Beijing, China, June 2017

It was one of those rare and beautiful blue-sky days in Beijing—a reminder of just how magical the capital can be if its government would find a way to reduce the suffocating pollution that normally blankets the city. Under a brightly shining sun, the giggles of children running and jumping rope outdoors echoed through the streets.

Having sprained my knee the week before in a father-son basketball game against my son Tom’s team, I lumbered on crutches through the expansive training compound of China National Petroleum Corporation (CNPC), the parent company of PetroChina. China’s state-owned oil giant, CNPC was now the world’s third largest oil and gas company by revenue and ranked third in Fortune Global 500. A training ground for CNPC’s various divisions, the whole campus seemed to buzz with training sessions.

I had been invited to keynote a conference for two hundred of the most senior cadres14 of China’s state-owned enterprises (SOEs). With a focus on stimulating SOE growth, the conference was jointly organized by China’s State-Owned Assets Supervision and Administration Commission of the State Council (SASAC), the umbrella organization that oversees 102 centrally owned companies, and a multi-billion dollar European family-owned private equity firm. Plagued by excessive bureaucracy and myriad other issues, China’s SOEs had become a drag on the efficiency of the national economy, falling behind on innovation and even standing in the way of China’s private sector. Asked to advise SASAC’s hosted cadres, I prepared to speak about the primary challenges hindering SOEs and how the system should be reformed in order to recruit and retain talent and promote a focus on innovation. Change was seriously needed if China wanted its state-owned companies to compete on innovation and grow globally through initiatives like OBOR.

***

To understand why SOEs are struggling, particularly in retaining talent, we must first explore the system’s purpose and organization.

All state-owned enterprises report back to SASAC. Even the CEOs of multidivision conglomerates with tens of thousands of workers have political supervisors at the top. As a result, they lack the autonomous command held by Chairmen or CEOs of American companies—who wield far more power. Unlike Exxon, where the CEO reports only to the Board of Directors, the CEO of PetroChina, for example, would need to report to the CEO of CNPC who would then have to report to SASAC.

Without much of a personal stake in their company’s earnings or the possibilities of high salaries (which are capped by the government), many SOEs operate with political goals in mind at the expense of purely market-oriented ones. Executives of SOEs typically care more about getting promoted up the political ladder than on profits or increasing efficiency. Consequently, a senior bank executive from Bank of China or ICBC (Industrial and Commercial Bank of China) might loan money to another SOE even if he knows the loan will become nonperforming; he’d rather garner the political support of other leaders in the system when seeking a promotion.

Yet this interplay with politics affects more than just the domestic realm. For instance, SOEs might become suspect when acquiring assets abroad that have security risks. Given that they report up the Communist Party chain of command rather than to profit-seeking shareholders, many foreign nations are wary of approving acquisitions by SOEs. In 2016, for example, the US-China Economic and Security Review Commission in its annual report to Congress recommended that Congress block all acquisitions in the U.S. by Chinese state-owned firms because the Chinese Communist Party (CCP) uses to the SOEs as an economic tool to advance national security objectives.

Tightly bound to complex incentive systems, China’s SOEs are a conundrum for even the most astute economist—at once both the key to China’s economic miracle and the greatest thorn in its side. On the one hand, SOEs are remarkably helpful. They continue business activities at the behest of politics even when it makes little economic sense to keep investing. Doing so shores up employment numbers and bolsters consumer confidence during economic hardship or increases investment in regions where returns are too low to attract private investment. A safeguard against unemployment, SOEs are also an effective tool for China’s central government to pump up the economy when needed. This has been particularly helpful in the post Great Recession crisis of the past decade when SOEs kept hiring during the downturn even while multinationals in China implemented hiring freezes.

Yet the political aspects of SOEs generate numerous challenges. Slowing growth and impeding prudent decisions, heavy bureaucracy and political incentives pose threats to China’s initiatives abroad. In the case of OBOR, for example, China’s state-owned sector requires several important reforms in order to lead investment coalitions efficiently. Walking a fine line, SOEs must become more profit-oriented, and less a mere tool of China’s political system or they will face opposition by the foreign lawmakers they need to grant approval for projects. In meetings with senior advisors to Vietnam’s President, for example, I was told that there was distrust and suspicion in many circles within Vietnam with what the end goals of SOEs investing in the country were. Tasked with exploring these challenges and their solutions, I reflected on how I would approach my audience.

***

The conference was held using CNPC’s largest auditorium. Decked out with cramped seats as a nod to President Xi’s austerity campaign, the venue veered noticeably from a Shangri-La or Grand Hyatt where similar events had been hosted under Jiang Zemin and Hu Jintao. At the back of the auditorium lay instant coffee and DIY tea packets, further emphasizing Xi’s anti-extravagance push. The only modern indulgence in the room—providing a minimal sense of comfort—were mobile phone charging stations installed at each seat. Even bureaucrats can’t live without their WeChat.

