. Communicate – The Future Lies With Bloodless Victors

Not everything as about knowledge and armaments. The Chinese know better than we that the best victories are won without fighting. And that means good communications. Elucidating America’s intentions around the world in a way designed to promote support for our goals, rather than have the US branded a loose cannon or worse, would be a good way to start. Mr. Obama began his administration that way, and the State Department is doing its part, but the military are, like it or not, diplomats in uniform, and they need to do more.

First, as Hendereschedt and Sbragia urge, there need to be more interactions between U.S. and Chinese military personnel, not to try to “win them over,” as that is unrealistic, but simply to know them better and to open more channels of communication.

Second, the military needs to craft a peacetime psychological operations capability that can work alongside (but separate from) an enhanced U.S. public diplomacy effort. Deterring a challenger without resorting to violence or coming close does not happen by accident: it is the result of a concerted effort to make clear the fruitlessness of a challenge. For too long the U.S. armed forces have shunted psychological operations into the reserve, calling upon its capability tactically and only in time of armed conflict. In this day and age, if you wait for the war to start psyops, you’ve waited too long. And it needs to be strategic, not tactical.

Finally, it is time to answer loudly the public criticism of small-team U.S. military engagement around the world. The oft-repeated wails of academics like Stephen Walt of Harvard that U.S. deployment in 140 countries is ridiculous only demonstrates their misunderstanding of the costs and benefits of such missions. Argue Iraq and Afghanistan all you want, but ignore the benefits of small-footprint presence at your peril. It is just those sorts of missions that are helping the U.S. military make it more challenging for China to achieve low-cost victories in the region. That’s communications, that’s asymmetric.

Again we can argue specifics, but these are the four strategic directions that the U.S. military should take in response to China today. To do less would be foolhardy, but to do more would be premature at best, and at worst could put us on a path to an avoidable and unnecessary conflict.

A Last Chance for Public Diplomacy in China?

In the Hutong
Blogbuilding
2027 hrs.

MIT’s Yasheng Huang notes in Foreign Policy that U.S. diplomacy with China is focused on far too narrow an audience.

But to engage only with official Beijing is no longer enough. It is vital that American leaders learn to communicate more effectively with the Chinese people — lest the conspiracy theorists do the communicating for them.

Dr. Huang echoes a post I made here and in AdAge China two years ago following the election of Barack Obama, calling for a renewed and expanded public diplomacy effort in China:

First, while the government and party remain in control, the means by which decisions are reached is evolving. China is increasingly governed through a process by which consensus is reached among groups and policy makers, or as I like to say “one party, many factions.”

Second, this change has opened a window for groups outside of the government to exert more regular influence on policy making. While China’s leaders and bureaucrats still operate in a system where they are free to ignore public opinion when they forge policy, they are (for a variety of reasons) seeking more input from business leaders, academics, foreign experts, and even the public itself.

Third, this is all taking place in an environment where the role of the web is growing in China, and the permissible scope of discourse is wider than most non-Chinese appreciate.

That Dr. Huang is having to repeat the point makes clear that the Obama administration has lost an opportunity it could have taken from the beginning. That failure is now starting to erode whatever popular support the U.S. had in China, and is postponing the day when that support might be grown.

The hour is not too late, but there is no time to lose. The Chinese people have a growing influence on the conduct of Chinese foreign affairs, and the balance of power in domestic politics is and has always been the key driver of China’s foreign policy. Washington must understand that it is no longer playing to China’s Party elite. It is also playing to the masses, and thus far it has done a poor job.

Beijing vs. the Provinces: A Rethink

Party cadres at a meeting 1983 开会
Image by kattebelletje via Flickr

Pacific Century Plaza, Beijing
Sucking Coffee Grounds
1145 hrs.

For a long time I have been trying to find a good way to frame the evolving relationship between China’s central government and the provinces in a way non-Chinese could start to understand. China is not a confederation like a “unified” Europe, nor a nation with a clear and constitutional division of powers between state and national governments like that of the U.S. Nor is it, fortunately, a coalition of regional warlords with a single leader as ostensible primus inter pares like the Republic under the Kuomintang.

