CHINA’S NEXT DECADE
An economic competitive analysis of China in the coming decade with emphasis on the socio-political structure and its effect on industry
As China enters the next decade it must do so methodically and cognizant of the constant influence of internal forces, and those that are foreign. Internally, adjustments will be seen with a new president, shifting labor climate, growing consumption from an expanding middle class and economic and political structures to accommodate it. Externally, demands from democratic communities about political openness, increased pressure from international organizations over human rights, a global economy that continues (though showing signs of slowing down) to grow, and it’s interactions with the US will become of greater importance as well.
This paper is focused on four key points to assess China’s competitiveness over the next decade, divided in the following sections:
I. China’s relationship with the U.S and westernization: political and economic.
II. Labor force: advancement in skilled labor, their self-perception and labor demands.
III. Changing demographics: one child policy, implication of mass urbanization on Chinese cities and consumption.
VI. Industry analysis: exploring competitiveness of national champions and their alignment with national interests and resources.
V. Conclusion: thoughts, suggestions and comments on our findings.
I. China and the USA
The modern and evolving relationship between China and the U.S. can be traced as far back as Nixon’s visit to Beijing in 1972, when he agreed to back off of Taiwan. The United State’s continued presence in the region now, and support of Taiwan, is symbolic of the tension that currently exists between the two nations politically. Add to this that the U.S. is a formal or informal military partner of many nations that surround China, and their military presence of The U.S. Pacific Command (PACOM currently has assets of 325,000 military and civilian personnel, along with some 180 ships and 1,900 aircraft). There is also the Trans Pacific Trade Agreement (TPP) currently led by the US, which can be seen as a threat to Chinese competiveness as it includes a number of Asia pacific countries excluding China. Consider just the previous mentioned stances the U.S has taken and you understand why Chinese officials might feel watched over and influenced by outside forces.
But as one nation positions to quite literally contain the other (China), we can’t help but wonder if one nation can live without the other. China can credit the United States for much of its success. It knows that the U.S. introduced it to global markets and many of their young entrepreneurs can trace their education to U.S. academic institutions. Also, the U.S still largely dominates foreign Investment in China.
There are however, questions as to when, not if, that relationship will be effected by a changing labor market, Chinese socio-structural needs at home, and western influence. After all, the majority of US activity in China has been two fold; economic investment, through hiring low skilled labor at very low costs for the benefit of U.S. consumption, and socio-political through the pressure American activists have placed on Chinese government over human rights and labor conditions.
But things are changing; Chinese companies have begun to acquire American companies. After a history of difficulty entering the US market the Chinese have been on an acquisition streak over the past five years (see exhibit 1). There was over $6.3 billion in FDI projects in the United States during the first three quarters of 2012 from China. With heavy investment focusing in the aviation and energy industries. It is also estimated that as of midyear 2012, Chinese firms employed 27,000 Americans. One such acquisition was that of MiaSolé, a renewable energy company based in California, by Hanergy. It was preceded by similar acquisitions of O.Cells (German), which has granted Hanergy with many patents that otherwise would have required a lot of investment.
We believe that heavy investment in the areas of energy and mobility are a response to the incredible growth in the Chinese middle class, actual and forecasted. This yields to the need for greater public services like energy and transportation that occur with massive influx of lower class Chinese citizens into larger cities. And these needs have led to large investment within China where spending has ramped up as well. In a working paper by the IMF, it is stated that China is operating at 10% higher than is healthy for a nation at their stage in development. One suggestion as to why is that it could be doing so as a defense mechanism from foreign investment. Regardless of their reasoning, the defending of their national champions and with an increasingly kind stance from CFIUS; future acquisitions, partnerships and joint ventures could come to fruition in the U.S. bringing value to both Chinese firms looking to acquire new technologies and U.S. politicians looking for labor growth or security in their home markets by accepting foreign investment.