Specifically, the conference had gathered these top SOE cadres to determine how SOEs should plan ahead in China’s shift from an economy based on heavy investment and manufacturing to one based on services and consumption. Most critically, SASAC wanted SOEs to focus on innovation in order to lead the economy in initiatives like OBOR. I was therefore asked to discuss human resources and their importance in creating a culture of innovation.

Occupying a larger role in China’s economy than most analysts realize, SOEs are critical to spurring domestic innovation. According to 2013 figures, while comprising only 30 percent of firms, the public sector accounted for 55 percent of assets and 45 percent of revenue.i

But SOEs were hurting. As anxiously reported to me by SASAC’s officials, state-owned giants were now losing out to start-ups in Shenzhen and Hangzhou, struggling to compete with China’s private giants like Huawei, Baidu, and Alibaba. Quickly surpassing China’s long-standing SOEs, these latter companies had started to offer better employee benefits—housing, education allowances, even international travel jaunts. If SOEs failed to attract top talent, how could they possibly take a lead in operating OBOR abroad?

Absorbed in thought and daunted by these challenges, I approached the podium. While having spoken at the renowned Three on the Bund to launch my last book, The End of Copycat China (after being invited by owner and friend Cherie Liem)—an event chaired by the head of the Communist Party School in Shanghai—I had never faced such a large and senior group of SOE cadres. On top of the pressure, a key component of my speech required criticism of the very audience in attendance. Already unsettled by the fact that many cadres were still looking at their phones, I was painfully aware of my status as an American outsider, anxious that my critiques might be ill received and viewed through a nationalist lens. Many Chinese still feel Americans are trying to contain China’s rise rather than help it along. Many Americans who formerly seemed to respect China and its government, like George Washington University Professor David Shambaugh, suddenly wrote that the Communist Party was on its last legs and ready to implode, creating ill will towards outsiders.

Taking a deep breath, I began by outlining why China’s economy had to become more innovative—as both President Xi and Prime Minister Li Keqiang had exhorted. Innovation was critical both for sustainable economic development and for Chinese leadership through OBOR, I argued. In light of the state-owned sector’s aversion to risk, this message was crucial to convey. Many of the cadres present had risen up the ranks precisely because they successfully placated political superiors, often keeping their heads down at the expense of generating revenue and taking risks. This had to change, I insisted. In the midst of rising real estate and labor costs, SOE executives had to take risks and prioritize innovation if they wanted to stay afloat. Looking out at my audience, I was heartened to see heads bobbing up and down in agreement. No one was looking at a phone anymore.

Much of their aversion to risk can be accounted for by the power structure in place. Given that SOE executives are politically selected—rather than having risen to the top by beating business odds—their long-term positions are fairly stable regardless of company profits. Because of this, SOEs grow intellectually ossified, especially at the top, unable to generate and unwilling to welcome fresh ideas. Yet even bringing in more profit-oriented business directors has often had its problems as they are not always accepted. Bureaucracy’s permeation of SOE culture has hindered Chinese who developed careers in the private sector. As one senior Chinese executive of a European tool company who had been educated at IMD (International Institute for Management Development) in Switzerland told me, “I tried taking a senior role in an SOE but left after less than a year. The culture made it impossible for outsiders like me, trained in European and American businesses, to get anything done. It was far too political.”

An additional frustration, SOEs often become too spread out and unfocused in one business line. SOEs in silk, grain, and dairy, for example, often seem more like real estate investors or mini hedge funds than firms targeting a single industry. Normally holding a remarkable amount of real estate, SOEs also decisively scoop up shares in the stock market whenever they see potential for returns.

Recognizing these inherent problems and the need to build a more market-oriented economy, Prime Minister Zhu Rongji took on China’s first great SOE reforms in the late 1990s. Highly successful, Zhu’s reforms eliminated several of the problems discussed above and ensured the nation’s last two decades of strong economic growth.

To the initial shock of the country, Prime Minister Zhu forced SOEs to lay off workers. Over 30 million workers lost their jobs, hundreds of SOEs privatized, and thousands shut. Until then, employment by an SOE was nicknamed the iron rice bowl. One simply never got fired. But as SOEs grew bloated and slow-moving, Prime Minister Zhu was compelled to make sweeping cuts. After taking a number of SOEs public, Zhu saw many become more profit oriented and productive.

