Challenges for China and the United States

China as an Emerging Superpower: Challenges for China and the United States

Edited by Jeffrey E. Michelman Chung Ping (Albert) Loh

FORWARD

The attached volume of scholarly papers serves as a tangible outcome of the second biennial joint UNF-BISU conference, held October 2006 at UNF. Equally as important in my mind, however, are the intangible outcomes resulting from the assemblage of business-educators and scholars from these two 21st century “superpower” nations. The knowledge represented by these papers and the relationships which developed during this conference provide hope that this century can be marked by a never-before possible level of cooperation between the U.S. and the People’s Republic of China. As an attendee, I came away with a genuine feeling that this was not just another academic conference. I believe it was and will continue to be a reoccurring event revealing how to best conduct relationships--not just between the universities of the two participating countries--but between world governments. The power of dialog and collaboration which took place probably is the most important instrument we have to assure that new knowledge is shared, global understanding is achieved, and stereotypical perceptions regarding people from other parts of our world can be eliminated. This conference and the many other international efforts UNF and our faculty/staff have embarked on for several decades, move us to a stage of University internationalization that ensure our taking lead roles in global business, accounting and economics. Coggin College of Business students who assumed leadership roles at the conference as coordinators, presenters and attendees are a perfect example of the transformative nature of such experiences. Their experience and enhanced academic repertoire/portfolio vividly reflect the rich global context that will forever inform their lives. I would like to express gratitude to all those involved in putting this meaningful event together, particularly to UNF’s Co-Chairs Dr. Jeffrey E. Michelman and Dr. Chung- Ping Loh. Additional gratitude also is due to BISU Business Dean Xiaomu Li for his foresight in proposing this series of forums. We also extend our thanks to former UNF Business Dean Dr. Earle Traynham and his faculty including Dr. Jeff Steagall, who developed the foundation for the relationship between our two institutions more than 12 years ago. We will continue these conversations, and hopefully this alliance-building on a biennial basis, hosted next in China by BISU in October 2008.

Mauricio Gonzalez Vice President for Student and International Affairs University of North Florida Jacksonville, Florida, USA

November 2007

iii iv PREFACE

As editor of this volume I have had the unique opportunity to read every paper in its entirety. At times I felt overwhelmed because of the breadth of material that the authors have covered. Yet in the end it is I who hold the most privileged position of all, the one who gets to integrate the ideas into a single volume. Although the papers were originally presented by alternating Chinese and American authors, in this volume I have chosen to present the papers of the Chinese scholars first as they represent what China is today and the great pride that they each take in their country. In contrast, my U.S.-based colleagues, each from their individual perspective, have tried to build on China’s potential, with the unique opportunities and challenges of their respective disciplines, for China’s future. It is this unique juxtaposition of present and future, hope and caution that made for such an interesting conference. We hope that the integration of these ideas will continue to build on the friendship and cooperation that has been developed between Beijing International Studies University, the University of North Florida; the people of Jacksonville and Beijing; and most importantly the blending of American and Chinese cultures and ideas which are happily often distinct from the politics that often separate our two nations. Liang Zhao and Gao Jing establish an important foundation for the papers that follow as they describe the importance of developing frameworks that incorporate the past throughout Chinese society and culture before the west destroys this rich history. Bai Yuan provides an important examination of the growing importance of higher education to China and how the developed world is increasingly providing education for a growing Chinese professoriate. Yuhong Wang presents an interesting analysis of how China’s growth is occurring in the service sector and the impact of both regional differences across the country and the impact of FDI on the service sector. Xiaoning Ni examines the role of China’s burgeoning economy on the both the Pacific Rim and the global economy as well as the importance of the RMB as a growing global currency. Zhao Yuhua provides a critical examination of some of the governance challenges presented by China’s capital markets as growth in this area continues at an ever increasing pace. Xue Tong provides an important discussion of changes in the banking sector as the Chinese government continues to liberalize this industry. Chunming Ye follows Tong’s study by examining the impact of a changing financial services sector on innovation, efficiency and risk in this sector. Xiaomu Li ties the previous papers together by examining how China’s travel services sector has changed and how these changes will set the stage for the 2008 Olympics. Harry Rothschild presents a fun transition with his paper that presents an American’s view of how Chinese history and culture are often adjacent to or in conflict with contemporary Chinese society. This paper is followed by Tom Leonard’s critical examination of Chinese Military policy and its relationship to the U.S. perspective on China. Mina Baliamoune-Lutz and Jing Yi Ju provide an important discussion of the impact of FDI on China’s burgeoning export market and the resulting income level within the country. Chung-Ping Loh, John Akin, Will Dow and Peter Lance present a timely analysis of the challenges facing China’s healthcare sector as the transition from a country served solely by Traditional Chinese Medicine to one that finds a challenging co-existence with both the perspective and costs of Western Medicine. Robert Frankel and Yemisi Bolumole examine the major challenges for China’s logistics infrastructure as well as how technology can be used to look at solving these problems in the future. Adel El-Ansary and David R. Whitsett present an important analysis that although there are 1.3 billion potential customers in China, making them customers and keeping them as customers will require unique marketing strategies that understand the Chinese culture and environment. John MacArthur and Ziming Rao examine the impact of Chinese culture on the development of management accounting systems that must be developed to bridge the gap between a planned economy and the development of private enterprises that are forced to react to

