Does China Need Billionaires to Spur Innovation?

It is often asserted that a high level of income inequality is necessary to induce innovation. One can point to the billionaires connected to successful companies like Intel, Microsoft, Cisco, Yahoo!, and Google whose fortunes have been made through their ownership of large shareholdings and the gains from exercising stock options. The existence of NASDAQ, as a highly liquid stock market for high-tech companies, has made these fortunes possible, but it is not clear that the creation of billionaires was necessary for the innovation process to occur. It must be remembered, moreover, that in the boom of the 1998-2000, many promoters of Internet companies made hundreds of millions of dollars by cashing in on the speculative stock market, even when the companies themselves turned out to be total failures.

China is now on the way to embracing this type of financialized business model, as the country seeks to transform into an innovation-based economy. Approximately six months ago, China launched ChiNext, the long-awaited NASDAQ-style board for high-tech start-ups. Due to the “extraordinary enthusiasm of investors” (Caijing, Nov 2, 2009), the first day of trading created 13 paper billionaires based on their declared stakes in the 28 IPO companies. The biggest winners of that day were Pu Zhongjie, CEO of Lepu, a pharmaceutical company, and Wang Zhongjun, Chairman of Huayi Brothers, a film company. Both Pu and Wang saw the value of their holdings exceed RMB3 billion. A total of 116 shareholders became instant tycoons with a combined value on paper of over RMB100 million. Yet such wealth still cannot compare to the gains of the husband-and-wife team of Li Li and Tan Li from the recent initial public offering of Hepalink Pharmaceutical. After the company sold 10 percent of its shares on the Shenzhen SME Board last month, the 80 percent pre-sale stake owned by Mr. and Mrs. Li was worth RMB42.6 billion (US$6.2 billion). Overnight, this low-profile couple became the richest people in China. Meanwhile Goldman Sachs’ original US$4.9 million investment in Hepalink in 2007 is now worth US$975 million (RMB6.7 billion).

While the new stock markets are creating enormous wealth for entrepreneurs and financiers, are they providing the financial foundations for the transformation of new ventures into innovative businesses? In the six-month experiment of ChiNext, 87 companies raised US$8.5 billion, according to the Wall Street Journal. Many of these companies have relatively long operating histories (in some cases as long as ten years) developing technology for niche markets. But, given their narrow niches, even the most outstanding companies seem to be overvalued in terms of their growth potential For example, Hepalink, which recorded the highest IPO price-earnings ratio – 73 – in the history of the Chinese stock market, relies almost exclusively on the export of heparin, a pharmaceutical ingredient for blood thinner extracted from pigs’ intestines, to three US pharmaceutical producers as the only Chinese exporter accredited by the US Food and Drug Administration. In the case of Hangwang, which raised RMB1.1 billion last month in its Shenzhen-based IPO, the company leads China’s e-reader market and has a growth potential as the technology provider to multinational companies of Chinese/Asian language handwriting recognition on touchscreen handsets. Even then, however, Hangwang’s key value generator, the e-reader, possesses little in the way of distinctive technology, and is gradually losing its price advantage to new low-cost competitors.

At the same time, for all the ultrarich people who have emerged from these IPOs, how many will continue to lead their companies to generate innovative products? Among these new tycoons, Li Li of Hepalink stands out as a technological innovator for perfecting the process of extracting heparin. Yet even in his case, it is difficult to see why his contributions to innovation warrant his ranking as the richest person in China. It is the highly speculative stock market rather than the value of his contributions to technological innovation that has accorded him this lofty position.

The danger now exists that the Chinese will adopt the ideology, widespread in the United States, that only the promise of enormous riches can spur smart people to provide their skills and efforts to the innovation process. In an advanced economy such as the United States, the creation of high-tech billionaires is the result of the emergence of successful companies in a highly financialized economy rather than a necessary inducement for entrepreneurs and managers to supply their skills and efforts to build these successful companies (see the research of the European Commission project on Finance, Innovation and Growth: ChiNext may be creating instant billionaires but will it support continued investment in innovation, which is an uncertain, collective, and cumulative process?

This article has aslo been published on the ChinaAnalysis Monthly Newsletter Issue 23, June 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.