However, while Zhu’s extensive reforms worked for nearly twenty years, by the mid-2010s, the same rot had started to seep in again. Too many SOEs had leveraged their political connections to fend off competition from the private Chinese and multi-national sectors. With this advantage over private companies, SOEs could more easily get away with lower quality goods and services. China’s telecom sector, for example, is largely closed off to private investment and has some of the most expensive yet slowest data plans in the world. Multi-hour-long waits are not unusual before seeing a teller at one of China’s state-owned banks. Good luck trying to open a credit card account or do Internet banking. State-owned hospitals are no better—seeing a doctor can take hours, even days, of queuing to spend just a few minutes with a doctor.

Treading on sensitive ground, I explained to SASAC’s cadres that rot begins at the top of an organization. If SOEs were to be truly competitive, the very leaders sitting in front of me needed to foster a culture of risk-taking, not squelch it. Equally imperative, SOE executives had to place far greater importance on consumers; ensuring customer satisfaction was key.

Having remained sluggishly static, too many SOEs failed to cater to consumers’ dynamic demands. Seemingly indifferent to the needs of non-SOE clients and consumers, SOEs particularly in the financial services and retail sectors were being swiftly overtaken by the Alibabas and JD.coms of the world. Even with their dominant political position, SOEs in the communications industry were losing out to private Chinese companies like Tencent—developer of WeChat. Offering consumers a far cheaper platform for communication, Tencent seemed almost a no-brainer for frustrated consumers who relied on state-owned companies for expensive voice calls and text messages. In a similar vein, Alibaba far outpaced state-owned department stories with its Taobao and Small platforms. Alibaba also outcompeted financial service SOEs in development of its Alipay division. Swiftly attracting hundreds of millions of Chinese users, Alipay offers consumers a way to buy goods online, transfer money, and buy wealth management products with-out even a credit card or securities brokerage account. Private hospital chains like Shanghai United or Parkway Health also saw wealthy Chinese flocking to their top-notch equipment, stellar doctors, and trusted medical care.

SOEs could no longer relegate consumers to a list of secondary priorities. In-novative products and services would be critical for customer retention. Unfortu-nately, however, consumers were not the only ones needing to be retained. One of the greatest challenges to China’s SOEs was their increasing inability to recruit and keep top talent.

Once a prime destination for top university recruits, SOEs have long enjoyed their pick of the best by providing generous benefits and relatively secure positions. In the Great Recession of 2008, when even huge multinationals experienced hiring freezes, SOEs refused to lay off workers. In recent years, however, China’s private companies have progressively offered greater job security and lucrative benefits. In conjunction with a declining reputation, SOEs have conse-quently lost their pull.

Perhaps the only benefit SOEs could offer that private companies were unable to guarantee are China’s coveted hukous, or residence permits. Hukous are the tickets for those seeking a life in China’s big cities, allowing them to buy homes and gain cheaper access to both education and medical care. But even the dream of securing an urban, tier 1 city15 hukou no longer sufficed to attract top talent to SOEs. Soaring salaries in the private sector quickly overcame concerns about ac-cess to education and medical care. Only housing remained a major stress point for young Chinese hoping to make a life in China’s crowded urban centers. Many cities imposed limits on the number of non-residents purchasing homes—regula-tions impervious to bribery or wealth. In Shanghai, for example, non-residents not only have to work in the city and pay income tax for a full five years, but also need to be married before they can even consider purchasing a house.

Salaries and benefits aside, cultural changes have also accounted for much of the state-owned sector’s falling retention rates. As China’s cultural psychology shifts away from political movements and collectivism, younger Chinese have increasingly prized individualism. In light of this trend, today’s top new talent often view SOEs as a doddering force, unable to compete in an environment of innovation and creative solutions. For those born after 1990, most popular brands—Tencent, Alibaba, OPPO, Mengniu, Yili—are all private Chinese firms. By contrast, companies most frustrating to China’s high-standard millennials—doomed by exorbitant prices and poor customer service—primarily consist of SOEs like China Telecom or Bank of China. Were private companies to have such issues, they would simply go out of business.

Seeking trendy avenues for creative expression, young people are wary of the SOEs’ corporate cultures, known for prizing political expedience over business acumen. Loath to adopt the lifelong careers of the past, young Chinese prefer to switch between jobs and companies every few years, seeking fortune over long-term stability. SOEs might offer a decadent package, but everyone knows the state-owned sector is no route to billions. And as President Xi’s corruption crackdown gains an ever-stronger grip, glamor-less SOEs continue to lose their talent.

Seeking to advise the cadres on how they might retain young talent, I shifted from talking about innovation in the finance and retail sectors to more groundbreaking sectors like biotech, Internet, and technology. To succeed in these industries, Chinese firms had to consider buying technology from abroad, either incorporating foreign parts into their own products, or buying out entire manufacturers. SOEs simply lacked the technical expertise to survive on their own in this way.