But a passage from Chapter 6 of Richard McGregor’s book The Party helped the penny fall into place.

“Every jurisdiction is a company, and every company a jurisdiction – all of them with powerful incentives to compete against each other.”

China functions, essentially, in a manner I would call “corporate federalism.” Each province and locality operates as an economic entity, and the political relationships among them and between the localities and the center are driven by the economic (i.e. commercial) interests.

As McGregor points out, the central government’s challenge is that the more it asserts its power over provincial affairs (including its tax collections), the more it serves to slow the economic engines in the provinces. The looser it holds the reins, though, the greater the opportunity for the negative effects of rapid development to run rampant, and the less responsive the provinces are to centrally-driven policy and regulation.

The ongoing process of maintaining a dynamic balance between the center and the regions in China is different than the classic issue of centralization vs. decentralization. While China’s local party organs and governments are structured to look like the central party and government in miniature, appearances do not reflect reality.

In truth, the system more closely parallels the way industry regulators in the west manage their corporate charges, with the focus being allowing the commercial entities the widest possible range of freedom as long as the economic benefits of their activity do not over-exceed the social and political costs thus incurred.

As such, the central government does not concern itself with a sharing of powers. Instead, it retains full power but informally grants the localities considerable license in return for playing their role in ensuring growth, and thus supporting the legitimacy of the party and the system. Only when local leaders publicly fail in this effort do central authorities step in.

Whether his is a “good” thing or a “bad” thing is subject to debate. What is laudable about framing centers of power in an economic context is that a) it keeps those centers focused on commerce, not on playing power politics (a fatal malady in a naturally centrifugal country like China), and b) it provides a framework for incorporating non-governmental economic actors, like major SOEs, in national decision making.

Traditional political power-sharing systems, like confederations or federal states, ignore non-governmental actors or pointedly exclude them from the process as non-relevant, forcing them to play sub-rosa roles in a polity or form alternative power basis. A corporate federalism, on the other hand, is in a position to integrate non-governmental actors into the system, something that, while inappropriate for parliamentary or republican democracies, may actually be a wise approach for developing states.

What I expect is that corporate federalism will be a transitory arrangement for China as it evolves. In the meantime, this gives us a framework to begin to understand the varying roles local, provincial, and national governments play in our businesses.

Responsa: Dealing With the Disposable Backhoe

Caterpillar 12G grader.
Image via Wikipedia

In the Hutong
Managing the Phoenix
1330 hrs.

Jack Perkowski continues our serve-and-volley on the future of China’s construction equipment makers here on his Managing The Dragon blog, and he brings out the Caterpillar fanboy in me when he notes:

“How should Cat, Komatsu, and the other global leaders prepare for Chinese competition overseas? By far, the best way is to compete successfully with them in China.  That is why the battle for the construction equipment market in China is so critically important.”

That seems obvious, but the next logical question is how?

They Drive ‘Em Different Here

The global majors are geared up to compete in very different kinds of markets. In any ordinary market, you are selling a piece of equipment to a construction company that is concerned about things like the total cost of ownership of a road grader over a 10-20 year life. To serve markets like that, companies like Caterpillar design their equipment to maybe be a bit more expensive up front, but cheaper to own over the long term. They support that with a dealer network, and they have a growing division that rebuilds the big machines, extending the lives of the equipment even further.

China is not an ordinary market. There are exceptions, but I am willing to bet that the average construction equipment customer is thinking rather less long term. He probably wants to buy a backhoe that will be less expensive up front, will save enough money so he can buy two rather than one, that can be repaired cheaply, and that may even be dumped or sold to someone in one of the inland provinces after a couple of major jobs.

As an aside, I know a little something of what I speak. The Hutong Party Secretary spent a good bit of time in her career trying to sell Linde forklifts to both Chinese and Western companies here in China. (For those who are not in the materials handling business, it is worth noting that Linde are the Porsche of forklifts, and offer many of the advantages over their local competition that Cat and Komatsu do.) No surprise: the western companies, concerned about total cost of ownership and the lot, bought lots of Linde forklifts. But our Hutong Party Secretary was extremely challenged trying to sell any to local firms.