There is another aspect of this change that should be addressed; there is reason to believe that as China becomes a more politically open society they will increase their interest in western style democracy. Aside from evolving consumption patterns currently visible in the nation, As Chinese become more self aware of their conditions in comparison to other developed nations, will they demand more integration and activity into world organizations (G20, UN) and western acceptance, or will they allow their feelings of isolation to lead them toward greater self-dependency? Our bet is with the former. They have too much to lose, and an abundance of knowledge and benefits from greater integration and cooperation with the rest of the world to gain, and to fulfill their current and expected needs.
Chinese/U.S. interdependence can lead to greater cooperation between the two nations. As one nation democratizes and westernizes, the Chinese citizens will undoubtedly ask for social models that more closely resemble those of the west. There are a number of similarities between the two nations; like the demand on energy they both require as classes converge. The next level of their relationship depends on China. Will they side with the international community regarding Iran and North Korea? Will they respect international patent laws?
Many questions remain, but we believe there are strong mutual interests for both nations to take steps towards building a stronger relationship. With that said, China’s competitiveness in the next decade depends heavily on what political (trade agreements, military partnerships, social reforms) and economic steps they take towards greater openness. Isolation would not help their international perception, and would increase speculation and lack of trust from the international community, especially from the nation they may need to depend on, the U.S.
II. China’s Cost Competitiveness and Labor Force
Several factors are leading to questions about China’s competitive position as a low-cost manufacturing destination. Some include, the government's drive to reduce the country's dependence on exports, the rising costs of raw materials in China and the fact that infrastructure is becoming more expensive to establish and maintain.
A very important area of concern for the country´s continuous development and production costs is energy supply. China currently suffers a domestic oil shortage. From 2003 onwards, the government has established a ‘going global’ strategy to address this issue. This involved National Oil Corporations such as China National Petroleum Corporation (CNPC) and Sinopec controlling exploration, production and distribution at home, and CNOOC taking the lead in acquiring overseas assets and companies in order to lock in foreign supplies of oil.
In the international arena, China has a comparative advantage over Western governments and other democracies in signing deals with regimes in weak, failing or failed states. By offering these states financial aid and diplomatic assistance in bodies such as the UN Security Council, in return for privileged access to oil assets or supply rights. However, the numbers show that in 2010, Beijing’s offshore equity oil production was around 1.37 million barrels per day (bpd), which meets only around 28% of its daily importing needs. Therefore the country will overwhelmingly rely on commodity markets to meet its oil needs for the foreseeable future, exposing itself to high oil prices in these markets, pushing up costs.
But the biggest concern of all is the wage inflation that the country is starting to experience. Government policies are favoring workers more than ever. And wages are increasing. According to Accenture, wage rates in China have historically been about 7 percent of those in developed markets.
This year, however, 13 provinces in China, forced by their respective governments, have raised the minimum wage level by an average of 20%. Also, major manufacturers doing business in China have raised wages to address problems of increasing employee turnover and even suicides.
Another aspect that contributes to this increase is that China’s economic growth has intensified competition for skilled labor within China among multinational and local companies doing business there, particularly in China’s urban areas.
Wage increases in China have been driven by a number of factors. First, is the fact that there is a shortage of skilled workers in eastern China where the majority of multinational’s manufacturing takes place. The shortage stems in part from the rising cost of living in megacities like Shanghai and Beijing, and real estate prices are skyrocketing. Tax cuts in rural areas have also made it more costly for workers to move to China’s coastal areas.
The number of rural workers available and suitable for labor-intensive work in the region dropped from 120 million in 2007 to just 25 million in 2010 as per findings of Accenture.
The aging of the workforce and increasing education levels among younger workers also play a role, having made it more difficult for companies to get workers to agree to the same terms earlier generations had accepted.
China will also see major demographic change over time, with old-age dependency rising and the labor force shrinking soon.