Providing better tech products through the incorporation of Western-manufactured parts would be critical not only for the retention of young Chinese workers but also for generating greater profits. And nothing was more central to making OBOR a success than being perceived as profitable.

Seeking to drive home this latter point, I emphasized that no one would be interested to be a mere political pawn in China’s play for global influence. Countries would take part in OBOR if, and only if, they could see themselves making profits. Consequently, to thrive both domestically and internationally, SOEs had to prioritize innovation, revenue, and the needs of their beneficiaries.

Upon finishing my speech, there was a smattering of applause. It appeared that the cadres had agreed with what I’d said, but most were waiting to deduce the views of others before publicly displaying their own. But once their clapping began to indicate my speech’s general acceptance, the cadres’ applause turned to a chorus.

Most revealing, however, were the questions and feedback that followed. Expressing wholehearted agreement, even the most senior SOE executives communicated that they wanted to reform. They understood they needed to change in the context of China’s global expansion. Doing so, however, would not be easy. Still anxious about other executives in China’s state-owned sector, many cadres remained concerned by the political ramifications of their decisions—both for their companies and their own personal careers. Without the assurance of system-wide changes, a prisoner’s dilemma would remain.

Having accepted my premise, many cadres now asked me for specifics. One executive raised his hand. Head of one of China’s large conglomerates, the executive had directed his SOE through the buyouts of American and European auto and aircraft parts makers. Now seeking to make his company more innovative, he asked, “How do we organize internally to promote innovation? And how do we get buy-in from senior executives and government officials who might not care about profits?” Within seconds, hands shot up throughout the audience as cadres piped up around him, asking similar questions. I quickly realized their barrier was not lack of will; if anything, they faced greatest resistance from the system’s internal workings.

What surprised me most, however, was my audience’s openness to criticism. Implicitly targeting many of the cadres I had spoken to, I argued that China’s legal order needs to be more fair and transparent. By using political maneuvers rather than competitive initiatives to compete with China’s private sector, SOEs were not only gaining an unfair advantage but were also holding back progress on a national scale. Expecting my audience to recoil, I was taken aback by the cadres’ affirmative nods. Equally surprising, they showed little objection when I presented uncomplimentary consumer data: 86 percent of the consumers interviewed by my firm, the China Market Research Group (CMR), had reported moderate or strong dislike of the service provided by the Bank of China. Many complained that SOE executives were far too focused on doling out loans to other SOEs, leaving little regard for retail business. The cadres seemed to agree with my conclusion of SOE customer dissatisfaction—an unintended opportunity for Alibaba’s Alipay or Tencent’s WeChat Wallet as alternatives to Bank of China. This would continue to be a failure of SOEs, and a failure of the entire system, if priorities did not change.

Yet even with the will of cadres present, the question of political capital still remains. The executives may want it, but will the government, in its continued efforts to control the economy, allow for more unfettered competition? With current incentive systems in place, how can decision-making be oriented around economic efficiency rather than political gain?

***

In China’s campaign to build international power through OBOR, SOEs may serve as the nation’s greatest help or prove to be its greatest hurdle. To achieve the former scenario, China’s state-owned sector must adopt the necessary skills and structure to lead investment and growth. Targeting areas rife with conflict, a great number of OBOR’s projects will operate on decades-long time horizons, taking years to reach break-even points. It is therefore highly unlikely that companies in China’s private sector—which are constrained by the requirement to report to shareholders seeking short-term profits—will take any substantive lead in these long-term investments.

Because they have the ability to shoulder these burdens, SOEs must gain a handle in recruiting the talent to be sufficiently competitive for expansion in these regions. Fortunately, even SASAC understands the need to continually improve its cadres’ management talent. I learned this after finishing my keynote and Q&A period, when I met with Zhang Hong, the Deputy Secretary General of SASAC in charge of training. Having served as a university administrator prior to his position at SASAC, Zhang Hong has kept the pleasant demeanor of one. Curious about his role within SASAC, I asked him what type of training he focused on most. Holding a kind but firm gaze, he said, “Any and all kinds of training that can help prepare cadres for the future. In an environment where innovation remains critical for creating sustainable businesses, the executives must change and improve for the better.”

I have been quite critical of SOEs for the past decade. Aside from their staggering inefficiency, they have hurt competitiveness within China. Nonetheless, I was heartened by Zhang Hong’s resolute and thorough approach. He and SASAC clearly recognized the need for continual training and SOE reform. Yet a combined effort between China’s SOEs and its central government has yet to be determined.