The pushback? They didn’t care about the quality. Breakdowns a problem? No worries – if we can buy three local machines for the price of one Linde (the differential wasn’t that large, but this is for illustration), we’ll buy two local machines and one will be operating while the other is being fixed, and we’ll still save money.

How does a company that extols its innovation, quality, durability, technology, and dealer support go head to head against companies that are ready to sell two disposable backhoes for the price of one good one?

Playing A New Game

At some point, in order to fight back without undermining their own corporate image, Caterpillar, Komatsu, Volvo, Bobcat, Kubota, and any other global equipment maker who wants to compete in China is going to have to find a way to win on the customer’s terms. And they are starting to get that.

Late in August, Caterpillar’s new CEO, Doug Oberhelman, came through China in the wake of a promise he made to Cat shareholders that he would make the company the leader in construction equipment in China by 2015. In an interview with Andrew Browne at The Wall Street Journal, Oberhelman hints at the foundation of a new China strategy.

[Oberhelman] said Tuesday that some Chinese equipment companies have become “pretty darned good” and that Caterpillar is studying their operations, including their product designs, as it goes toe-to-toe with them in China and, increasingly, in the U.S. and Europe, where good-quality Chinese exports are taking hold.

The exercise is driving down costs at Caterpillar and encouraging innovation, he said. Already, Chinese engineers are developing parts for Caterpillar wheel-loaders, a type of tractor that is made in China for a domestic market. Of the company’s 6,200 employees in China, only about 100 are expatriates, Mr. Oberhelman said, including managers brought in from other Asian countries. “We’re pretty Chinese,” he said.

Based on these and other directions that the market is taking, I would expect a global construction equipment maker to pursue some mix of the following three approaches in the effort to go head-to-head with the locals.

Three Strategic Directions

First would be to sell second-hand, factory refurbished machines. As I noted, Caterpillar has made a huge businesses rebuilding and refurbishing construction equipment. China might be a good place to sell some of that gear, especially since I suspect there is plenty of it floating around in the depressed construction markets of the world.

Second would be to buy a local construction equipment manufacturer. That might be tough, though: China has proven itself rather touchy about selling off healthy companies, especially in this sector. As other companies have discovered, betting your future on a complex local acquisition often takes management attention away from other means of building business. But if the right opportunity comes along (an underperforming factory, for example) and the government gives a quiet nod, expect a bidding war.

Third – and I like this best – would be to launch an OEM line of construction equipment carrying a different brand, using local designs but with inspectors and other “soft inputs” from the international company. It would not be necessary to own the factory, just to contract the production capacity. The separate brand creates the division between the quality standard of the core brand, while offering many of the advantages of working with the global brand. The company would offer that brand alongside its own in China and in export markets in the developing world, where Perkowski notes the Chinese manufacturers will be looking when it is time for them to export.

The Stakes

I am reflexively skeptical of any company who makes the case for doing business in China by saying that success elsewhere depends on success in China. That sort of thinking tends to lead to bad business decisions, like foregoing profits for market-share victory. If you are not planning on making money in a given market, you are effectively declaring it a money sewer, and down that path lies heartache.

But for the world’s leading construction equipment manufacturers, what is at stake is that in order to thrive on the development of the world’s emerging economies, those companies need to build large and profitable businesses in China serving the full range of customers. China is a must win, but the Big Iron merchants must win on China’s terms, not their own.

Freeing China’s Free Agents

New Business Elite in China

In the Hutong
Homemade buffalo wings
1809 hrs.

As with many memorable blog posts, Paul denlinger’s excellent article about China and its outdated version of capitalism holds a few hidden gems not to be overlooked. On second reading, this one popped out at me:

“Most of the reasons which [Ronald Harry] Coase outlined for the creation of the corporation in “The Nature of the Firm” no longer exist. Thanks to Google and other tools, small organizations can resolve all of these issues for almost no costs at all. Isn’t it time we start thinking and talking about deprecating large corporations?