v market demand. Finally, Christie Shea and I examine the challenges presented from guanxi and U.S. businesses trying to take advantage of opportunities in China. The conference would not have occurred without the support of Deans Xiaomu Li and John McAllister. We all appreciate both their leadership and support. Financial support from the Jacksonville Chinese community (the Jacksonville Chinese Association in particular), our good friend Tai Mak who continues to support our China initiatives, the Division of Student and International Affairs and the UNF Flagship Program in International Business were all critical to making the program possible. Vice President Mauricio Gonzalez’s support of our initiatives in China continues to be appreciated. Moreover we are quite pleased that 5 Coggin College of Business students were involved in the conference as co-authors and presenters. An event like this does not take place without an outstanding organizing committee comprised of Robb Frankel, Andres Gallo, Tom Leonard, Mu Lin, Chung Ping (Albert) Loh, Harry Rothschild, Jeff Steagall, Earle Traynham, Bobby Waldrup, Yi (Derek) Ye, Debbie Wang and Mei Zhao. Mu Lin, in particular, provided extraordinary support as photographer during the conference. Sam Kimball, the Chair of UNF’s English department provided critical help and insight into editing this volume and Leanna Payne for help with the manuscript. Chung Ping (Albert) Loh provided invaluable support as both the conference co-chair and an editor of this volume. Most significantly, we all need to thank Jeff Steagall whose insight into the importance of International Business to UNF has been the cornerstone of everything that we have accomplished, including this conference.

Jeffrey E. Michelman University of North Florida Jacksonville, Florida, USA

November 2007

vi CONTENTS

Preserving the Historical Character of China: The Creative-Culture Industry and the Hosting of the 2008 Olympic Games in Beijing Liang Zhao and Gao Jing, Beijing International Studies University……………………..…1

The Trade Pattern of the International Education Service And its Theoretical Interpretation Bai Yuan, Beijing International Studies University…………………………….…………13

Investment Development of China’s Service Industry Under the Condition of Opening a Dual Economy Yuhong Wang, Beijing International Studies University…………………………….……23

Status Quo of Chinese Economic Influencial Power: Observations on Statistic Data Xiaoning Ni, Beijing International Studies University……………………………….……37

Analysis of Shortcomings of Chinese Corporate Governance within a Parent- Subsidiary Framework—Examples from 196 Listed companies Controlled by SASAC Zhao Yuhua, Beijing International Studies University………………………………….…43

Measurement of Banking Service Trade Liberalization in China Xue Tong, Beijing International Studies University………………………………….……51

The Opening of China’s Financial Services Market—Risks and Controls Chunming Ye, Beijing International Studies University…………………………………..59

China’s Travel Services Trade: Analysis of BOP (1985-2004) Xiaomu Li, Beijing International Studies University…………………………………..…..71

Connecting Past and Present: A Tang Dynasty Renaissance in the 21st Century Norman Rothschild, University of North Florida…………………………………………..79

Views from Beijing and Washington: China’s Foreign Policy and Military Strategies Thomas M. Leonard, University of North Florida……………………………………..…..85