Government policies, as well, have increasingly favored local workers and their rights, which is part of the government’s economic stimulus strategy. Chinese government’s most recent 5-year plan included a priority to “increase Chinese people’s income.” Labor Contract Law of 2008 improved wage standards as well as provided protection for workers from baseless dismissal. Chinese law enforcers have grown increasingly tolerant of mass protests; particularly those demanding higher pay and better working conditions from foreign employers.
These wage increases in China are expected to impact manufacturing costs and the impact will vary across industries and product categories. Most notably, evidence suggests that the impact of volatility in labor costs on end price or margin of companies with a strong manufacturing base in China is significant.
However, the right way to measure manufacturing competitiveness is comparing entire supply chains, not by comparing labor costs alone. Even if labor costs are much smaller than those in China, the unreliability or unavailability of many components may make it uneconomic to make things elsewhere. In the short to medium term, infrastructure superiority and the likelihood of efficiency improvements and its effects on undercutting the damage of higher wages on margins, will not impact sourcing decisions on a large scale. As we see it, moving to other low developed countries with lower wages will pose challenges such as less developed infrastructure in ports, roads and facilities; shortages of skilled workers and political instability.
In this sense, is therefore more important than ever for China based manufacturers to strive for automation, production efficiencies and greater speed to market. It is also important to notice that the total factor productivity growth would likely soften as efficiency gains from first-generation reforms diminish and technology gaps with high-income economies narrow.
This effort for increased productivity would allow China to maintain competitive advantages in the short run in some labor intensive industries and probably compete in the long run with some less labor intensive industries, but will not be enough to attract new FDI at the pace that was being attracted before.
Moreover, eventually, low cost countries will challenge coastal China's grip on basic manufacturing as they progress in their development, as they have already started to do, and therefore these measures probably will not be enough to maintain China´s advantages in the long-run.
In this context it is expected that industry and investment would see their importance in GDP diminish, while the share of services and consumption would rise.
The rising costs of labor, energy, and raw materials are already undercutting the competitiveness of Chinese manufacturing companies, particularly since suppliers have so far in the vast majority, failed to differentiate and upgrade their products and services.
The World Bank data is already showing Industry employment growth has started to slow, whereas employment growth in the services sector remained robust. The relatively good performance of the services subsector was explained by demand from the real estate management and health sectors. Employment in wholesale and retail trade continued to grow, reflecting the continued strength of domestic consumption.
But in China, as in all economies, services will be the future engine of job growth. According to Alliance Capital Management, the country's manufacturing sector shed 15 million jobs from 1995 to 2002, when large state-owned factories restructured their operations. As manufacturing productivity rises, still more jobs will be lost.
Therefore, in the long run, if China wants to maintain is competitiveness, its manufacturers must move up the value chain. They could no longer solely rely on bolting together sophisticated products designed elsewhere; they need to do more design work themselves. For this, the labor force has to be more knowledgeable.
The Made-in-China advantage is starting to fade. In the future, the goal needs to be Created-in-China. Innovation requires far more than cheap labor. As experience has shown in other countries that followed that same path, imaginative financiers, inspired entrepreneurs, and first-class researchers are needed. Even with all this, a culture of entrepreneurship and innovation is required.
University and education play an important role, with special importance given to overseas students and exchange programs. Right now, China attracts many bright young people who would like to build new companies. Every year a wave of “sea turtles” as Chinese who have studied or worked abroad are referred to, return to the country. Many have mixed with the world's best engineers at MIT and Stanford and have seen first-hand how Silicon Valley works. Indeed, Silicon Valley veterans have founded many of China's most innovative firms, such as Baidu. But still is not enough. China must embrace the new culture of innovation at a much larger scale or slow down.
To make the move from manufacturing to services, China must raise the quality of its university graduates. Few of China's vast number of university graduates are capable of working successfully in the services export sector. A shortage of world-class university graduates in key occupations such as finance, accounting, engineering, and business represents a major problem for multinationals in China, for Chinese companies, and for the country's policy makers. In the longer term, China's economy as a whole needs more such graduates if it is to compete in the world beyond the simpler, labor-intensive manufacturing areas in which it is now the global leader.
