To keep their places on the Global 500, Chinese companies will have to develop a global mindset more characteristic of multinationals from small countries like Switzerland, a transformation that has to date eluded most Japanese businesses.

It’s entirely possible that this could happen, but the triumph may be fleeting. In the late 1990s, Japanese firms came close to outnumbering U.S. companies on the list, until a combination of a graying workforce and declining productivity caused them to slide back off. Japan’s experience, which is similar to that of China today, provides an uncomfortable precedent for the consequences of a slowdown in domestic growth.

In 2018, Fortune’s Global 500 ranking included 111 firms headquartered in China—just a handful fewer than the United States’ 126. In 1995, only three Chinese firms made the list; in 2018, three were in the top 10. No wonder some observers predict that China will soon overtake the U.S. as the home to the highest number of Global 500 firms.

Idea in Brief The Problem Although it is very likely that China will soon overtake the United States as the home to the highest number of Fortune 500 firms, that triumph could be short-lived. Why It’s Happening China’s Fortune 500 firms are heavily reliant on domestic revenues, and a rapidly falling working-age population will severely reduce domestic GDP growth in the absence of improvements in labor productivity (which are unlikely to occur). Japan provides an uncomfortable precedent for the consequences of this demographic shift. The Solution To keep their places on the Fortune 500, China’s domestic giants will have to develop a global mindset more characteristic of multinationals from small countries like Switzerland—a transformation that has to date eluded most of Japan’s businesses.

There’s no question that China is on the rise. In 2018, Fortune’s Global 500 ranking included 111 firms headquartered in China—just a handful fewer than the United States’ 126. In 1995, only three Chinese firms made the list; in 2018, three were in the top 10. No wonder some observers predict that China will soon overtake the U.S. as the home to the highest number of Fortune 500 firms.

It’s entirely possible that this could happen, but the triumph would likely be fleeting. Our skepticism is rooted in Japan’s example: In 1995, Japan was second only to the United States on the Fortune 500 list, with just four fewer companies. It had achieved that position thanks to several decades of soaring growth in the domestic economy—an astounding 1,171% from 1973 to 1995, a growth factor of 12. The China story is almost identical: Since 1995, the domestic economy has grown by a factor of 16.6, from just $735 billion to $12.2 trillion today, and the correlation between the rise of Chinese GDP and the ascent of Chinese firms onto the Global 500 list is 99%.

In our view, China’s share of global business is predicated, as was Japan’s, on a dynamic domestic economy. The top three Chinese companies on the Fortune list in 2018—State Grid Corporation of China, China Petrochemical Corporation, and China National Petroleum Corporation—generated more than 85% of their revenue domestically. They, along with 84 others out of China’s 111, are state-owned enterprises, or SOEs; you would expect such companies to be reliant on domestic revenue for growth. But many of the privately owned enterprises (POEs) on the list also generate the bulk of their revenue from domestic customers. The numbers for tech giants Alibaba and Tencent, for example, are 74% and 80%, respectively. The implication is clear: With a few exceptions—notably Huawei and Lenovo, which generate 50% and 75%, respectively, from sales in foreign markets—the great majority of the Chinese companies on the Global 500 would be vulnerable to a major slowdown in the domestic economy.

And a slowdown is inevitable, we believe. Demographic data shows that China’s working-age population is shrinking. In the absence of drastic improvements in labor productivity, a smaller workforce means a lower GDP growth rate. Japan has experienced a similar decline in working-age population, and it has been unable to achieve the productivity gains necessary to maintain growth. It is unlikely that China’s firms will succeed where Japan’s have failed, primarily because the factors that have driven China’s spectacular growth over the past 20 years—a low baseline of productivity to begin with, an excess supply of rural workers, and easy access to foreign technology—have significantly weakened.

China’s other option for averting an economic slowdown—boosting international sales and exports—also faces headwinds: China’s penchant for debt could hamstring attempts to innovate by reducing the capital available for investment in international sales and dampening the country’s export competitiveness. And Chinese management style is antithetical to fostering innovation. For these reasons, we believe that after a meteoric rise, China’s giants could face a rocky future. Let’s begin with a review of the demographics.

