Business in China, like business everywhere else, is being walloped by the global crisis. The slowdown is also exposing some deeper flaws

Illustration by Claudio Munoz

A SMALL stretch of land, a two-hour drive from end to end, reveals much about the economic transformation of a vast country. This slice of southern China runs from Guangzhou, the old treaty port reserved for foreigners before Mao expelled them, to Shenzhen, the city established after Mao's death as an experiment in private enterprise. Over the past decade it has become one of the world's fastest-whirring economic engines—a global hub in the manufacture of clothing, shoes and electronics—serviced by tens of millions of migrant workers.

Now the region is undergoing an equally remarkable contraction. In the past year thousands of factories, perhaps one-third to one-half of the total, have closed. Reliable statistics are hard to come by, not least because many factories operate in a legal netherworld, but the severity of the slump is plain. The flow of migrants has gone into reverse. Some of the newly unemployed have stuck around (and a few have started a new industry: street crime). The lucky ones have found work at factories that moved inland, although at lower pay.

On the road through Dongguan, a sprawling industrial city roughly halfway between Guangzhou and Shenzhen, building after building—residential as well as industrial—displays red banners advertising its availability. Local agents say there is no interest from buyers. A lack of demand for whatever a factory might make is part of the explanation. So is concern about the quality of properties for sale: a lot of factories were put up in a hurry and have been maintained poorly if at all. And so is the nebulousness of Chinese property laws. Purchasers cannot be sure that what they buy they will truly own.

Oh, for yesterday's problems

The rapid collapse of economic activity around Dongguan indicates that China's private companies are being subjected to the same battering as their counterparts in many other countries. Yet it also raises questions about the long-term survival of many of these companies. They have been among the most dynamic components of China's fast rise towards prosperity. Their turmoil may be transient. Then again, there are also worries that it is in fact tied to profound flaws in the Chinese economy.

Six months ago Chinese manufacturers were being pounded by increases in all manner of costs, from wages and the prices of materials and energy to interest rates and taxes. Just about every type of skilled labour was in short supply. Annual results for 2008, due to be released in the next couple of months, will show that these forces did much to hold back Chinese business for a large part of the year.

Now those manufacturers are taking a different sort of pounding: a dramatic falling-away of orders. December's official industrial-production data, for what they are worth, showed a marked drop in annual growth; January's are delayed (see article). Exports, on which the figures are more reliable, were 17.5% lower in January than a year before. Imports were down by 43.1%.

The slowing economy has sent all those costs in the other direction. It has brought the prices of materials and energy down sharply and slackened the labour market. After years of steadily pushing up interest rates and increasing banks' capital requirements, the financial authorities in Beijing began to cut both in September, and lending has been vocally encouraged.

Fearful of the social consequences of widespread unemployment, both local and national governments have backtracked on policies put in place between 2006 and 2008 that raised private companies' costs. Exporters' tax rebates have been restored, for example; and new laws on wages, work rules and benefits that added costs a year ago are turning out to be more flexible than they at first appeared. Around Dongguan, local officials no longer seem bothered about pushing the region towards higher-value-added products. Makers of labour-intensive goods, such as apparel and toys, find that they are no longer under pressure to move away. A strike that the municipal government would have all but encouraged for much of 2008, it would now help to settle. None of this has come anywhere near offsetting the decline in orders. Worse, the malaise may go far deeper than the short-term effects of a slump in demand.

A footloose business

Much of the remarkable success of Chinese business has been based on low-margin, low-technology activities. Broadly speaking, China is a net exporter of goods with a low technology content and a net importer of more sophisticated wares. In richer countries, not surprisingly, the reverse is usual (see chart 1).

Many Chinese businesses have been built on using cheap labour to produce cheap, commoditised goods such as clothes and shoes for export. Lots of others produce higher-grade stuff, such as electronics goods or branded sportswear for Western companies. The trouble is that other countries can also do this, sometimes more cheaply.

Granted, China has plenty of important companies which do not need to worry about their business disappearing to other emerging economies. More than 30 of the 100 firms anointed by the Boston Consulting Group in January because they are “contending for global leadership” are Chinese. No other country can boast so many. However, almost all of these are owned at least in part by the government and benefit from protective barriers in their home market. China Mobile, for example, is the world's largest mobile operator, but its competition is limited, by ministerial decree, to just a few other domestic rivals. The same goes for steel, aluminium, energy, finance and a host of other areas that the government deems “strategic”.

