Doing Business in China

Legal teams face more data and more scrutiny than ever. They need AI built for both. Relativity is the AI platform for legal work, delivering defensible AI that handles the tedious tasks so judgment stays where it belongs, with you. Learn more at relativity.com/ideacast. AI agents are suddenly everywhere you turn, but without identity, you can't really control what they do. Okta helps you assign every agent a trusted identity so you get the power of AI without the risk. Secure every agent. Secure any agent. Okta secures AI.

Hello and welcome to the HBR IdeaCast, a biweekly audio show from Harvard Business School Publishing. My name is Paul Michelman. I'm an executive editor here, and I'll be your host. [Speaker:GREGORY ROSS] In our first segment, we welcome Jim Eisner, Director of Media Relations of Harvard Business School, back to our studios. Jim sits down with HBS Professor Felix Oberholzer to glean some fresh insights into how both multinational and native companies are doing business today in China. In a climate that is anything but static, Oberholzer helps us understand what's really going on. And in our brief second segment, we'll take a look at how great managers manage people. So snapshot your cell phone, boot up your iPod, and give the next 20 minutes, give or take a few seconds, to us. First up, doing business in China today.

I'm here today with Harvard Business School Associate Professor Felix Oberholzer. Professor Oberholzer is an expert on corporate strategy, and he has spent the past few years examining how both native and multinational companies do business in China. With a growth rate of 10%, a huge and low-cost labor force, and an ever-increasing consumer class, China is a poster child of the term booming economy. Felix, thanks for being here.

Thank you for having me.

Felix, to begin, tell us something about the nature of China's business environment. What's the good news? What's the bad news?

Well, Jim, your introduction has pretty much summed up what's exciting and new and enticing about the Chinese economy today. They're really creating quite spectacular growth rates. The macroeconomic environment has been relatively stable and very successful for more than 10 years now. So double-digit growth rates, as we have basically not seen them anywhere else over this expanded period of time. So that's really quite impressive. There's good reason to believe that perhaps the real numbers are a little bit less than what appears in the official statistics. But this is still a very, very impressive business environment to create.

What's the bad news?

What's surprising about this business environment, that is, you would think this is a manager's dream, right? Where— and in fact, many of my students, when they think about where should I start working, what's the right country to be in, where are exciting opportunities, China is on the top of many many of those lists, turns out that profitability of companies in this spectacular environment is actually much less stellar than you would expect.

Let's say I'm an American multinational coming into China. What can I expect?

So let's maybe talk averages for the entire economy and then look at how this breaks down a little bit. My colleague, Tarun Khanna and I have just received a dataset. We think it's probably the largest dataset on company performance of Chinese and both multinational and Chinese companies that's out there that indicates that the average return on assets is somewhere around 5% for companies operating in China. And given the business environment, that seems surprisingly low. About 80% of the companies operating in China, we're talking roughly around 7 million 1,000 organizations or so, they have return on assets that are less than 10%. So a lot of companies earn less money than what we think must be their cost of capital. Now, because this is a big economy, keep in mind that still plenty of companies are, are doing just fine. So there are about 30,000 companies in our data set that have returns on assets in excess of 20%. So there's some stellar success stories, spectacular successes, but at the same time averages are just not what you'd expect to see. First culprit one would think is, oh, this is because of state-owned enterprises. As everybody knows, the Chinese economy is to a large extent still dominated by state-owned enterprises and by what we call collectives, which are basically state-owned enterprises that are owned by local and provincial governments. And there's some truth to this, So these state-owned enterprises, and particularly the large ones, they on average, they break about even. They're really not that profitable. But if you look at multinationals, they're actually doing worse than the collectives. So multinationals on average have returns on assets that are 3.5%, 4%. For collectives, this is closer to 7%, 8%. So it's not the case that the multinationals, even though you would think they have all these advantages, they have access they have access to talent, they have access to better technology. In this particular business environment, for one reason or another, these advantages don't translate into immediate increases in profitability.

And do we have any sense why? I mean, it would seem almost counterintuitive that a collective would be able to do better than a multinational.