The Demographic Disaster

The demographic parallels between China and Japan are striking. China’s working population (people aged 15 to 64) is estimated to fall by 9% from 2015 to 2035, and by 20% in 2050. That’s a loss of 200 million people—more than the total working-age populations of Germany, France, the UK, Italy, Belgium, the Netherlands, and Switzerland combined. Japan has experienced a similar decline over the past two decades: Its working population fell 13.4% from 1997 to 2017.

The Rise and Fall of Working-Age Populations The steep decline in China’s working-age population is likely to be accompanied by a sizeable drop in GDP in the absence of dramatic gains in labor productivity. Japan experienced a similar decline in its working-age population and was unable to boost productivity enough to maintain GDP growth.

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China’s infamous one-child policy, implemented in 1979, is often seen as the reason the birth rate fell from 2.9 children per family to 1.6 in 1995. But demographic data suggests that the policy only accelerated a decline that China was already experiencing. The country’s birth rate began falling a decade earlier, reflecting a nearly universal pattern of economic development in which birth rates fall as standards of living rise. In Japan, the birth rate fell from 2.1 in 1965 to 1.6 in 1989 without the help of a one-child policy.

A country’s workers are its most powerful consumers; when the working-age population shrinks, so do revenues. That has already happened to Japan’s global giants. As the country’s working-age population fell, domestic consumption faltered, and Japanese firms started sliding off the Global 500 list. The correlation between the decline in the working-age population and Japanese firms’ leaving the Global 500 was 94%. China faces the same situation.

Two key ways a country can compensate for a shrinking workforce are by boosting the number of workers through immigration and by boosting the productivity of the remaining workers. Immigration as a countervailing force to a falling birth rate seems unlikely for China, which, like Japan, is not known for welcoming foreign workers. According to World Bank data, in 2015 less than one-tenth of one percent of the people living in China were foreigners. During Japan’s heyday, that country’s rate was somewhat higher, but still only 1.7% of people living in Japan in 2015 were registered foreigners. By contrast, the number of registered foreigners in both the United States and Germany that year was about 15% of the total population.

Countries can also offset a shrinking working age population through dramatic improvements in labor productivity. With increased productivity, companies can pay fewer workers more money and still remain profitable, and the higher pay translates into higher domestic consumption per worker. In Japan’s case, the improvements didn’t happen. The country averaged 13% per year in productivity gains for the 20 years leading up to its peak working-age population in 1997. But in the two decades that followed, during which the workforce shrank, productivity growth averaged less than 1% per year. And the vast majority of those gains came from the manufacturing sector, not the service sector, which now represents 70% of Japan’s economy.

China’s penchant for debt will likely hamstring attempts to innovate.

China seems to be following a similar path. Although its productivity growth averaged 15.5% from 1995 to 2013, when its working-age population reached its peak, productivity growth slowed to an average of just 5.7% from 2014 to 2018. In other words, China’s productivity growth rate is decelerating just when it needs to speed up. This gloomy scenario is especially problematic for China’s SOEs. Although they have larger revenues than POEs, on average, they also have significantly higher numbers of employees (a median of 143,927 versus 77,073) and lower profits (a median of $746 million versus $1.7 billion). That means they are heading into the slowdown with a productivity growth rate significantly lower, on average, than that of the POEs, as measured by revenue per employee ($326,338 versus $496,172) and profits per employee ($5,355 versus $22,507).

Can China correct or compensate for its falling productivity? That will depend on the long-term outlook for the main drivers of its labor productivity and on the ability of its firms to replace falling domestic revenues with exports (producing in China and selling abroad) and international sales (producing abroad and selling abroad).

The Outlook for China’s Productivity

To assess the outlook for Chinese productivity, we have to determine whether the factors contributing to its impressive growth to date are likely to improve, stay the same, or decline. Economists and business strategists point to three drivers of China’s growth: the fact that the country started with a very low productivity level, an excess of rural workers available to migrate to more-productive city jobs, and firms’ ability to trade market access for productivity-enhancing foreign technology.