A more durable model for less privileged companies would involve more higher-margin activities, based on innovation and higher quality, with their home-grown brands to the fore. So far, however, Chinese companies have been plagued by an actual or perceived lack of quality. Only a few have built respected brands. The underlying causes of this are a weak system of property rights (including intellectual-property rights) and a financial system skewed in favour of big, state-controlled companies. They will not be easy to fix.

The downturn has shown much of Chinese business to be remarkably footloose. It is as if the companies that died simply evaporated without leaving a tear or a trace. There is more to this than the eradication of excess capacity or the shift of production inland. Buyers in Hong Kong who a year ago drove over the border to buy clothing in southern China now take flights to Dhaka in Bangladesh. Nike will produce more trainers (sneakers) in Vietnam this year than in China, its leading source for 15 years.

In 1988 a small, secretive, Taiwanese plastics manufacturer named Hon Hai opened a factory in Shenzhen that has since grown to the size of a city, with more than a quarter of a million employees. Little of what its Chinese subsidiary, Foxconn, produces is directly disclosed by the company but it is broadly believed to include iPods, Nintendo and Microsoft games consoles and laptops, either in whole or part, for most leading brands.

Because of the sheer number of people it employs, Hon Hai's every move generates huge interest in local newspapers, although the firm itself says little. In 2007, presumably for much the same reason that it moved to China 20 years ago, it opened a facility in Vietnam which is said to be undergoing a large expansion. Last summer the Taiwanese press was abuzz about production moving back home. Now reports from Taiwan say that the Shenzhen workforce will be cut from 260,000 to 100,000 and that there will be more jobs inland. Whatever the figure turns out to be, Hon Hai is a nimble transnational company, able to move production around as circumstances change. And it is not alone.

Admittedly, there are still good reasons to remain in China. Vietnam, Indonesia and other countries have only a finite ability to expand quickly without overloading their infrastructure or sparking wage inflation. China still has lots of cheap labour. Perhaps most important, it has a vast domestic market, much of which is protected from foreign producers. But as the frailty of the southern Chinese manufacturers demonstrates, these virtues have their limits.

Higher margins are often linked to higher quality. In a recent survey of 700 international business professionals by Interbrand, a consultancy, 80% of respondents cited low quality as an important barrier to the sale of Chinese products abroad. Two-thirds said “cheap” was the chief attribute of Chinese goods. Only 12% believed quality was improving.

Judged by the struggles Chinese companies have had operating abroad, such impressions are well founded. With rare exceptions, notably Lenovo, which purchased IBM's laptop business, and Haier, the maker of cheap, small refrigerators that furnish the rooms of numberless students, Chinese names have failed to make much of a dent. Where they have thrived is either in cost-conscious emerging markets or in cost-sensitive areas of developed markets defined by clear specifications and minimal innovation. The greatest examples of this have been ZTE and Huawei, makers of telecoms equipment.

The poor external reputation of China's products hurts not only Chinese companies but also Western firms known to be selling Chinese-made goods. Last year, in response to a series of scandals, buyers' complaints and lawsuits over Chinese toys, America passed laws requiring elaborate certification. This is costly for good manufacturers, but American toy distributors found themselves incapable of judging the safety of products they imported from China. Out of similar concerns, India has imposed restrictions on Chinese-made toy trains and cars, dolls and puzzles.

Why, then, have Chinese manufacturers not done more to improve the quality of their goods? The benign explanation is that China is undergoing the same problems as Japan once did, but in a litigious, consumer-centred age in which every flaw is magnified.

There is something to this, but Japan's national obsession with quality was apparent early in its post-war industrialisation, when it adopted the teachings of W. Edwards Deming, an American quality-control guru. Companies such as Honda crushed the British motorcycle industry by offering higher quality as well as lower prices; Sony and Panasonic did the same to American makers of radios and television sets. Almost all the successful companies began by producing at least some components for others (Sony still does) but were equally determined to carve out names for themselves by making distinctive products. To say these companies had long-term visions is an understatement. Konosuke Matsushita, the founder of Panasonic, drafted a 1,000-year corporate plan.

There is no equivalent in China yet. However, many Chinese companies are aware of the pervasive criticisms of their quality. Some big firms have begun employing Westerners with long experience in the best American and European facilities. The Chinese authorities are also awake to lack of quality, because of its deadly effects in the (heavily protected) domestic market, where it has been all too easy to succeed by being shoddy. Last year, after poisoned dairy products killed six children, the chairwoman of Sanlu, the most notable producer, was sentenced to life in prison. Two suppliers were condemned to death.