Examining the linkages between exports, FDI, and income in China Mina Baliamoune-Lutz & Jing Yi Ju, University of North Florida………………………..99

The Demand for Health Care in China Chung-Ping Loh, University of North Florida; John Akin, UNC-Chapel Hill; Will Dow, UC-Berkeley; Peter Lance, Measure Projects………………………….……..109

Logistics in China: The Industry in 2006 and the Near Future Robert Frankel & Yemisi Bolumole, University of North Florida……………………….129

Macro Antecedents, Micro Outcomes: A Frame of Reference for Understanding Marketing To, In, and Out of China Adel El-Ansary and David R. Whitsett………………………………………….………..137

Cultural Influences on Management Accounting in the People’s Republic of China John B. MacArthur & Ziming Rao, University of North Florida…………………..……..163

The Foreign Corrupt Practices Act, Sarbanes-Oxley, and the Implications for American Business Success in China Christie Shea and Jeffrey E. Michelman, University of North Florida…………………...181

vii viii PRESERVING THE HISTORICAL CHARACTER OF CHINA: THE CREATIVE-CULTURE INDUSTRY AND THE HOSTING OF THE 2008 OLYMPIC GAMES IN BEIJING

Liang Zhao Gao Jing College of International Economics and Trade Beijing International Studies University

Abstract

Hosting the 2008 Olympic Games, Beijing is a famous historical city. As local university professors, we are indebted to the world for a chance to have in-depth research on the unique character of Beijing – its history and its modernity. The concept of the creative-culture industry is new in China, where the central government has emphasized its importance. The concept is central to the project of renovating historical buildings and preserving the relics of China’s past as a means of showcasing China’s cultural heritage on the occasion of the 2008 Olympic Games. When the games open in Beijing, international visitors will see a special, unique, and charming international city, one that retains its history in combination with its modernity and that projects an image of One World, One Dream.

1. Origin and History of China’s Culture Industry:

In recent years, especially since 2003, the new concept of the “Culture Industry” has been introduced into China. How has this concept come into being? What is its meaning? What similar concepts antedate its emergence? What does this concept, along with its antecedents, try to explain?

1.1 The emergence of the “culture industry”

Culture Industry was initially proposed by the British and has come to signify intellectual innovation, literary and artistic creation and dissemination, and economic development in a global consumer society. The concept of the “Culture Industry” was brought forward in 1997, when Tony Blair was elected British Prime Minister. At that time Great Britain set up a task force to investigate how the nation could further adapt to and maintain steady economic growth in a post-industrial age of an information- and knowledge-based economy. In 1998 and 2001 the task force published two research papers in which it defined the culture industry as “those industries which have their origin in individual creativity, skill, and talent and which have a potential for wealth and job creation through the generation and exploitation of intellectual property.” The culture industry includes advertising, architecture, art and antiques, crafts, design, fashion, film, drama, interactive entertainment software, music, the performing arts, publishing, photography, television, radio, and tourism.

1.2 The history of related concepts

The concept of the culture industry is still broader than this listing indicates, for it now covers the major activities of up to 95% of the population in industrialized countries. In this regard, after World War II, one American group noticed that only about two percent of the population in industrialized countries produce farm products and only about two percent produce industrial products. Together, five percent of the work force is able to meet the basic material living requirements of the entire population. What, then, does the other 95% produce? The change in Japan’s economy from the 1960s to the 1970s underscores the way modern nations have experienced a radical change in the nature of their economies. In the 1960s, the per capita GDP in Japan reached $1,000, an amount that enabled the Japanese to satisfy their basic consumption demands. In the 1970s, per capita GDP in Japan reached $10,000, an amount far, far in excess of what was needed to meet basic needs. In the post-industrial era, when an economy reaches a certain level of development, nearly everything that the society actually produces and consumes is in some form or another culture. Culture becomes a driving force of the economy which drives culture in turn. Not surprisingly, in the 1990s the OECD redefined the culture industry as a facet of the “Knowledge Economy.” Because economy is now so thoroughly a matter of cultural values, such values should be added as a central component of the culture industries. One aspect of the knowledge economy includes what in America has been the “copyright” or “key copyright industry” and the “distribution industry.” In the 1980s, experts in the field of intellectual property rights brought the American concepts to China, where these ideas have evolved into the “Copyright Culture Industry” and “Culture Industry.” In 1992, a set of guidelines (“Grand strategy for speeding up the development of tertiary industry”) used the phrase “Culture Industry” for the first time. In October, 2000, the phrase appeared in another key government document (“Advice on the tenth five-year plan for national economic and social development”). In November, 2002 the Sixteenth National Congress explicitly announced a policy of and guidelines for developing China’s culture industry.