It is as well a must to change the way it finances its universities. Expenditures for tertiary education are growing quite rapidly, however, the number of students increased even more, so expenditures per student fell. Funding is also spread unevenly throughout the country: in Beijing average spending per student is more than 30 percent higher than it is in second-place Shanghai and more than twice the level in 25 of the 31 provinces according to McKinsey.
In addition, China must continue to improve its English-language instruction. Since 2001, the Ministry of Education has required all students to start learning English in third grade. This is a step in the right direction, but there is a shortage of professors China must train many more English teachers and do more to recruit them from abroad.
Finally, China's policy makers must ensure that its many students who study abroad return home, since a relatively high proportion of them have the skills needed to work for multinationals. India's students abroad and expats that returned have played an important role in the growth of the Indian IT and business and process services sectors, while helping to alleviate the country's management shortage. It is a good mirror for China to look itself into, showing that China too needs people with overseas experience and new ways of thinking.
III. Shifting Demographics
In recent decades, China has been facing massive demographic changes that now point to an uncertain future for the country. An array of demographic factors, including a rapidly aging society, a shrinking working-age population, and increasing urbanization, pose a severe risk to China’s economic growth in the years ahead.
China is currently the most populous country in the world with a population exceeding over 1.3 billion. In the 1950’s, China’s population was just at around 550 million, but by the early 1980s, the population had grown dramatically to 1 billion. Since then, china’s population has been continuing to grow, yet at a somewhat slower rate mainly due to the implementation of the One Child Policy. According to the International Data Base in the U.S. Census Bureau, China’s total population is projected to increase by just 4% between 2010-2030, where it will reach a peak and then proceed to decline thereafter (see exhibit 2).
The One Child Policy was put into place in 1979 by then Chinese leader, Deng Xiaoping, as a measure to maintain low birthrates, and consequently prevent over population in the country. The policy is mainly enforced in urban areas and restricts couples to only one child. Although the policy was meant to be temporary, it continues to be strictly enforced today.
The One Child Policy has been highly supported by top leaders in china, whom directly link it to the country’s economic growth and particularly to the creation of the demographic dividend. Throughout the last three decades, as childbirths and fertility rates began to drop, the dependency ratio subsequently decreased as well. Thus, with fewer younger dependents per household, Chinese workers have been able to enjoy higher incomes per head and increase personal savings. Initially, the policy effectively created an optimal population age structure, where the largest segments eventually moved to the middle working age. However, over time, this naturally caused the composition of the Chinese population to change significantly, resulting today in a rapidly ageing society.
An Ageing Society
As China’s working-age population is shrinking and the older growing, due to low birthrates and an increase in life expectancy, the country is experiencing a demographic shift into a “top-heavy” age structure. According to the National Bureau of Statistics of China, China’s “working-age” population declined for the first time in 2012 by 3.45 million from 2011. Additionally, there was an increase from 2011 of 0.59 percent in people aged 60 or over, accounting for 14.3 percent of the total population (see exhibit 3).
A declining young labor force, poses a serious challenge to China’s “labor-intensive” industries as well as its competitiveness in the global arena. As supply of cheap labor continues to be drained, low wages and high percentage of private savings China once enjoyed seem likely to end in the near future. It begs one to wonder how China will begin to fill the void of the declining working-age population.
Moreover, China’s ageing population will require significant reforms in China’s weak social infrastructure, particularly its pension and health care system to correspond to the needs of their large senior population. But will China be able to meet the needs of its rapidly increasing ageing population? And if so, at what cost?
China has been undergoing huge expansions of its cities over the past decades. Last year, according to the National Bureau of Statistics of China, China’s urban population increased 21.03 million, hitting 711.82 million, or 52.57% of the country’s population - 1.3 percentage increase from 2011. While urbanization is a key component to China’s economic development, such rapid growth must be accompanied by adequate policy structures to sustain it. As China’s cities flood, the provision of social services (housing, social security and education) as well as tackling environmental issues need to be urgently addressed. This will present many challenges for leaders since it will require securing a large amount of public funding.
