China’s domestic market the target for European firms in the short and long run

For European firms producing relatively sophisticated, high-tech machinery, China’s domestic market is their main target for the long run.

During the rollercoaster ride of the past week, I was in Europe talking about China. The financial meltdown provided an interesting backdrop to our discussions. I went primarily to talk about long-run issues, especially energy use and environmental degradation. But the turmoil in financial markets naturally brought the conversation to the short run.

A group of Swedish bankers and industrialists with long experience in China was cautiously optimistic about prospects for China in the near term. No one buys into the idea of “de-linking”—that is, they all thought that China would be affected by the global slowdown. But the exposure of Chinese banks to the failing institutions in the West is minor. So, there will not be much direct impact of the financial crisis on China. There will, however, be an indirect effect. Clearly the U.S. economy is in for a period of no or slow growth, and Europe and Japan have slowed down as well. This will inevitably have spillover effects for China.

Most of the industrialists I talked to use their factories in China both to export and to produce for China’s domestic market. They already feel the slowdown in exports and expect that to get significantly worse. China is a big player in the global market, and as the world economy slows it will be impossible for China to keep up export growth at the same rate as in the past. At the same time, domestic sales in China are holding up well. For these European firms producing relatively sophisticated, high-tech machinery, China’s domestic market is their main target for the long run. Much of the discussion was about how well Chinese demand would hold up, as the world economy slows. No one can know for sure. So, far it is holding up well, and China’s overall growth was at a 10% rate for the first half of 2008, which is in line with our projection of China’s potential growth rate. Anything faster, for long, will generate inflation. As the world economy slows, China may well slow down further, but the government is in excellent fiscal shape to stimulate the economy if necessary. As one investor put it: “If China slows down below 8%, it will be because the rest of the world is really falling apart, so China will still be the place to be.”

Turning to the long-run issues, there was an appreciation among these investors that the environment will present good business opportunities in China. The approach to mitigating the country’s water crisis, air pollution, and excessive energy intensity will involve, to a great extent, the application of new technologies already in use in Europe. In the area of adopting new technologies, the industrialists had interestingly diverse experiences. In some sub-sectors investors can have wholly-owned subsidiaries while in others—presumably “strategic” —foreign investors have to have 50-50 joint ventures with Chinese firms, usually state enterprises. One big firm has 19 different subsidiaries in China, some wholly owned, some 50-50 joint ventures, depending on sector. No one had anything good to say about the joint venture format. It is bureaucratic and unwieldy, and the investors generally found their partners poorly committed to the success of the venture. Rather, their main focus was on their larger domestic enterprises.

The investors were frank about their strategies. They generally brought their best technologies to their wholly-owned outfits, and outdated technologies to the JVs. They have a particular interest, which should not be forgotten, but they all thought that the JV restrictions worked against China’s objectives. Their experience was that their best technologies diffused outside of their wholly-owned subsidiaries fairly quickly and were imitated by Chinese firms. In the “strategic” sectors, on the other hand, China was simply not getting the best technologies.

If technologies diffuse quickly, then how can the investors make money? “It’s a race,” one industrialist told me. “By the time the current generation of technology spreads to Chinese firms, we have to have invented something new. Otherwise, we have no future.” For the moment these investors are making money, and their experiences provide a shop-floor look at one of the powerful benefits of globalization. These Swedish firms bring advanced technologies to China, which tend to spread quickly throughout industry, fueling productivity growth and resource efficiency. At the same time, the Swedish firms are under tremendous pressure to keep inventing new technologies because their current proprietary technology will be common knowledge in a short time.

Some of the firms had moved as much as 20% of their worldwide R&D effort to China, and they insisted that this was not “window dressing” to please the government. They can hire excellent, motivated young engineers right out of Chinese universities, so that this is a smart R&D strategy. On the other had, the firms complained that there is a gap between the high end of the labor market—engineers, IT experts—and the low end—the very good semi-skilled manufacturing workers with nine years of education. That is, there is a missing middle: it is hard to find excellent technical workers for the more sophisticated production that is developing. They felt that China needs to invest in upgrading basic education so that there are sufficient workers to fill the growing demand for skilled workers.