Of course, many in the US and China would argue that only a very small and select minority would be able to work on different time zones and in remote locations with minimal supervision; I would beg to differ. For many service jobs where key personal relationships are not important, this will become the norm within 20 years. It’s just that the US and Chinese government haven’t figured it out yet.”

There are still many industries in which scale makes sense, perhaps not because large enterprises are the best loci of production, but because they are as yet unused to the challenges of integrating large-scale projects across multiple businesses. Boeing’s challenges with the 787 Dreamliner leap to mind.

But in his book Free Agent Nation, Daniel Pink made the case that for a growing number businesses, the traditional corporate structure had become a relic of the industrial revolution. Pink’s point was simply this: when the means of production for an industry can fit into a medium-sized backpack or a largish purse, the future belongs to the post-modern equivalent of the skilled craftsman.

Pink was writing about America, but Denlinger’s article poses a question: is China’s future, like America’s, more about forging coalitions of small firms – or even independent professionals – than the massive enterprises that currently dominate her landscape?

Much depends on a factor Pink identifies in the US: the need for an infrastructure to support such enterprises and individuals. Pink calls out several areas where America falls short in supporting free agents, and China has a long way to go.

As the nation begins to debate the issue of political reform, one of the matters on the agenda must be the final liberation of labor, the crafting of a legal and political infrastructure designed to empower not only small and medium businesses, but what Pink calls the “micro-enterprise.” This will be more difficult than it sounds in a nation whose very ideology is rooted in the industrial revolution.

In Search of Chinese Monopolies

In the Hutong
Parent-Teacher Conference Day
1253 hrs.

In a provocative dispatch today, the Associated Press is reporting that the chief of the Anti-Monopoly Bureau of China’s Ministry of Commerce, Mr. Shang Ming, acknowledged in a news conference that the only companies that have been required to scrap or change merger or acqusition plans under the 2008 Anti-Monopoly Law have been foreign companies.

Regulators have examined 140 cases [of mergers and acquisitions and whether they violated the Anti-Monopoly law] and rejected outright only one, Coca-Cola’s 2008 bid to buy Chinese fruit juice maker Huiyuan, said Shang Ming, chief of the Commerce Ministry’s anti-monopoly bureau. He said five other deals, all involving foreign companies, were passed with conditions such as selling off some assets.

This upsets foreign businesspeople in China, because it has been the abiding suspicion of many of our number since the drafts of the law began circulating in 2006 that the law was aimed squarely at foreign companies. I have been on the somewhat more reserved side of the equation, believing that the history of China demonstrates that what is important is not the law, but how it is enforced.

The frank admission by Mr. Shang that the foreign companies are bearing the brunt of the law tends to support the critics who saw its passage as Protectionism by Another Name. I am not yet convinced.

First, the outright rejection of a single foreign deal does not constitute a trend, and as I have argued elsewhere (“Seven Reasons for the Coke-Huiyuan Epic Fail“) there were enough other miscalculations in Cokes attempt to buy Huiyuan, so it cannot be used as a litmus test. That would, I would suggest, leave us with the five deals that required some rearrangement of assets that would need to be evaluated individually before we can make a call.

Second, Mr. Shang’s contention that the data is skewed because there was so much more foreign-driven M&A in the period in question than locally-driven deals may well be true. Again, we would need more data to make that call.

Third, we must consider the possibility that the foreigners are not the primary targets, but are intentionally the first targets of the law. China watchers familiar with the necessities of Chinese politics will acknowledge that any effort by an organ of the central government to block a politically powerful SOE from an acquisition is fraught with peril for the regulators involved. All the more so when the organ doing the enforcing – the Anti-Monopoly Bureau – is still building its own political legitimacy in China.

A good way of establishing that legitimacy – and the legitimacy of any later action against a Chinese enterprise – is to go after some foreign scalps first. Prove to the government, to SOEs, to the provincial leaders, and to the people that you have made the foreigners pay first, and they will be more inclined (or readily compelled) to acknowledge the legitimacy of the action against the local enterprise.

In fact, I would argue that this is the reason the Anti-Monopoly Bureau held the press conference in the first place, and why it did not shy from laying out the statistics like they did. The Ministry of Commerce is playing to a domestic audience, one that believes that foreign companies have more than their fair share of the local market. Against such popular sentiment, the first target can only be foreigners.