A low productivity baseline.

In 1994 China’s GDP was just $564 billion, and its GDP per capita was only $473. In 2014, GDP topped $10 trillion. The economic reality is that the larger GDP gets, the harder it becomes to maintain the same rate of growth. A falling number of workers compounds the challenge. Suppose a country is growing at a rate of 6%. If its workforce falls by 3%, productivity growth from that smaller workforce has to increase to 9.3% just to sustain the baseline. The difficulty of achieving this over long periods is obvious.

An excess supply of labor.

Most experts acknowledge that the migration of people from rural areas devoid of modern machinery and technology to industrialized urban areas plays a big role in driving productivity in a developing economy. It certainly did in Japan’s recovery after World War II and in China over the past 25 years. But internal migration happens only if a country has an excess supply of rural labor. That no longer appears to be the case in China. Over the past 10 years, migration from rural to urban areas has dropped precipitously, with just 0.3% of the population leaving the countryside in 2016, according to the Chinese government. In the 10 years prior to that, more than 280 million workers migrated from the countryside to the city. This slowdown is starting to be reflected in higher pay: Wages for migrant workers in the eastern urban regions of the country rose by 7.4% in 2016.

Will China Follow Japan’s Path? Powered by meteoric growth in the domestic economy, China is poised to overtake the United States as the home of the most Fortune Global 500 companies. But it faces the same challenges that reversed Japan’s trajectory in the late 1990s.

These indicators suggest that China is reaching what’s called the Lewis turning point (LTP)—that is, when migration from country to town effectively stops. Many economists believe that China reached its LTP prior to 2018. Many of the residential areas built in major cities over the past 10 years to accommodate expected internal migration remain vacant. Some reports put the number of unoccupied apartments, almost all located in urban areas, at more than 64 million. Based on this evidence, China’s recent announcement that it plans to move another 250 million people from rural to urban areas by 2025 may be wishful thinking.

Easy technology expropriation.

Foreign firms increasingly recognize that giving away proprietary technology in return for market access makes little sense in China’s mature, increasingly competitive business landscape. UNCTAD data reveals that FDI flows into China—a reasonable proxy for investment in local technological capabilities—grew by an average of only 2% per year from 2012 to 2017, down from the 10% annual average from 2002 to 2012. Companies such as GoPro, Panasonic, Sony, Hasbro, Revlon, and L’Oréal have recently closed shop or significantly reduced investments in the country. And many more multinationals are reconsidering expansion plans because of an unwillingness to trade technology for market access along with concerns about tariffs, political pressure, and rising wages.

Chinese companies’ activities abroad are also coming under scrutiny. Foreign governments and companies increasingly see Chinese tech giants as security threats, as reflected in the recent high-profile arrests of executives from Huawei and the restriction of business with that company imposed by governments in the United States, Canada, and the UK. Western companies and agencies have accelerated their efforts to protect databases and proprietary technologies from Chinese hackers, which we can assume will further slow the transfer of foreign technology into China.

The Chinese government recognizes that the days of easy productivity gains via technology expropriation are over. In 2015 it released its Made in China 2025 plan, which calls for transforming 10 strategic industries into world leaders through homegrown technology innovation. But successfully shifting from strategies based on imitation and expropriation to ones focused on creation and innovation requires changes in organizational culture so large that the majority of companies from all countries fail in such attempts. To think that Chinese companies will fare better defies the odds, despite all the government support they get. What’s more, many Chinese companies favor top-down, autocratic approaches to management, which is inconsistent with a culture of innovation. And Chinese companies face another uniquely Chinese hurdle: All companies with more than 50 employees must have a Communist Party representative on-site. This muddies decision making, skews rewards, and bureaucratizes the innovation process.

For these reasons, we believe that Chinese corporations will have a hard time achieving the productivity gains that will be required in the future. That leaves only one way for them to keep their places on the Global 500: by boosting exports and international sales. But two serious obstacles stand in the way: high levels of debt and a conservative, inward-focused management culture.

