Promoting Innovation at the Expense of Indigenous Firms?

On April 9th, the Chinese Ministry of Science and Technology (MoST) website announced a new draft plan for accrediting “indigenous innovation products”, covering a range of high-tech sectors including computers, telecom equipment, automatic office equipment, software, new energy, and energy efficiency devices. These accredited products will enjoy priorities in Chinese government procurements. After being excluded in the initial accreditation plan issued in 2009, foreign companies had been complaining ever since. This time, however, there are two significant changes in favor of multinationals: the accredited products must possess “intellectual property rights” and a “registered trademark” in China rather than the previous accreditation criteria of “indigenous intellectual property” and “indigenous brand”.

The draft plan is complementary to the State Council 2010 Circular No. 9 issued on April 6th, which aimed at encouraging R&D investment of multinationals in China through series of favorable polices including cheap land, tax holidays, and financial liberalization. MoST’s latest accreditation plan is, however, a major setback for many Chinese indigenous companies in the growing government procurement market for high-tech products, estimated to be over one billion dollars per year. Since multinationals are more competent in the market of technology-sophisticated products, the 2009 accreditation plan intended to expand the market share of local firms by giving them privileged access to government procurement contracts. So far, it is not clear whether multinational corporations have directly influenced this year’s draft plan, or whether MoST is pursuing a deliberate strategy that de-emphasizes indigenous innovation for the sake of leveraging access by multinationals to the Chinese market in exchange for technology.

What is clear is that the Chinese state is inclined to abandon government procurement as a policy tool to promote indigenous innovation. That having been said, the Chinese government has spent billions buying underdeveloped products from local firms such as CPU, office software, etc, which still remain commercially uncompetitive and technologically backward. There were even worse scenarios in which large local PC vendors acted as middlemen between the Taiwanese OEMs and the Chinese government, with their huge profits from the procurement market only resulting in diminished productive capabilities. Nevertheless, procurement money can be of great importance for financing innovative firms; prime examples are Huawei and ZTE in the Chinese telecommunication industry. Procurement money provides possibilities for firms to endure the high fixed costs of technological catch-up until they can succeed in generating the high quality products at low unit costs that define innovative success. But such possibilities may be about to disappear.

This article has aslo been published on the ChinaAnalysis Monthly Newsletter Issue 22, May 2010.

Evaluating SOE Performance: Do Top Executives Deserve Their Bonuses?

This year, China’s largest state-owned enterprises (SOEs), including China Petro, China Mobile, Sinosteel, State Grid, and other industrial giants, are facing a new 3-year Performance Evaluation policy from the Chinese state. Effective Jan. 1, 2010, this new policy requires the SOEs governed by SASAC (State-owned Assets Supervision and Administration Commission of the State Council) to calculate their net profit by taking into account the opportunity cost of capital, both debt and equity. The initial cost of capital is set as 5.5%. In essence, the concept of EVA (economic value added) is being used to evaluate the performance of the SOE top executives.  SASAC now governs 128 central SOEs, with US$3 trillion in assets, US$3 trillion in sales, and 12 million employees, concentrated in sectors of national priority, such as energy, transportation, communication, and heavy machinery (the 30 national financial companies are not governed by SASAC).

The new evaluation policy represents an attempt to constrain executive compensation at SOEs.  With the transformation of SOEs into huge profit centers over the last decade, SOE executive compensation has grown rapidly. Government officials disclosed that in 2007 senior managers earned 18 times the average pay of workers in China’s SOEs.  Although this number is well below the US ratio (360 in 2007), the official survey may well underestimate the gap. In Beijing, the annual salary of a fresh graduate is 40 to 80 thousand RMB annually, and of a middle manager in SOEs 200 to 400 thousand RMB. There are many news reports of SOE top executives who are paid more 2 million RMB. In 2006 Jiafu Wei, CEO of COSCO (HKSE 0517), was reportedly paid 18 million RMB, making him the highest paid SOE executive in China. In 2007 China Ping An Insurance Co. (HKSE 2318), an ex-SOE and publicly traded company, paid Mingze Ma, the CEO, 66 million RMB, which is 1,000 times more than an entry-level position. Executive pay in SOEs is becoming a highly controversial issue in the Chinese society, particularly with regards to companies that enjoy a position of regulated monopoly.

The new policy may restrain the compensation of top executives, as it is estimated that half of the SOEs being affected currently produced a negative EVA. But if the experience of executive pay in the United States is a guide, Chinese executives will counter with financial behavior and accounting tricks that will produce positive EVA, and justify their pay increases, even if the sustainable growth of the companies they oversee is compromised. More generally, a focus on “bottom-line” measures such as EVA is a poor way to evaluate the performance of a company. Rather, the state should provide “patient capital” to encourage sustainable growth and investment in innovation, and evaluate company performance in terms of the actual development and utilization of productive resources.

Background: Currently, there are approximately 113000 state-owned or state-controlled enterprises in China. The 128 central SOEs governed by central SASAC are among the largest corporations in China, and many of them enjoyed monopoly position or shared market with a few SOEs, as these sectors are considered of strategic importance in the national economy. Data from Ministry of Finance shows that in 2009, the total profit of SOEs (excluding the financial sector) in China was RMB1.34 trillion (approximately US$0.2 trillion) in 2009, among which RMB0.7 trillion was generated by central SOEs. Not long ago in 1998, the total profit of SOEs national wide was only RMB21.3 billion, with 2/3 of all SOEs having deficit.

The newsletter issue 21, April 2010 is a compact version of this article.