To be sure, lots of high-quality things are made in China, from sporting goods and MP3 players to luxury clothing. China has become the world's largest exporter of information and communications technology. Local markets and trade fairs are awash in aspiring brands. In transport alone, there are a dozen sizeable carmakers, 300 tyremakers, 1,000 bicycle-makers and several thousand scooter-makers, all hoping to make an impression. More than 3,500 watchmakers list their services on Alibaba, a sourcing website, as do 8,000 razor-makers. And myriad companies churn out the fake Gillettes and Rolexes sold on street corners.

That very little of this effort has been converted into strong brands is something of a puzzle. Foreign companies account for most high-tech exports (see chart 2). The simplest explanation is that anonymity suits many Chinese companies. In Dongguan, Yue Yuen, a subsidiary of Pou Chen, a Taiwanese company with a similar model to Hon Hai's, produces sports shoes for leading Western names. Smaller firms make everything from tennis racquets to European luxury goods. Because wide publicity of the common origin would do those brands little good, the Westerners usually insist on contracts with clauses blocking disclosure.

Anonymity also spares Chinese companies from official and press scrutiny of labour conditions, which can be abysmal. But there are limits to this strategy, in as much as margins on undifferentiated production have proved low. Retaining customers means holding off competition from any country with lots of cheap labour, and, as southern China is finding out, businesses of this sort are vulnerable to being wiped out in a slump.

In Taiwan many of the companies that once were leaders in anonymous production have slowly developed high-quality products under their own names, notably Acer, Asus and HTC. The most glaring impediment to creating the same kind of operation in China is the country's weak intellectual-property protection. Why invest in design or innovation when the results can be knocked off by competitors? Aware of this barrier, the government has passed new laws and has been vocal in supporting greater protection, but settlements remain trivial and enforcement patchy. Most Chinese patents granted to domestic applicants are still of a type known as “utility model” patents, mainly awarded for incremental improvements, rather than for innovation or new designs (see chart 3).

The weakness of intellectual-property rights can be seen as part of a deeper problem: the weakness of private property rights in general. Before China's reopening in the late 1970s, says a recent study on Chinese innovation by the OECD, this issue did not arise: innovation and technological development were assigned to government institutes; factories received work orders. Even today only the rarest company can claim unfettered independence. According to Yasheng Huang, an economist at the Massachusetts Institute of Technology, explicitly state-controlled firms make up half the economy. That probably understates the true effect, because even private firms understand that their existence depends on their relations with the state.

In state-controlled companies, senior managers are rotated at the behest of government. China Mobile is said to have 100,000 suppliers. One reason is that with its management and operating franchise subject to frequent government intervention (it was reorganised last summer), technological innovation must be done outside. Leading managers have low salaries and often let stock options expire even when they are in the money, which suggests that rewards are not closely tied to creating value for shareholders.

Medium-sized companies have their own conflicts. Factories inevitably occupy land that was once state-held. As a consequence, their shareholders often include local government. Officials have little interest in industrial efficiency: mergers, for instance, are unattractive if they mean losses of local jobs. Invariably, if there is a photograph on a wall at a corporate headquarters, it features a visit by a senior government official—showing who matters.

Blurred ownership distorts finance, management structure and long-term planning. To insulate themselves from the vicissitudes of China's state control, companies go through all manner of legal contortions when they list shares. Haier, for example, is incorporated in Bermuda. Securities offerings must be approved by the government and the bulk of legal financing comes from state-controlled banks. With all these political ties, lack of innovation is hardly a surprise.

Theoretically, the smaller, private firms are more flexible. But raising money is hard: loans to such firms account for only a small part of the total lending by those state-controlled banks (see chart 4). The source of small firms' money is one of China's great mysteries, but there are hints. China is filled with grey-market financiers, including pawn shops, “credit-guarantee” firms, and small industrial companies that lend to other small industrial companies. Because finance from such sources is informal, however, it is short-term, changing the nature of investment. It often depends on the personal relationships of the firm's owner; that too can distort managerial decision-making.

None of these impediments has prevented China from growing. Indeed, the extraordinary way in which money, people and companies seem to come and go illustrates the country's adaptability. But they are impediments all the same.

Two years ago, on one of his frequent trips to China, Bill Gates said he was often asked where the next Bill Gates and the next Microsoft might emerge. To the delight of his government hosts, he predicted Asia, because of the changes he had witnessed, the level of education and the impact of technology. It is easy to imagine that someone from China might follow in Mr Gates's footsteps. In today's conditions it is, alas, hard to imagine that someone from a Chinese company might do so.