Right. To see the research project that we're working on largely focuses on this question: why are these companies not as profitable as we would expect, and how can this be explained by the particular business environment that China affords? And what we find is that you shouldn't really think of China as one big market because politics is so important and because politics is highly decentralized in China. What we find is that there are really lots and lots of local business environments, so to speak, and many of these business environments are characterized by massive protectionism, massive protectionism of basically domestic companies that probably couldn't compete very well without the help of the government. And so what we find is that the surprisingly mediocre performance of foreign companies really suffers as soon as a multinational is located in a relatively protectionist province as soon as you are located in a city where government officials and bureaucrats think it's their business to run businesses.

Felix, there's a lot of conventional wisdom, it seems to me, about doing business in China. And, for example, that it's all about guanxi, relationships, or that it's important to get in first and have that first mover advantage, or at the coastal cities such as Shanghai where all the action is. What's your take on those?

Let's take the last fact that you mentioned. This is basically, again, the result of deliberate policy on the part of Chinese leaders. When they first opened up the economy, they set up little— think of these as experimental zones where they could to see what capitalism would be like, whether or not foreign investment would flow in once they liberalized their business environment. And so all of these zones, basically for historical reasons, tended to be close to the coast. So that has created the growth centers of Guangzhou and Shanghai and others along the coast. And in the early years, economic activity was very much concentrated in these areas. What we see in the data now is that this is, that this is no longer true. So some of the advantages that companies have had along the coast have now been available for quite a few years basically throughout the country. So used to be the case that you needed to balance foreign exchange requirements at the plant level, which of course is a complete nightmare for someone operating company in China. Now, many of these restrictions have gone away, and so the business environment in some sense is more even now than it used to be. The other development is a development that, of course, we're familiar with from all market economies. If you have hot growth in one area, that usually means the cost of production will increase in that area. So we see significant wage growth along the coast now. If you're looking for cheap labor, Shanghai and Guangdong and Shenzhen are not the places to look. And so growth gradually moves up. One of sort of the geographic patterns that we see in the data is that it moves up along the big rivers that can serve as transportation routes for the goods that the Chinese manufacture. And for a very long time, this was not so obvious. I remember talking at the alumni forum that Harvard Business School had in Shanghai, where I first described this trend about 2 years, I think, ago now. And people seemed to think, oh no, this is very implausible. Chongqing, far inland, it's not a place where you want to do business. I think it's fair to say now that these attitudes have changed quite dramatically. So we have Intel now building a plant in Chongqing and lots of other people who exploit the resources that China has, just not along the coast.

And finally, what about the whole concept of relationships, that you must know people, the right people to succeed?

They're seen from multinational companies I think this is perhaps less of an issue than it is for Chinese domestic companies. Chinese domestic companies' availability of capital is still a big issue because banks often don't lend to small enterprises unless you know someone who can recommend your business, and it's not up to the company to decide whether it wants to to be listed on the national stock markets. So access to capital is very much influenced by who knows whom and do you have the right connections. For foreign companies, we see that they significantly suffer from local protectionism. And again, if there is a way around local protectionism, it would usually involve knowing someone, getting to know someone who can help you out. So in that sense, it's ultimately the influence of politics in the Chinese business environment that makes these relationships so valuable. As the market economy develops and as price signals and cost advantages or price premiums become more important, I'd expect that these relationships will become less important also.

Finally, Felix, there are probably some budding entrepreneurs listening to this program. What advice might you— a couple of things you might say to someone who's thinking about going off to China to set up shop?

Don't forget anything you learned in business school when you make this decision. Very often when I talk to people who have invested in China in the past or are thinking about investing in China, it seems that they put China for one reason or another in a special category. China is a special opportunity. We should think about the Chinese market in different terms, using different metrics, using different ideas than we would say if we invested in Indonesia or Portugal or somewhere here in the United States. It isn't. It's not a special case. So take the size of the market. China is a poor country. Average incomes hover around $1,000 annually. So for very many companies, the Chinese market isn't actually big at all because there are not enough consumers with high enough willingness to pay to purchase their products. So whatever you remember from, from your business school days, apply that very logic to, to this decision. Switch the name. Say, if we think about an investment in Spain, the way we think about an investment in China. And then I think a lot of the mistakes that companies have made in the past, you're safe from, you're to some extent safe from these mistakes. The second dimension that I think is very important, and we talked about this a little bit earlier on, don't think of China as a single market. It's not, right? It's just the way Europe is sort of a single market, but not really. Right? There are some barriers between countries that don't exist in these markets, but there are lots of barriers that are tremendously important. So in the profitability dataset that we have, we just see tremendous variation across provinces. And, you know, the basic strategic rules apply to China just as they apply everywhere else. If everybody piles into Shanghai, with more or less undifferentiated products trying to roll up the Chinese market from the very same location. What do you think what's going to happen? Well, no one can make a whole lot of money, right? Being different is the source of profitability in China as it is elsewhere.