1.3 The nature and scope of the culture industry

According to British experts, the culture industry covers thirteen areas of economic activity (see Table 1): (1) The performing arts, including modern and traditional Chinese drama, music, dancing. (2) Public entertainment, including night clubs, dancing halls, Karachi halls, digital games centers, and billiard rooms. (3) Audio and visual services, including film, video and audio tapes, laser audio, digital video, DVDs, MP3, MD, and multifunctional cell phones. (4) Mass communication, including newspaper, radio, and television. (5) Print publishing. (6) Film, including feature films, biographical films, and documentaries. (7) Tourism as both leisure and educational activity. (8) IT, including ISP and ICP. (9) Electronic entertainment, including online games, game software development and distribution, electronic game equipment design and production. (10) Athletics, broadcasting of sports events, sports and exercise equipment, and sports lottery sales. (11) Culture training industry, in contrast to compulsory education, committed to personal growth. (12) Art galleries, art collection, art auctions. (13) Industry product exhibitions, open to the public, and open source conferences focusing on hi-tech products, art and other cultural goods, and information exchange (art exhibitions, book fairs, film festivals, photography shows, educational exhibits, tours, automobile and aviation shows, brand commodity fairs, and flower shows.

Table 1: Component Areas of the Culture Industry

Trade Products and Services Advertising Consumer research (consumer preferences, buying habits and patterns), promotion and public relations in different media Architecture Design, planning, review and approval, information design Arts and antiques commodities, including painting, sculpture, paper crafts, antique guns, books, maps, calligraphy, specialty textile goods, Arts and mass-produced goods in general and furniture, pottery, glassware, and Antiques toys in particular, gallery sales, professional meetings, shopping malls, online sales Arts and Creation, production, and exhibition of textiles, pottery, ceramic and Crafts metal jewelry, glassware Brand identification, corporate image and information design, logos,

packaging, design of industrial accessories, interior design, and Design environmental design Fashion Design and manufacture of clothing Movies Creation, manufacture, distribution, and exhibition of films Interactive Leisure Game development Software Audio products and copyrights, lyrics, live performances (of other Music than classical music), management, production and reproduction, and promotion of music Creation, production, and performance of original works, including Performing Arts ballet, contemporary dancing, drama, musicals, opera Publishing Popular literature, children’s books, educational books, periodicals, newspapers, magazines, digital woks System software, compact, solutions, system integration, system Software Design design and analysis, software structure design, projects management, foundation design Television and Program designing and matching (data base, sales, channels), radio Radio broadcasting ( program list and media sales), Cable TV Broadcasting

Together, these components of the “culturalization of economy” and the “economization of culture” confirm that knowledge is now the preeminent economic “product.” Its core is “intellectual creation” as it is supported by mass communication. In terms of professions, the culture industry is a tertiary industry; in terms of value, it is an aspect of the “soft power” of a country or region. The culture industry responds to the market to satisfy the demands of both the individual and the business consumer. Experiences from other countries reveal that the thriving nature of the culture industry is an inevitable result of the globalization of trade and of the dissemination of information and knowledge. The production of culture can be profitably mass produced, marketed, and made available to a wide general audience.

3 This kind of industry generally concentrates in places where industrialization and natural resources have reached their limits.1 In those regions and countries where the economization of culture is well under way, there is always a complete market chain from product design to manufacturing to marketing to consumption. Moreover, there is always a mature intermediary service industry and expanded intermediary service organizations. For this reason underdeveloped countries may be rich in their cultural traditions but they never have a culture industry as such.