China’s Debt Crisis

China’s government debt is about $34 trillion—266% of GDP—and is growing fast. Corporate debt is also on the rise. According to July 2018 data provided by the Ministry of Finance, total debt among China’s state-owned firms amounted to more than $16 trillion, up 8.8% from the previous year. That’s about 15% more than the debt of all U.S. nonfinancial corporations combined. China’s indebtedness has quadrupled in the past seven years, and it grew 14% in 2017 alone. China’s Declining Birth Rate Many observers point to China’s infamous one-child policy as the catalyst for its declining birth rate. However, World Bank data shows that the birth rate had already begun to slow more than a decade earlier. The drop is most likely associated with the near-universal pattern whereby birth rates fall as standards of living rise. So far China has been able to sustain this level of borrowing, largely thanks to robust internal rates of savings; that allows it to avoid the high interest rates that outside lenders might charge. It continues to run a large current-account surplus—that is, it exports a greater value of goods and services than it imports—which has enabled it to be a net lender to other nations. It still has the potential to simply grow its way out of the problem, even as the economy slows down—provided debt does not continue to mount at current rates. That, however, is a big proviso. China has long had a penchant for borrowing in order to stimulate the economy. If, as we predict, a shrinking workforce and lower productivity growth cause the economy to slow further, the government will be likely to double-down on borrowing, particularly through SOEs. That will only reduce the capital available for investment in international sales and do little to improve the country’s export competitiveness.

But even if Chinese firms had plenty of capital to invest in international sales capabilities, they would still face a more fundamental challenge: their management culture.

A Crisis of Leadership

Like China’s firms today, Japan’s Fortune 500 companies in 1995 derived 85% of their revenues from domestic sales. When Japan’s working population began to shrink and domestic productivity stalled, executives were unable to compensate for the hit to their revenues through exports and international sales. Why?

From our firsthand experience working with Japanese firms at the time, we found that, with the exception of a handful of firms (such as Sony, Toshiba, and Toyota) that were already international in outlook, most management teams refused to accept that the domestic economy was not going to revive until they simply couldn’t deny the reality any longer. It took until about 2002 before Japan’s 1995 giants had fully refocused their strategies on international growth.



Richard John Seymour

About the art: In his project, “Yiwu Commodity City,” photographer Richard John Seymour explores the largest small-commodity wholesale market in the world. Located in Yiwu, China, thousands of stalls exhibit slight variations on particular items.

Unfortunately in Japanese firms, Japanese leaders who understood both their domestic markets and international ones were in short supply, while internationally experienced non-Japanese top executives were virtually nonexistent. The reason was perfectly understandable: Why would companies put significant focus on developing leaders for markets representing only 15% of revenues? And why would rising Japanese leaders risk their careers by taking expatriate assignments away from the main action?

Moreover, Japanese firms were not attractive to foreign talent, because the path to advancement lay through achievement in the domestic market. Our research found that from 2005 to 2010 essentially all the top executives and board members of Japanese firms were Japanese nationals. Also, nearly 100% were male. Recognizing this, non-Japanese leaders who had international experience and savvy were hesitant to join Japanese firms. The lack of diversity at the top has not changed. We examined a random sample of 20 of the 52 Japanese companies on the 2018 Global 500 list and found that nearly 97% of all executives and more than 98% of all board members were Japanese nationals, and more than 90% were male.