This is neither to apologize for the AMB nor suggest that the critics of the Anti-Monopoly Law are necessarily wrong. But it does suggest that at the very least we need more time and more data before we can make a strong case for veiled protectionism.

Fixing GOME

GOME is in trouble.

There is a lot of happy-talk coming out of China’s electronics retail giant, suggesting that despite a 14% drop in revenues and a 39% plunge in earnings for the first nine months of the year, things are actually looking pretty good. Same store sales are apparently up 2.1%, and they expect the chain to grow.

Reading between the lines of the WSJ report, GOME management is suggesting that the drop in sales was due to the global financial crisis. I am not so sure. Even if you grant that the crisis did have an effect on China’s economy (and therefore electronics sales), there are several other factors at play that the company does not seem to be addressing.

Hoping for Amnesia

What has kept GOME in the headlines over the past year has not been its prices, its selection, or its stores, but the arrest of its founder and allegations of serious ethical and legal violations on the part of the company’s most senior management. This is what is known as “bad publicity.”

Now, bad things happen to good companies, and usually when something like this happens the correct response would be to own up to the problem, distance the company from the wrongdoing, demonstrate that any malfeasance had no effect on customers or their purchases, make an all-out effort to prove that the bad behavior is history, and show how that the company has been made better by the process.

GOME has done none of that.

Instead, it has chosen to ignore the strategy and hope that it goes away and that people just forget about it all. That does not happen too often in China: remember, this is a country where the people are still pissed off at the British and French for sacking the Summer Palace 150 years ago. Memories are long. It would be dumb for a foreign company to bet on mass public amnesia to solve its image problem in China. It is incomprehensible that a local company would do so.

Unfortunately, the longer you allow negative perceptions to fester, the more deeply seated they become. It is not too late for GOME to address these problems, but the cost of doing so is rising by the day.

Problems In Store

The perception problem is not being helped by what appears, at least to this longtime GOME customer, to be a decline in the company’s operations. This is even more worrying. If the company is going to survive, much less thrive and beat local rivals Dazhong and Suning and interloper BestBuy, it needs to respond immediately to the dismal state of its shopping experience.

Stores are neither consistently sized, consistently laid out, or consistently merchandised. I went to three different GOME stores, and except for the logo on the front of the building they could have been from three separate chains. What this means is that a trip to a new GOME is like a box of chocolates: you never know what you’re going to get. That inconsistency of experience undermines the value of GOME’s brand.

Despite the chain’s “Shanzhai Rebranding” (i.e., “look, guys, we have a new logo – now we’re re-branded”), the stores I go into in Beijing seem more dismal and rundown each time I visit. Leave aside the tired-looking fixtures, the display cabinets with the logos of one manufacturer and the products of three or four others inside, and the well-worn decor. On the third floor of the store we went into – the floor with the highest value merchandise – the smell of cigarette smoke was so choking it drove us away from even looking at the selection of home theater setups. The excuse given: “oh, our breakroom is on this floor.”

Having started my own career as a retail associate, I understand the need to get away from customers for a few moments and relax. But never were the needs of the worker allowed to cause inconvenience to the customer, much less physical discomfort and, potentially, harm.

The M Word

Most noticeable, however, is how miserable the selection in brands and merchandise have become. Just looking through the computer section, only a small handful of the major brands are available, and a tiny number of models. Walking through a store owned by Dazhong, on the other hand, offers dozens of computers from a number of manufacturers, and while the selection does not match, say, a Fry’s, it is worlds better than GOME.

Merchandising is a craft, and Chinese retailers have historically eschewed the task of selecting the products to sell, buying and inventorying their own stock, and even working with manufacturers to create exclusive lines. Merchandising is, after all, expensive, it is hard work, and it takes a set of soft skills and hard research that are difficult to find in China.

Most companies – apparently GOME included – have outsourced the merchandising to the brands themselves, meaning that the appearance, stock, and selection in their stores is limited by how high a priority the vendors assign to that store, and how good the vendor people are in servicing that store.