By the time President Xi took over the government in late 2012, he knew the state-owned sector was in dire need of modernization. But it remains to be seen whether Xi intends for SOEs to be truly competitive and take risks in the pursuit of profit. Some speculate he might instead want them to serve as a tool in advancing his political aims and to ensure a stable, moderately prosperous economy—not maximally efficient, but a fair provider of employment. So far, it looks like President Xi is following a mix of the two routes; he aims to make SOEs more competitive, but does not intend to follow a Wall Street, profit-at-all-costs mentality.

In approaching the sector, President Xi’s first step was to cut down on corruption, force mergers of SOEs and rotate executives among the competition. Former Chairman of China Unicom Chang Xiaobing, for example, was named Chairman of its main competitor, China Telecom in 2015. He was detained a few months later for corruption. One concern I have is whether these super-sized SOEs will become more innovative or even more bureaucratic and stifling.

As we saw in Chapter 1, President Xi has also tightened his control on more facets of China’s bureaucracy, primarily by installing loyal military men in positions of power. The state-owned sector has not been immune to such actions. Establishing such large SOEs with loyal cadres, Xi has ensured they will have the girth to benefit from OBOR. Perhaps even more importantly, these SOEs are poised to follow President Xi’s directives to invest in regions that are politically strategic to China but which pose little profit-making ability. As a result, while some SOEs may adapt to China’s increasingly innovation-driven economy, and thus focus on profits, a large portion of the sector will be channeled towards Beijing’s political motives—sacrificing revenue in favor of Chinese influence abroad. It will be critical for foreign firms to also profit substantially from OBOR or else the whole initiative will be seen as a tool for China to achieve power and profits, and thus face pushback from other nations’ citizens.

***

In light of these new developments under President Xi, foreign brands have a momentous opportunity to sell to SOEs as they vie to become global players. To capitalize on the trend, brands must first understand Xi’s concept of the Chinese Dream—a notion heavily promoted by the President, and now a critical component of China’s national discourse.16 Upon assuming office, Xi challenged the nation’s citizens both to reflect on what it means to be Chinese and to consider how they wanted to build a strong Chinese society.

Results spanned the gamut. Many Chinese began turning to religion, such as Christianity and Buddhism. Seeking greater meaning and purpose in life, these citizens had come to reject the craven push for money, now looking for spiritual wealth. Greed for profits had resulted in a seemingly endless stream of counterfeit medicines and poor quality foods flooding the market—harming vast numbers of the population. China’s buildings suffered too. Hoping to increase profit margins, many Chinese contractors and real estate developers began cutting corners in construction projects producing shoddy results, a trend later termed “tofu construction” by former Premier Zhu Rongji. Hurt by the effects of greed, many Chinese embraced the Chinese Dream as a calling to higher, more civilized ideals.

But in business and political terms, President Xi wanted the nation to promote indigenous innovation and Chinese brands. Hoping to discourage consumers from slavishly purchasing Western European and American brands, Xi instead wanted to instill pride in the “Made in China” label. And Chinese consumers were open to the shift—they loved that Chinese companies like Alibaba and Tencent were among the most innovative in the world. As first-rate domestic brands began to flood the market, many consumers were proud to discuss Chinese brands in a context other than complaints about shoddy quality, even if those fears indeed still existed.

Chinese attitudes towards brands—both domestic and international—are critical for foreign businesses to understand. Perhaps more than consumers from any other nation, the Chinese have a tremendous wealth of knowledge when it comes to the heritage of different brands. A typical 26-year-old young woman from Chengdu will be able to rattle off that Chanel is from France, Moncler from Italy, and Shiseido from Japan. Furthermore, she will have a keen understanding of the stereotypes by which brands from those countries are judged in China.

In fact, it is exceedingly difficult for brands to overcome country-level stereotypes or even distance themselves from the identity of their national origin. For example, Korean products are always seen as cheap and a good value. Similarly, food products from Eastern Europe or Southeast Asia are considered safe but cheap. These inalienable stereotypes provide excellent opportunities for food companies from Eastern European and Southeast Asia; nations like Poland, Bulgaria, or Thailand. They can easily position themselves as cheap but safe, finding their way to the third slot of Chinese grocery shelves, between cheaper domestic Chinese brands and expensive Western European, Australian, Scandinavian, Chinese, or American ones. Companies from negatively stereotyped nations, on the other hand, like Mexico, may struggle to find a spot on the shelf at all.

