Innovative Enterprise and the Historical Transformation of China

In his Economic Manuscripts of 1861-63, Karl Marx wrote, “Gunpowder, the compass, and the printing press were the three great inventions which ushered in bourgeois society.” But Karl Marx might have not well realized that the origins of these great inventions can be traced back to Ancient China, which in his eyes is a stagnant peasant society. Indeed, despite generating numerous inventions of historical significance, Ancient China failed, as a society, to evolve into a dynamic socioeconomic system. To this day, scholars ponder the “Needham Puzzle”: the question of why capitalism ceased to advent amid the economic prosperity of ancient Chinese empires.

But the sentimental age of craftsmen’s ingenuity is gone forever. After centuries of decline and impoverishment, China has emerged (again) in last decade as a budding economic superpower. However, much of China’s current growth is built upon exploiting its large population base and consuming scare natural resources. The Chinese economy is steaming forward, but the risk of such growth model increases even faster. If the ongoing Dalian oil spill is just another warning of the huge environmental costs of China’s stunning GDP growth, the recent widespread labor unrest (see my last entry) is seriously questioning the sustainability of its inequitable growth. Once again, the country is facing an old problem: how to transform the economy so that it generates sustainable prosperity?

The only way out is innovation, as I had been advocating in this blog. Innovation, by definition, generates more and better goods and services with fewer costs of resources; by increasing productivity it creates more value, value that could be distributed among a larger population. Then the question is how to engage in innovation in the age of information?

As elsewhere, China relies business enterprises to house most of its innovative activities, either inside large industrial conglomerates or clusters of smaller, specialized firms. It is rarely the case today that a small company, not to mention an isolated individual, is capable of innovation. Modem innovation is a collective, cumulative and lengthy process. Its complexity requires the integration of a wide range of capabilities over a long period of time, with an uncertain chance of success. Even a slightly improvement on a single industrial product may requires teams of specialists from different areas to work together for months. An example is the recent “Antenna gate”, in which it takes approximately three months for Apple, one of the most innovative companies on this planet, to fix a small design flaw of its latest iPhone 4.

The analysis of the innovatin process requires, as Professor William Lazonick has shown, a theory of innovative enterprise. The transformation of China into an innovative economy depends on how its business enterprisess develop capabilities to overcome the uncertain, collective, and cumulative process of innovation. For example, it has been a “puzzle” of why some China’s companies become efficient and innovative players even in the most competitive sectors without being privatized, as advocated by many economists. The theory of innovative enterprises would argue that it is the control over the allocation of resources, and not necessarily the form of ownership, that determines successful industrial performance. Groups of professional managers with the incentives and abilities to allocate resources to innovation gained strategic control of these enterprises. They implemented incentives to ensure organizational integration so that people engaged in the enterprise’s hierarchal and functional division of labor would expend their efforts and apply their skills to the collective processes of transforming technology and accessing markets. They also ensured that the enterprise would have the financial commitment required to sustain the cumulative innovation process until it could generate financial returns. As Qiwen Lu showed in his pioneering book, China’s Leap into the Information Age (Oxford University Press 2000), strategic control, organizational integration, and financial commitment underpinned the innovative success of minying (people-run) companies such as Legend (Lenovo). On the other hand, the story of Foxcom’s suicidal workers tells that the building of innovative organization of production is far from complete. In addition, to encourage more companies invest in innovation, China also need its financial sector to actively aid companies to endure the high fixed costs of lengthy innovation, which till today lacks the financial commitments to most of the country’s private sector.

Ancient Chinese demonstrated how a nation could lose its wealth and status when it failed to transform the ingenuity of invention into the collective and cumulative process of innovation. It will not be difficult to predict that, the success or failure of the modern China’s innovative transformation will have a similar impact to the world and history.

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.