Well, these are fascinating insights. Your work on this is important and we'll continue to follow it. And thank you for being here.

Thank you for having me.

And in our final segment, how great managers manage people. The chain of events that leads to strong and sustained business results starts with great managers who defy common management practice at virtually every turn, according to consultant and author Curt Kaufman. What is the defining contribution of great managers? They boost the engagement levels of the people who work for them. According to Gallup organization research, only 28% of U.S. employees are engaged or are actively pursuing top performance on behalf of their organizations. And Gallup studies show that this has a direct impact on the bottom line. Engaged employees lead to engaged customers, who in turn drive a company's growth, long-term profitability, and stock price. So what distinguishes managers who not only retain valuable employees but, by boosting engagement, also extract their full value? According to Kaufman, co-author with Marcus Buckingham of First Break All the Rules: What the World's Greatest Managers Do Differently, the answer lies in rejecting conventional wisdom in four core areas of managing people: selection, expectation setting, motivation, and development. First Selection. Most managers select employees according to the skills needed for the role, but great managers select people for their talent. Kaufman defines talent as a recurrent pattern of thought, feeling, or behavior, and accounts for the different results produced by those with the same skills and training. Talent is abundant, Kaufman observes, yet people whose natural talents fit their role are a rare and valuable commodity. Consider what differentiates top-performing customer service representatives, Kaufman notes. All reps in a firm get the same training, but the best take one-third fewer calls than the average to resolve the same complaint.

Why?

Because they use the phone as a tool of intimacy. They can envision what the customer looks like, what room he is in. They smile and nod even though the customer cannot see what they're doing. Instinctively, their talent leads them to manage each customer relationship in the most effective manner. Great managers resist the temptation to hire people whose skills are a good match for how a job is already configured. Instead, they seek those whose talent will redefine how the job is done. Next, expectation setting. Conventional wisdom says managers should specify the steps that employees need to take to accomplish a specific task. But great managers define the outcomes they seek and let each person use her individual talent to achieve them. For example, while great managers do not usually mandate steps to be taken, They do provide specific direction when accuracy or safety is involved or when a company or industry standard is at stake. But even then, they don't let the steps obscure the focus on the outcome. Next, motivation. Conventional wisdom says that anybody can be anything they want to be, and thus managers tend to focus on finding and fixing a person's weaknesses. This leads to reviews and development plans that focus on negatives. Where the emphasis is on improving a person into someone he is not. In contrast, great managers emphasize the development of their subordinates' unique strengths so as to help further their talent while finding strategies to support their weaknesses. The key here is determining how to take greater advantage of what people already do well. And finally, development. Conventional managers rate the person and develop the performance. Great managers rate the performance and develop the person. They realize that every person is different and should be treated as such. Most companies view promotion as the natural path of progression, but is that always the right course? No, says Kaufman, because success in one role is not necessarily an indication of success in another. Consider how many outstanding account representatives fail miserably when they are promoted to sales managers. The ability to sell is entirely different from the ability to manage. What's more, promotion removes the high-performing salesperson from the position in which she has been producing substantial value for the company. Great managers seek the right fit for a person's talent. They work to see that he is rewarded for his performance, and they endeavor to ensure that his talent is developed through progressively more challenging and meaningful assignments. We hope you've enjoyed this edition of the HBR IdeaCast. If you have any comments or ideas you'd like to share about our program, please send them to my attention. That's Paul Michelman at this address: ideacast@hbsp.harvard.edu. And if you'd like to catch up on our previous IdeaCasts, please visit us at our new home on the net, www.hbrideacast.org. Thank you, and we hope you'll join us again soon for our next IdeaCast.