While consumer-held stereotypes are no doubt grounded in reason, many also take their root in the historical influence of Chinese government propaganda on the Chinese mentality to buy or shun certain brands. Given that China was cut off from much of the rest of the world during the Cultural Revolution—not to mention China’s isolation during and prior to the Qing Dynasty beforehand—contact with foreigners was largely restricted to port cities like Shanghai and Tianjin. As a result, much of the population experienced little to no interaction with foreigners until the 1980s. Opinions have thus largely been formed in the past four decades. Even when I first arrived in the mid 1990s to study Chinese at Nankai University in Tianjin, China, many Chinese peasants told me I was the first American they had ever spoken to.

While not politically correct, Chinese tend to look at the world through skin color. White is good and dark is bad. Part of this mentality stems from associations founded in China’s feudal times. Darker skin historically meant that its bearer was relegated to working the fields and getting sunburnt, while the wealthy protected their light skin under parasols and by staying indoors. Deeply ingrained, these cultural relics have led Chinese consumers to assign a higher value to brands from predominantly white nations, accompanied by a desire to get closer with their governments.

This is one reason why Chinese flock to members of Britain’s Commonwealth to buy real estate or send their children to school, as we shall see in Chapter 7 on Immigration and Real Estate. Three major recipients of Chinese investment in housing and education, Australia, New Zealand, and Canada, have also received an enthusiastic welcome by Chinese markets. Selling everything from Manuka honey, to kiwis, to dairy products, to beef, many of these countries have been able to export into China at a higher price and with the guaranteed trust of consumers.

But aside from the profits one can derive from selling directly to China’s consumers, foreign brands must learn to capitalize on President Xi’s more recent fight for indigenous brands. Currently, the drive for indigenous innovation and Chinese products is not well understood by many western observers—even those who have resided in China for many years. For example, China-based American businessman James McGregor, Chairman of communications agency APCO China, has erroneously criticized China’s moves as protectionist with the goal of stopping foreign brands from growing and making money. While his arguments may hold some truth, the reality is much more nuanced. President Xi’s vision of making great Chinese brands does not exclude collaboration with or opportunity for foreign businesses.

Quite the contrary, there are plenty of opportunities for western brands to profit and thrive in Xi’s promotion of indigenous products. Let’s take aircraft maker Comac (Commercial Aircraft Corporation of China, Ltd.) as an example of a SOE building a brand while sourcing their products from western brands. Comac’s new C919 airplane17 is intended to compete with the dominance of Boeing 737 and Airbus 320. Positioned as a Chinese brand, the Comac actually sources most of its foundational technology and mechanical parts from Western brands. In its development of the narrow-body twin-engine airliner, Comac offered tenders for the engine to Pratt & Whitney and CFM International—a joint venture between GE Aviation and Safran Aircraft Engines (a division of France’s Safran). Nexcelle was chosen to provide the engine’s nacelle,18 thrust reversers, and exhaust system. Belgium’s Solvay, an international chemical group, was critical in developing the coating technology for the Comac C919’s maiden flight.

In other words, although the Comac C919 is considered a Chinese brand, it has actively used foreign components. Although protectionism exists, it certainly does not mean that foreign brands cannot have success. Foreign brands that will do best in catering to China’s prolific construction of indigenous brands will be ones like CFM, which has stakeholders in both France and the United States. As SOEs use their wallets to gain political support in different regions, it is more likely that a U.S.-French joint venture will get a deal over a purely American one. It also means that smaller countries like Belgium or Sweden will benefit. In the pursuit of numbers, China seems to use its Wallet to gain political favor and currency across as many nations as it can reasonably move into its Warm or Hot Partner categories.

Ignorance of these motives has left many Western companies in the dark when attempting to sell to China’s state-owned conglomerates. Few understand that the considerations of SOEs do not merely concern the quality and price of a service or good. Operating well outside the boundaries of business, SOEs must also evaluate a whole host of political factors given their accountability to SASAC and President Xi’s political motives. A Chinese airline like Air China or China Eastern will most likely always buy a certain number of Boeing planes as well as a similar share of Airbus ones, seeking to placate businessmen in both America and Europe if they also start to buy Comac planes. Whichever region is most in favor will get more planes, but a sufficient profit will always be handed to the competitor. It is only politically expedient to do so. See GE, for example, a vocal supporter of Beijing’s OBOR. Given GE’s role as a political heavyweight in the U.S., China’s SOEs and central government will always dole out enough deals to the corporation. So, if Washington starts to criticize China for some reason, a well-treated GE can be relied on as China’s proxy.

In many ways, China and its SOEs will single out and identify companies as Hot, Warm, and Cold Partners, just as they do with countries. GE and Honeywell, for instance, will always benefit from their seat at the Hot Partner table, while Google and Twitter, because they and their founders have publicly criticized the government, will remain banished to China’s Cold Partner category under their current leadership. And when considering the Cold Partner category, companies that dwell in this position will be blocked altogether from even a penny of China’s Wallet. While Cold Partner countries might have a foot in the door, China’s government excludes Cold Partner companies from even the chance to thrive in China.