Following their shift in strategic focus, Japanese firms finally started to see a boost from international business—just when the financial crisis erupted. The ensuing recession hit Japanese exports hard: They slumped by 25.4% in 2009 and didn’t recover for three years. International sales were less affected by the recession as the investments in overseas operations began to pay off. But even so, Japanese firms significantly lagged their global rivals on this front, with dramatically lower levels of investment in foreign assets as a percentage of GDP. The underperformance was actually larger than the graphic suggests, because some of the increase in the rate came from a flat denominator (GDP) rather than from increases in the numerator (overseas investments). As a consequence, Japanese firms lost 65% of their peak share of the Global 500 list in less than a generation. Given the persistent lack of global leadership at the top, we do not predict a major recovery in the near future. Can Exports and International Sales Make the Difference? Companies can compensate for a declining working-age population, even in the absence of productivity gains, by increasing exports and international sales. China leads the world in exports in absolute numbers, but as a percentage of GDP, it lags other nations—suggesting its largest firms risk losing their Global 500 rankings in a domestic slowdown. The parallels with Chinese firms are worrying. We also looked at a random sample of 20 Chinese firms on the 2018 Global 500 list and found that just over 97% of board members and just under 97% of executives were Chinese nationals. Thirteen of the 20 firms were SOEs (65%), similar to the share on the list overall (71%). The seven POE firms in our sample demonstrated similarly low levels of diversity, with one, notable exception—AIA, a major insurance company. We then examined an additional 10 randomly chosen POEs from the Global 500 list. Here we found a somewhat higher level of leadership diversity than in SOEs, but it was hardly convincing: Over 80% of the board members and 87.3% of the senior managers were Chinese nationals. So although we do anticipate that leadership diversity will increase somewhat in the years ahead, we don’t expect the composition of top teams in Chinese firms to resemble those of successful Western multinationals any time soon.

There is little that CEOs and executives can do to change China’s demographic realities and the macroeconomic forces behind the productivity slowdown. But the leadership crisis we have described is a cultural challenge that is within their capabilities to manage, as are many of the other innovation challenges they face. Chinese firms must learn to rely less on an inward-looking, hierarchical approach to management and more on the innovativeness and agility that characterize the world’s most successful multinationals.

Building Global Leadership Capabilities

Many Western multinationals are known for agility, adaptiveness, and innovation. These sources of competitive advantage don’t happen by accident; they are the consequences of a management culture and capabilities that firms deliberately adopt, acquire, and develop. The Swiss giant Nestlé, for example, is competitive globally because it has deliberately diversified its leadership pipeline and created an outward-looking management culture. Chinese firms could theoretically do the same. But their management style would have to change in five important ways. Specifically, China’s corporate leaders must:

Show respect.

In our work, we hear two complaints about Chinese businesses and executives. The first is best captured by a government official in a country in which a number of important Chinese firms have made significant investments over the past few years: “Maybe it’s because China is so big and has been growing so fast for so long, but Chinese executives come in and are a bit arrogant and think they can manipulate suppliers, ignore communities, and discount the environment like they do back home.” We heard similar complaints about American and to a lesser extent European executives 30 years ago. All have learned through bitter experience that what works at home does not necessarily work abroad. This is a lesson that more Chinese executives will need to absorb if their efforts to boost international sales are to succeed.

The second complaint relates to a mindset that we call international business for China. “Every company has a degree of self-interest,” one executive told us, “but Chinese companies [operating] here seem to care only about how to suck out value for their own benefit and to help China overall.” Stakeholders increasingly demand that foreign businesses create value for, and not simply extract value from, the countries and communities in which they operate. These common complaints reflect a China-centric mindset that is out of step with today’s global business environment.

Promote inpatriation.

Chinese firms need to accelerate their efforts to bring global leaders together, not just via email or teleconference but in person. Nestlé has about 2,600 employees at its headquarters and offices in Vevey, Switzerland. An estimated 800 of them are foreigners.

This level of inpatriation, or bringing people into the center for international assignments, is viewed as necessary to develop leaders, bring diversity and breadth of perspective to the company, and build networks and trust. In our work with Chinese companies over the past 30-plus years, we have yet to see one that supports any serious inpatriation. Japanese firms have also failed in this regard. Chinese leaders’ reluctance to fully integrate international leaders stymies innovation, creates barriers to local responsiveness, and sends powerful messages of exclusion to talented leaders outside the country.

China’s Diversity Challenge Leadership diversity correlates with strong international sales and exports, research shows. Our analysis reveals that Chinese firms are headed almost entirely by Chinese nationals, indicating that they will likely struggle, as Japanese firms did, to compensate for a slowdown in domestic growth with exports and sales abroad. Switzerland leads the developed world in both leadership diversity and in exports and foreign assets as a share of GDP.

Fix expatriation.