2. The Necessity of Promoting the Culture Industry

Joseph Nye, a noted scholar in the field of the international culture industry has explained that in the information age, the status of traditional assets, capital, natural resources and even real estate, has been shaken. In particular, the investment-driven economy has come to its end, and we must turn to an innovation- and knowledge-driven economy. Joseph Pen and James Gil, two founders of “experiencing economics,” hit the nail on the head when they suggest that the world economy is experiencing a transformation from a product economy to a service economy to an emerging but as yet poorly understood experiencing economy. In this regard, John Howkins, in Creative Economy, points out that those who have ideas are more powerful than either those who use machines or even those who own machines. Howkins says that, world-wide, the creative economy is valued at about $22 billion per day and that it is growing at a rate of five per cent. In some countries the growth rate is even more amazing: 14% in America and 12% percent in Britain. As Richard Florida elaborated in his Rising Up of the Creative Class, the new economy includes the appearance of a new professional class. In addition to three traditional occupation classes – an agriculture class, an industry class, and a service class – there is now a creative class composed of a core group of super-creative individuals in science, engineering, construction and design, education, art, music, and entertainment. Their main task is to create new concepts, new technologies, new solutions – in short, new ways of thinking about the world and its economic opportunities. In addition to this core group, there are highly creative professionals in business, finance, law, health care, and related fields. In response to its review of practices in other counties, in 1988 the British identified the culture industry as a key industry in London and, in fact, as a primary engine of the world economy (see “Creative Economy Scheme: New England’s Creative Economy Investment Blue Book,” 2001). In 1998, Singapore committed itself to developing its culture industry with the government developed a plan, “Creative Singapore,” to become an Asia renaissance metropolis, a world culture and design center, and a world multimedia center. In 2002, a Hong Kong a research paper addressed the current state of the culture industry. At the same time the governments of Australia and New Zealand also developed plans to further their culture industries. From 1997 to 2001, the growth rate of the British economy as a whole was 70% while the growth rate of the culture industry was 93%, a figure that represented an annual growth rate of 8%, more than threefold the growth rate, 2.6%, of the entire British economy. The culture-industry is the fastest developing industry in Britain, and it highlights the transformation of the British economy from a manufacturer to a creative server. Statistics published in the “Special Report on the Creative Industry,” published by the British Department of Culture, Media, and Sports, fills in the details of this general picture. In 2000, for example, the added value of the creative industry in Britain exceeded 50 billion

1 Moreover, it tends to develop in ways that are unique to the specific characteristics of these places.

4 pounds, or 7.9% of GDP. The industry provides over one million and accounts for 4.1% of all employment. A year later, 2001, the added value the of creative industry was, at 122.5 billion pounds, accounting for 5% of GDP and 8.2% of GVA, the highest added value of any other industry. In 2002, the added value of creative industry has reached nearly 181 billion pounds, second only the financial services industry, with 122,000 commercially registered businesses employing 1.9 million people. Since then it has increased still further.2 In 2003, a task force pointed out that judged by employment and output, the culture industry had overtaken the financial services industry in importance.3 As of 2002, supported by a special governmental preference policy, the value of exports of the British culture industry reached $17 billion, lowering considerably Britain’s balance of trade deficit. At present, then, the expansion of the culture industry gives it a value and force that is to some extent on a par with political, military, diplomatic, and other economic institutions. Although it is a “soft power” by virtue of its content, the culture industry has intensified the stream of information, the rate of consumption, and the flows of capital and human resources. For this reason it is urgent that China, and especially Beijing, expand the nation’s culture industry. To this end Wang Qishan, the mayor of Beijing, suggested that we need to establish local government regulations and preferential policies, break trade monopolization, and strengthen the funding for the culture industry.

3. The Current Strengths of the Culture Industry in Beijing

In recent years, Beijing has attached great importance to extending its culture industry. In 2003, the culture industry contributed an added value of 24.6 billion RMB, accounting for 6.7% of the municipal GDP, becoming one of the mainstays of the economy. In 2004 the culture industry contributed an added value of nearly 32.9 billion RMB, a one- year increase of 8.2 billion RMB. Clearly, the culture industry is expanding at an astonishing rate. It is doing so for three major reasons.

3.1 Resource superiority

First, China’s resource endowment is a dominant factor determining its competitive advantages. Beijing is extremely rich in cultural resources that have potential still to be tapped. On the one hand, Beijing has an incomparably rich cultural history going back 3000 years, the evidence of which is available in the more than 3,500 historical relics that have been discovered. There is also the evidence that is available in the present architecture, some of which is 300-400 years old and bearing inscribed legends over doorways, gates, and other entrances. Indeed, Beijing is increasingly concerned to preserve this priceless heritage. On the other hand, because Beijing is a metropolitan gathering place for people of talent, it is a hub of creative activity.