In other words, they outsource their differentiation. And since the manufacturers don’t seem terribly concerned about GOME’s differentiation, they don’t spend a lot of time working on it. Mind you, there was a time when this was different, when GOME was the buzz leader in the electronics merchandising space, and electronics brands were ready to make deals. But that means having a position of strength with vendors, and having vendor relations types that know a little bit about merchandising. In its current weakened position (perceptually, anyway), GOME has less pull with the major vendors, explaining why I couldn’t find the DELL sub-notebook I wanted the other day. Nor, for that matter, would GOME sell me a battery for my mobile phone, nor did it have any stock of the new mobile phone my wife, the Hutong Party Secretary, wanted to buy (even though it was in the display.)

This is a bad thing. Because even though prices may attract buyers, unless you have what they want when they walk into the store, they’ll walk right out again.

Serving the (New) People

Perhaps most telling is the difference between the post-sales experiences at GOME and one of its competitors. At GOME, we bought a high-end DVD player and a new small kitchen appliance. Three weeks later, we have yet to hear anything back from the store.

At the competitor, we spent about the same amount of money (total) on a new kitchen appliance. We have received three follow-up calls, one from the original saleslady to check on how things were, one to explain how to get a rebate on our old appliance (which the store removed for free), and one from a service auditor to ensure we were happy.

I don’t mention the competitor’s name because that’s not the point. The problem is that GOME continues to deliver an acceptable level of service. Unfortunately, the market – the competitors, certainly – are evolving far beyond the acceptable and setting a standard that Chinese consumers to which CHinese consumers will rapidly become accustomed. Unless GOME can up its game to match or surpass the competition, the people who have money to spend will increasingly pass them by.

Make it Better, Bain

I have no doubt that the economic downturn hurt business at GOME. But These other factors, which touch on communications, marketing, merchandising, and operational excellence, underscore some more fundamental problems that suggest GOME’s comeback may not be as quick as its executives hope. By ignoring the outrageous (but, given the headlines, understandable) perception that GOME stands for “Gangsters Offering Mediocre Electronics,” GOME is allowing its customer base to erode like a sand castle in a typhoon.

As a longtime observer of China’s retail business, a gadget freak, and a onetime GOME customer, I view the recent investment by BAIN Capital in GOME’s operations as a hopeful sign. I may well be kidding myself: a 10% stake in a public company means much less in China than it does in the US. But if the GOME management and owners are smart, they’ll lend an ear to some of Bain’s ideas for improving the retailer’s prospects.

At this point, it could only help.

Indra Nooyi’s “focus” on China

In the Hutong
Fall hath Fallen
1634 hrs.

Pepsico CEO Indra Nooyi did a grand tour of China not too long ago, forgoing the normal jet-in-jet-out itineraries that frame most global CEO China visits. Given the time constraints that face any CEO, regardless of the size of the business, carving 12 days out of the executive schedule to do a deep dive anyplace is no mean feat. It must have been that much harder for Nooyi, who runs a Fortune 500 fast-moving consumer goods company with a global market.

Even better, Nooyi prepped extensively for the trip before she even got on the plane, and once here she pulled herself out of the standard boardroom-and-powerpoint grind that is the meat of most CEO visits, and actually got out on the streets and into the hinterlands.

Granting that there is a limit to what you can learn in two weeks, and that there are dangers implicit in thinking you know China better than you do. I remain skeptical of any CEO who calls China a “core” market but will not pick up and move here for a year or more.

Nooyi, however, deserves a lot of credit for making an effort that sets a new standard for CEO visit to China should be. By her actions she has issued a challenge to other senior corporate leaders to match or beat her approach. What will be interesting is to see what initiatives come out of Pepsi in China as a result.

Nooyi needed to come to China, because the core fizzy-sugar-water business is probably not going to grow here to anything like it is in parts of the world where people have been slurping carbonated beverages for generations. Pepsi in China is going to have to go its own way if it is going to grow, much less fight off growing local competitors like Wahaha or the marketing and distribution monster that is Coke.

And getting the boss here to see exactly why that is the case was a superb ste