Another issue that will need to be looked at is the current “hukou” household registration system that is in place. This system works to limit the movement of people into urban areas by prohibiting rural people who move to the cities from becoming official urban residents. Without legal permits, the migrants do not have access to local social benefits. If there is a large potential amount of young workers still out there, the “hukou” is only deterring them from joining the urban workforce. Is the country really ready for mass urbanization? Can they fund the infrastructure needed to support and sustain growth in the next decade?
Moving forward, meeting and creating demand for offshore services is key for China’s economic growth and ability to sustain it. As previously stated, emphasis should be placed on the development of internal talent being educated abroad to lead the way in technological and services innovations back home. The development of services offerings should begin in areas of expertise to complement those companies that are already succeeding internationally.
Where we’ll likely see services offerings will be in successful industries like software and pharma where China can still leverage competitive low labor costs, knowledge and technological prowess to serve needs of foreign investors. Take the example of pharma, where …”companies can also run bigger, and therefore faster, clinical trials in China more cheaply, thereby cutting overall product-development costs as well as approval and release times.” This is of course heavily dependent on the development of higher skilled global workforce.
Currently, the telecom industry is where China has placed significant emphasis. In early 2008, the Chinese government implemented several reforms that integrated three of the biggest Chinese telecom companies, namely China Mobile, China Telecom & China Unicom with a long-term view to boost the telecom market, create a competitive environment, and become national champions.
The rapid increase in population and the rise of the spending power in the middle class in China has seen an increase in demand for connectivity. This has not only bolstered stiff competition among the three telecom brands but has also helped the Chinese become the world’s leading telecommunication and smart phone market (for 2012, 7 of ten mobile owners used smartphones).
Innovative telecom operators, China Mobile, headquartered in Beijing, have more than 1.1 billion users and have lately conducted 4G trials (also developing 4G roaming between China & US) to attract more customers, increase profits and gain market share. Moreover, China Mobile International (CMI), a wholly owned subsidiary of China Mobile have set up offices in Hong Kong (to meet the growing Asian demands) and USA & the UK to compete in the international market by providing quality services in Mobile, Voice and Internet.
China Telecom, operating the worlds largest fixed line network, have expanded internationally and tied up with telecom operators Orange and IIJ (Japan) to expand their reach in the international market while also competing aggressively in the local market by heavily investing in providing quality 3G and broadband services all over China including the highly populated and underserved segment in the remote areas.
Other companies like China Unicom, 5% owned by Telefonica International, have also been growing fast by investing in lower priced smartphones and providing cheaper services targeting the fast growing and digital native young Chinese urban segment.
According to the Mckinsey & Co., China’s exploding population of internet users have already surpassed 420 million users, of which 333 million people are using internet on mobile, and are expected to grow up to 750 million by 2015. Thus, the heavy reliance between mobile, technology and telecom services has created an unprecedented demand that should spur innovation and the opportunity for more growth moving forward.
The technology sector has seen heavy investment and success as well. Tencent Holding Ltd., the 3rd largest publicly listed internet company in the world, has seen profits of 28,496 billion yen (2011) by focusing on diversifying to international markets and capitalizing on the growing mobile market. They’re providing mobile services like social networks, online gaming web portals and an instant messaging service that has 700 million active users; an audience as large as Facebook’s global community.
The popular search engine, Baidu, second only to Google, reported profits of 6.6 billion yen in 2011 and have also been featured in the Forbes’ 5 most innovative companies of 2012. Baidu entered the Chinese market in 2000 and by 2010 captured 80% of the market share in China since Google shut down operations in China in 2010. With their recent innovation of their own operating system, Baidu Cloud and mobile app platform, they’ve also diversified offerings by expanding into the smartphone business.