3.2 Market dominance

In addition, because it is China’s capital, Beijing is the political center of the nation, a fact that reinforces its cultural preeminence. With a population of 15 million residents an additional 3.5 million “floating” residents, and 3.6 million tourists from home and abroad, Beijing is an enormous market offering the city unparalleled opportunities to showcase its culture industry both to the rest of China and to the world. Moreover, the sheer

2 A symbol of the increasing importance of the culture industry is the size of the software industry, which in 2002 replaced fashion as the largest component of the culture industry. 3 Art and culture expenditures of tourists to London from home and abroad exceeded 6 billion pounds one year ago.

5 numbers of people living in and passing through Beijing enable the culture industry to diversify; in particular, these numbers enable relatively small cultural niches to reach and satisfy the demands of very large numbers of people. When the city’s per capita GDP reached approximately, $1,000, the civilian culture consumption dramatically rose. At that point consumption of culture industry products accounted for up to 18% of per capita expenditures. At present, per capita GDP in Beijing is more than $5,000. The result is a rising tide of culture demands and consumption. Clearly, Beijing’s culture industry has a very bright future.

3.3 Infrastructural advantages

China’s culture industry is supported at the top by all its leaders and at the bottom by all those who are involved in the daily work of this industry. Beijing’s economic development strategy for the industry emphasizes the knowledge economy as the future direction for the country. Strengthening the culture industry is not only a matter of economic strategy but of national pride. China’s culture industry is thriving in part because China is rich in educational resources. The culture industry depends on artistic creativity as well as on innovation in science and technology. For this reason the industry requires talented people who have interdisciplinary training, ability, and interest. Not surprisingly, Beijing is the nation’s largest training base for professionals seeking advanced knowledge, both specialized and cross-disciplinary. Beijing is also one of the nation’s higher education centers. It has 77 colleges, universities, advanced vocational education institutions, and foreign student educational institutions. These educational organizations have turned out countless numbers of highly trained professionals. Moreover, the institutions themselves are a storehouse of high-level human resources, contributing to the development of culture industry. Finally, Beijing has an enormous cadre of professionals in science and technology, and their innovations are affecting the culture industry at a speed unprecedented in history. The commercial application of advances in science and technology has one of the engines driving the emergence and expansion of the culture industry.

4. The Current Weaknesses in the Culture Industry in Beijing

As is to be expected, the culture industry has encountered some contradictions and other difficulties in the process of its development.

4.1 Confusing the cultural industry with the cultural cause

The related concepts of the “culture industry” and “cultural cause” differ in their economic character. The concept of the culture industry refers to the marketization of culture in which profit-seeking entrepreneurs respond to consumer demand for cultural goods and services. The concept of cultural cause, however, refers to public culture – that is, to those cultural developments that promote the common good and that should not be left to the market. In reality, however, the promotion of China’s culture cause is inseparable from the market-based activities and processes of the culture industry. To the extent that China’s policies have aimed at promoting the cultural cause regardless of market demand, the development of the culture industry has been impeded.

4.2 Divergences between culture, economy, education and science technology

World economic development shows that scale advantages rather than comparative advantages are essential to the developing process of the culture industry.

6 Separate, isolated, monotonous kind of development will exhaust a country’s comparative advantages and make resource endowment a burden. Therefore, China should avoid relying on its comparative advantages. In this regard Beijing must integrate its cultural resources (especially its educational, scientific, and technological resources) in order to achieve the scale advantages that will enable China to become a world culture industry center.

5. The Importance of Protecting Historical Sites and Cultural Relics

The protection of historical sites and cultural relics, which is vital both to China’s cultural cause its culture industry, should be:

• Promoted by way of a tenth five-year plan. • Integrated with the process of industrialization. • Supported by appropriate government policies.