To succeed, foreign brands need to show that they will not only provide the right services and products to Chinese companies, but also that they will adhere to Chinese laws and regulations and for which the Chinese government is willing to allow foreign investment. For example, LinkedIn has succeeded in China as a social media company—while Facebook and Twitter remain blocked—precisely because it has shown a willingness to follow China’s laws. Other companies, such as GE and Honeywell, have so publicly supported OBOR that the government will use its Wallet to support them.

There is, however, too much protectionism in the country that does need to change. For example, there are far too many restrictions still in the auto and financial services sectors that force American companies to establish joint ventures with Chinese counterparts. There is a concern that the Chinese government uses these partnerships to force technology transfer so that the American companies essentially are partnering with companies that will become their competitors in five years. Yet, despite the protectionism, China can still be a major driver of growth for even the largest companies.

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Dialogue:
Victor Shih, political economist at University of California at San Diego and the founder of China Query, LLC

I first reached out to Victor Shih online several years ago after reading some of his analysis on China’s debt and political system. Shih has researched China’s banking system for nearly 20 years and was one of the first if not the first person to make public China’s local debt problem. Perhaps he brings such strong analysis on China because he has experience in both the academic and business worlds. Aside from being a professor at UCSD, he is also the founder of a consulting company that focuses on China’s debt dynamic and elite political economy. Shih also worked a stint in the Global Market Strategy Group of the Carlyle Group and assisted on macro trading in the group. Shih holds a Ph.D. in Government from Harvard University and a B.A. summa cum laude from The George Washington University.

Rein: Do countries have cause to worry about SOEs acquiring assets abroad, as they are tools of the CCP, or are fears generally overblown?

Shih: For non-high-tech, nonstrategic industries, I don’t think governments have to worry too much because Chinese companies have to obey the law of their host countries just as much as any other companies. For high-technology industries, especially those that have dual-use potential, countries do have to worry because China has an explicit plan to take over a number of high-technology industries and become the leading power in Asia. Recently, it has taken a very aggressive military posture in the Asia-Pacific region.

Rein: What role will SOEs play in initiatives like OBOR? What do SOEs need to do in order to be successful? Hire enough local employees? Ensure profits are spread to other companies? Actively seek to avoid and counteract environmental degradation?

Shih: SOEs will likely take a major role because they are willing to be “patient investors” who take losses on their investment. Of course, they also will receive preferential loan packages from China’s policy banks. If, by success, you mean that these companies will become acceptable to the host countries, then I think they indeed have to hire more local employees and to subcontract out more to local companies. That will build strong local constituencies in favor of Chinese investment which is the only viable long term strategy. If contracts all go to Chinese companies which bring their own workers, serious backlashes will be inevitable. If, by success, you mean generating returns that are higher than putting one’s money in a wealth management product in China, it will be much more challenging because Central Asia is plagued by a number of factors that deter growth such as geography, low human capital, and weak contract enforcement. Generating healthy returns without strong partnerships with local insiders will be very challenging.

Rein: Do you think there is a level enough of a playing field in China for private Chinese companies and multinationals to compete against SOEs? To what extent does protectionism get in the way of this competition? How should private Chinese companies go about leveling this playing field and competing successfully?

Shih: At the retail and light industrial level, the Chinese market is highly competitive as your work has shown. The more capital intensive a sector is, however, the more partnership with or at least acquiescence of the Chinese government is crucial for success. If the Chinese government favors an SOE or a privately owned national champion, foreign competitors would have to contend with billions in financial subsidies, protectionist policies, and preferential government procurement policies. This definitely creates an unfair playing field for foreign competitors, but some companies have overcome obstacles with partnerships with large Chinese companies and a ton of lobbying. Some domestic private companies resort to “partnerships” with relatives of high-level officials, but that has its own risks.

Rein: How would you recommend China reform its SOE sector? Should it continue to privatize companies? Or reduce the number of companies that report to SASAC directly?

Shih: We have seen many SOEs that are losing money in their traditional production take advantage of the cheap financing they have access to and branch out into other sectors, thus crowding out the private sector. This is rational behavior on the part of the banks because they view central SOEs especially as risk-free. The government has to begin to allow even larger State-owned companies to go bankrupt and for banks to take haircuts in the process so that the banks no longer privilege state-owned companies in making credit decisions. Of course, given the recent instructions to banks to stop all signs of financial instability, allowing a wave of SOE bankruptcy is unlikely.