As mentioned earlier Chinese acquisitions of American companies have been steadily growing over the past few years. But an earlier purchase was that of Lenovo when it made a move on IBM in 2005. Since the acquisition of the IBM computer business, Lenovo has grown year over year, becoming the worlds leading PC provider (2012 revenue: 29.6 billion yen), and helped the whole of Chinese manufacturing along the way; positioning itself as a high quality made-in-China company. Almost exclusively known for the Thinkpad line of PC’s, Lenovo have entered the smartphone, smart television and tablet market to meet internal and international growing consumer needs.
As Chinese companies continue to compete internationally they will also need to look for allies in the non-market. And this is where we see the relationship with the west either being strained or blossomed.
HUEWAI is an example of a company with a history of not being able to get past non-market players. They have fiercely competed with network equipment manufacturers CISCO in the US who has undertaken lobbying efforts with the US government warning them of the potential threat HUEWAI poses to US national security. Their efforts, along with selfish interests of U.S. policy makers have deterred significant investment and growth of HUEWAI in the U.S. If this were to continue on a large scale one would like to assume a looming trade war between the US and China in horizon, at least in this sector. But one would have to ignore the overwhelming support for investment in the US as of late (exhibit 1), and such an assumption seems far-fetched.
While the U.S. perhaps has not received Chinese telecom companies with open arms, other parts of the western world have. The UK is a great example of a nation that looked enough past security concerns and has allowed HUEWAI to invest heavily (1.3 Billion recent announcement) and operate over the past decade.
One final point to mention is the growing concern over intellectual property and China’s image of being mere copycats. Though it’s certainly clear the nation likes to “borrow” from the other foreign companies, the next ten years poses a great opportunity for them to show just how innovative and original they can be.
As we have explored in this paper, China has very capable industry champions, a progressively higher skilled workforce, and the capital to drive their national champions into new markets. But we believe a perceptual shift in the way the world sees Chinese manufacturing and expertise can also be a huge opportunity for them to take. Although, this may take some time for the world to digest, their recent innovations in the technology world and the increase in R&D spending in 2012 (159 billion) that is growing by 20% every year show their dedication to earn that image.
Taking into account some of the realities (challenges) China faces in the coming years, one thing we believe will occur is that China’s international competitiveness will occur from rapid and massive growth within the country. Sure, they will invest abroad, acquiring new technologies, competencies, patents, etc., but the demand driving those moves to acquire is coming from within. They need to take care of their own people. The demands of megacities being built to support mass urbanization and the massive infrastructure to support the movement will be a driver of industry for decades to come.
The government’s role is crucial in the next decade. Much of the economic growth will come from contracts to build housing, power grids, bridges, roads, etc. They will also need to adjust and move toward being a more open society. It’s inevitable that the demand will grow with a more educated and larger middle class aspiring to social models of the west. And without socio-political changes and intellectual property reform the United States will continue to have something to hold on to, a trust issue, a bartering point to pick with China. We believe a lot of their success in the next decade will revolve around these topics and the strength of their industries in the non-market environment, where interdependence with U.S. on a variety of issues could be tied to economic growth.
 San Jose Mercury News (San Jose, CA), April 29, 2011. “U.S. –Educated Entrepreneurs Likely to Return to India, China.”
 According to Investopedia.com, Demographic dividend is broadly defined as a rise in the rate of economic growth due to rising share of working age people in population
 According to data.WorldBank.org, Age dependency ratio is the ratio of dependents--people younger than 15 or older than 64--to the working-age population--those ages 15-64.
 “2013 BrandZ Top 50 Most Valuable Chinese Brands,” Millward Brown, December 2012.
 “2013 BrandZ Top 50 Most Valuable Chinese Brands,” Millward Brown, December 2012.
*with assistance from Ethel Jerez, Julio Fernandez and Viraj Dhawan
*In collaboration with Ethel Jerez, Julio Fernandez and Viraj Dhawan