The protection of historical sites and cultural relics has been underway for many years. With the founding of New China in 1949, Liang Sicheng called for the protection of Beijing’s historical identity. He wrote: “If you pull down the gates to the outer city, that would be like cutting off my flesh; and if you take away the bricks, that would be like peeling off my skin. You must be terribly regretful in fifty years.” Sicheng’s caution elicited a strong sympathetic response. Many people sighed with emotion and devoted themselves to heeding his warning. As Chinese, we cannot help shedding tears whenever we think of the vision he and the intellectuals of his generation aspired to actualize. We feel ashamed of those of our generation who worship money and who lack a sense of responsibility to their society and the cultural causes of the nation as a whole. As it undergoes a process of relentless change that is evident with every passing day, Beijing is increasingly at risk of losing the traces of its astonishing history. Beijing needs strong voices to direct the people away from short-term economic benefits and toward cultivating a long-term sense of social responsibility. Having experienced too much social turbulence and poverty, the people are naturally concerned with achieving a higher standard of living. But this concern risks being at the cost of losing many of China’s cultural relics and spaces, such as its traditional courtyards, and the cultural memory associated with these spaces. As Deng Xiaoping once said, it will take 50 years of painstaking effort before China catches up with moderately developed countries. He is referring not only to a material living standard but also to a spiritual living standard. China must promote its collective spiritual life by protecting and cherishing its historical sites and cultural relics. To this end we have begun to rethink our attitude toward our history. In the past, those of us who have studied abroad in America have laughed at how Americans are so tendentious in glorifying their short national history, that is scarcely more than 200 years old. But now we are beginning to comprehend the way Americans cherish and adore their brief history and to see in their example all the more reason for feeling proud about our millennia-old civilization. Here, those of us who study abroad have an opportunity to take advantage of both the technical knowledge developed countries have and the sense of their collective spirit. In comparing our culture, with its roots going back not hundreds but thousands of years, we have a more acute sense of the value of Beijing’s unique history. This realization enables us to devote ourselves to protecting our heritage and thus to live up to the wisdom of people like Liang Sicheng and the intellectuals of his generation. What gives Beijing its unique architectural appearances is not its modern but its historical buildings –for example, its majestic city wall, its lofty gated tower, the flamboyant tiles surrounding the Forbidden City, the railings and stone bridges guarding the city river, the sylph-like turrets on the Palace Museum, the lovely porches and booths in the

7 gardens, and countless temples and houses built according to ancient aesthetic principles. What is the most important is that, from the grandest to the most common buildings, the built environment is coherent, coordinated with itself, integrated, and thus beautiful in a way that is unique to this city. Beijing exemplifies how a city’s architecture can integrate a traditional style with a people’s wisdom and spirit in the overarching design of an entire city. For this reason we now treasure our historical sites and are focused on taking care of each temple, each hall, each building, each tower not as isolated architectural units but as part of a coherent environment. We refuse to allow our splendid and beloved buildings to fall into ruin or to become humiliated by being isolated in the middle of inharmonious surroundings and being left to deteriorate.4 To this end Beijing’s municipal government realizes the meaning and value of its cultural heritage and no longer regards the cost of protecting it as an economic burden returning no benefit but as an opportunity to further develop the culture industry and integrate it with China’s commitment to its cultural causes.

6. The Current Status of Beijing’s Historical Sites and Cultural Artifacts

In Beijing, there are 3,553 protected or registered historical sites, include five that have “world cultural heritage” status. Within the old city (surrounded by the second ring road and covering 62.5 square kilometers), there are two sites with “world cultural heritage” status. In addition, 34 sites are under state protection, 39 sites are under regional temporary protection, and 478 are registered. Within the planned city proper (ranging from Ding Fuzhuang in the east to Nan Yuan in the south to Shi Jingshan in the west and to Qinghe in the north, covering 1,040 square kilometers), there are 615 protected and registered historical sites. Within the new city (including ten remote districts and covering 16,800 square kilometers), there are 2,138 protected and registered sites. At Beijing’s Political Constitution Conference, Shu Yi, son of the famous writer Lao She, described Beijing’s uniqueness in that its historical sites are spread throughout the city. Indeed, in addition to the thousands of registered sites, there are many thousands of unregistered sites. There are so many that no one traveling across the city can ignore them. Therefore, it would be a disaster for Beijing to become crammed with skyscrapers, as is Hong Kong and New York. We must work hard to avoid losing our historical architecture and spaces in the process of modernization and post-modernization. As Tan Ying, professor of architecture at the Academy of Tsinghua, said, new construction in Beijing since 1990 has been hugely successful. Most of the dangerous buildings have been either repaired or torn down and rebuilt. Unfortunately, some of the construction that has been done near the center of the old city has been done on a scale that does not fit with its size and character and has severely compromised and even damaged its unique style, features, and ambience. Therefore, those of us devoted to preserving the cultural specificity of Beijing appeal from the bottom of heart: Stop pulling down buildings. Preserve the ancient city style.