It is natural for globalizing firms to send expatriates from the mother ship out to foreign satellites. Although there are benefits in terms of ease of communication, research has documented the serious limitations of this approach. Learning from experience, American and European multinationals have significantly added “third-country nationals” to international assignments. Nestlé, for example, has over 2,000 expatriates around the world, but more than 85% of them are not Swiss. Potential leaders typically get foreign postings early in their careers to test and develop their global perspective and potential.

Unfortunately, Chinese firms look much more like Japanese firms than like Swiss firms. Decades of research have shown that Japanese firms proportionately send nearly twice as many “home-country nationals” to foreign outposts as do firms from most other developed countries. Chinese firms are headed down the same path. They will need to break the pattern if they are to avoid the long-term liabilities of this approach, not the least of which is difficulty attracting and retaining the best and brightest foreign leaders.

Invest in leadership development.

Filling the global leadership pipeline requires not only expat assignments but also formal training programs. In many cases, these programs include multiple learning modules that bring participants together more than once and have projects and other activities that keep people connected even while they are back home and physically separated. UBS, Nestlé, and ABB all run customized programs in conjunction with major business schools that are required for advancement. The exposure to people and best practices outside the company are particularly valuable.

Chinese firms tend to regard leadership development as a training function—so while they often spend heavily on technical training and basic business skills, their commitment to developing global leaders is frequently lacking. They pay little attention to program content or participant engagement, sticking with a dated education model that emphasizes mass lectures in huge auditoriums filled with participants who never put down their smartphones.

Learning from Switzerland’s Example The Swiss economy is one-twelfth the size of China’s, which means that Swiss firms have no choice but to focus on international sales and exports if they are to grow fast enough to hold their own in the global economy. And hold their own they have: Relative to the size of their economies, Switzerland exports 2.3 times as many goods and holds 10.7 times as many foreign assets than China does. What is the secret to Switzerland’s outsize performance? To answer this question, we conducted structured interviews with more than three dozen executives in Switzerland and found that nearly 70% of them ascribed Swiss firms’ international success to one thing: leadership diversity. As one executive put it, “If you are going after sales across many different countries, political systems, regulatory bodies, and customer preferences, you need people with broad experience. This is not possible if [leaders] all come from one country and have spent their working lives in that country. Global revenues require global leaders.” The numbers back this up. On average, 62% of nonexecutive board members of large Swiss companies are non-Swiss. In the 20 largest Swiss companies, 55% of the CEOs are foreigners. At banking giant UBS, the 13-member Group Executive Board is composed of four Swiss nationals, two dual nationals, and seven non-Swiss. The board of directors is even more diverse. Of its 15 members, two are Swiss, three are dual nationals, and eight are non-Swiss. Although no exact threshold of optimal diversity has been established, research shows that when the international composition of leaders is misaligned with international revenues, growth slows and profits lag. Swiss firms recognize this and take a “passport blind” approach to recruiting, developing, and deploying executives.

In fairness, a few Chinese companies have begun embracing the development of global executives. In 2018, Alibaba set up a leadership academy comprising a 16-month, all-English program in China. The participants are required to rotate across three business units. Other Chinese firms should pay close attention.

Innovate outside of China.

The government’s Made in China 2025 initiative faces many challenges, especially if it insists that innovation can only happen at home. A number of leading global firms, including Japanese firms such as Takeda Pharmaceutical, have established strategic innovation centers in foreign countries. Many wisely choose to locate them in geographic hotbeds of innovation, including Tel Aviv, Berlin, Austin, Boston, and Vancouver. Of course, success requires more than just investing in facilities or even hiring top people. The right culture is also essential for the success of these investments. That means that the China-centric mentality will have to change. The good news is that all the previous recommendations mentioned here will help this fifth one succeed.

Conclusion

Although most Chinese firms are well positioned to use their size and ecosystems for domestic advantage, they are ill-prepared for the global expansion they will need to undertake if they are to maintain their newly acquired global rankings. Absent a major pivot in thinking and approach, they will be unable to deliver the productivity gains needed to offset the consequences of the steepening decline in the country’s working-age population. If the current leadership composition continues, we predict that like Japanese firms before them, Chinese companies will begin to slide off the Global 500.