Rein: The Chinese government is pushing for a greater focus on innovation within SOEs. To what extent do you think this goal is achievable? What are the challenges to innovation in the state sector? What should SOEs do to better compete in innovation?

Shih: As you know better than anyone else, there are some success cases. However, there is also incredible waste. The reason is that policies encouraging innovation also come with generous fiscal and financial subsidies, which every state-owned company would like. Thus, even SOEs without the technical skill to develop certain technology will try to do it in order to obtain central subsidies or financing. On the one hand, production in “new” sectors such as solar panels and industrial robotics can take off in a short time. On the other hand, cheap and substandard knockoffs often crowd out the genuine innovators. The government’s tendency to massively subsidize “strategic” sectors then becomes a problem for the world as cheap Chinese-made products in these sectors soon flood the global market.

Rein: Now and in recent years, SOEs are losing good talent to private Chinese companies like Alibaba and Tencent. What do you think are the reasons for this? To what extent does this trend have to do with political factors over profit-oriented incentives among SOE executives?

Shih: There was a time in the recent past that, including grey income from corrupt activities, an executive in a state-owned company could do very well for herself. Those days are over for most people and thus it is natural that talented individuals may think that their lifetime income would be much higher in a successful private company. However, for people who think that they probably will not succeed in the private sector, a steady paycheck from an SOE is still the preferred option.

Rein: Do you think the government’s crackdown on corruption is changing how SOEs do business? How so?

Shih: For rank and file SOE employees, the perks they receive have diminished substantially—such as gift cards and fruit baskets around New Year time. For high-level executives, they clearly have to be much more careful, but some corruption probably still exists. The moment that anti-corruption organs in China relax their grips, SOE executives, who still have enormous power within their firms, will become tempted to engage in corruption again.

Rein: To cut down on corruption and inefficiency, the government has been merging SOEs, such as in the upcoming merger of ChemChina and Sinochem. Do you think these mega mergers are economically expedient, or should the government focus on streamlining giants instead of making them bigger?

Shih: We have seen this play out before. Mergers do not make state-owned companies more efficient. Mergers just make it much more difficult to cut off financing to them and much easier for them to lobby for government subsidies and bailouts. As long as political objectives are more important, SOEs, no matter their scale, still will have no incentives to improve bottom lines in the medium term.

Case Study:
Don’t Underestimate the Ability of SOEs to Innovate and Move Up the Value Chain

One of the most common perceptions of China’s state-owned sector is that its SOEs are a lumbering bureaucracy, kept from market-oriented goals by senior executives whose exclusive focus consists of moving up the Party ranks. While these perceptions are true in several respects, it would be a mistake for foreign multinationals to underestimate the innovative ability of many SOEs. It would also be a mistake to pin SOEs as static forces, unable to evolve. As demonstrated by the response to my SASAC keynote, many executives earnestly want to increase their focus on quality control and build significantly more profitable, market-oriented businesses. SASAC, for their part, have also offered the requisite support and encouragement.

Take Comac, for example, the aerospace manufacturer poised to compete with Boeing and Airbus. Given that nearly all of China’s small cities have their own airports and rail links, Comac has evolved to meet this China-specific demand, catering to smaller cities with its scaled-down airplane models.

An even better example can be found in Bright Food, China’s second largest food and beverage manufacturing company. While it may appear surprising given China’s widespread food safety concerns, Chinese food companies are likely today’s most innovative firms precisely because of present fears. In a race to counteract consumer anxiety, Chinese companies have been compelled to go upmarket, developing higher quality and more numerous premium brands. Equipped with insight into Chinese consumer fears regarding the food sector—and particularly the dairy sector, Bright Food has led the wave, becoming one of China’s greatest success stories in the food business.

Take its yogurt line, for instance. Positioned as a high-end product, Bright Food yogurt is full of probiotics, marketing its healthful attributes. At the height of China’s melamine scandal in 2008, executives from Bright Food decided to visit Momchilovtsi, a small Bulgarian village of fewer than 1,500 inhabitants, famed for the longevity of its citizens. Taken with the village’s clean air and natural environs, Bright Food soon thereafter launched an entire brand of premium yogurt named after the village. Bringing back large quantities of the village’s Lactobacillus bulgaricus bacteria to put into its yogurt,ii Bright Food capitalized on the pure origins of its ingredients, attracting otherwise panicked buyers.

In order to further underscore the product’s use of imported, high quality ingredients, Bright Food used high-end packaging embossed with Cyrillic writing. The SOE even created folklore, using Momchilovtsi’s imagery on their yogurt packaging and in advertising campaigns. By 2015, sales had hit $250 million USD, driven by safety- and health-conscious Chinese consumers.

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