7. New Ideas about Protecting Historical Sites in Anticipation of the 2008 Olympic Games

We need to bring out a batch of demonstration projects, integrate Beijing’s protection of cultural sites into the cultural industry, and prepare for the 2008 Olympic games.

4 Our task is, we once told some world famous architects and preservationists, like pushing an iron ball uphill. One of them responded that it is more like pushing an iron ball through a marsh.

8 Presently, in Beijing there are neighborhoods where the value of historical sites has been integrated into the activities of the cultural industry. The Shi Shahai tour area, for example, is noted for its beautiful views of lake and mountain and for its folk customs. A resort destination for foreign tourists coming for Beijing, it is the site of a thriving culture industry. At the present, then, there are 150 pubs, nearly 10 courtyard restaurants, and numerous galleries. From January to October 2005, tax from these enterprises made up 48% of the local tax revenue. At the 2008 Olympic Games there will be a huge influx of tourists. Besides watching splendid sports competitions, they will have the opportunity to visit Beijing’s unique neighborhoods. If they only catch sight of the city’s modern office buildings, palaces, the Great Wall, and the Palace Museum,5 they will acquire a distorted image of Beijing. Thus, it is an urgent task for us to find an appropriate way to offer to the Olympic Games access to the full range of Beijing’s riches, local color, diverse neighborhoods, regional features, and historical sites. What is common to those countries that protect their cultural sites is that they do so in a way that pays both cultural and economic dividends – that is, in a way that capitalizes on these sites as a way of drawing tourists. Singapore, for example, has undertaken many efforts to protect its architecture. Its first five star hotel, the Hilton, was originally a state post office. When it was converted to its present commercial use, its exterior was fairly well preserved. Now it is a landmark and tourist attraction that retains its historical beauty and its modern function while contributing to Beijing’s economy in a way that redounds to the entire city.6 In sum, cultural sites are not black economic holes that suck up investment without return. To the contrary, they are unique, uncopiable, and potentially invaluable cultural assets.

8. Advice and Solutions

Looking forward to the 2008 Olympic Games, we have limited time to take advantage of our unique cultural assets – to protect them, on the one hand, and to make them available as a marketable resource, on the other hand. In my opinion, we can do so in six different ways: First, we should develop an eleventh five-year plan for Beijing’s culture industry. We need to identify the direction we want to go with regard to the future development of the culture industry development and come up with a rational plan of action, one that will be sustainable and profitable to Beijing in the long run. To this end we should expand the program outline in the “2004-2008 Development Plan for Beijing’s Culture Industry” in ways that will take advantage of the unique opportunity afforded Beijing by virtue of being the Olympic Games host city. We should make sure that all appropriate departments of the government should formulate development plans for each of the individual trades that are part of the culture industry. We must stick to the principle that we formulate these plans in ways that can be put into action. We then need to bring the

5 Neither the Great Wall nor the Palace Museum can accommodate all the tourists who will arrive to watch the Olympics.

6 Wallace is another successful case. It was once a Government House but now is the most famous hotel in Asia. An unusual feature of the protection measures the operators of this For sake of protecting this unique building, there is a fire drill each month. The visitors are all very cooperative.

9 plans to completion. Finally, we need to put into place a process to review on an annual basis our progress in actualizing our plans. Second, we should construct a zone devoted to the culture industry. We should positively integrate the resources we have, get the different trade organizations to work together, expand the scale of our preservation efforts, and make our cultural sites readily available as user-friendly tourist destinations. There are many historical sites in Xicheng, Dongcheng, Xuanwu, Chongwen, Haidian, most of which, however, have been illegally appropriated for private use. These sites must be returned to the people of China and to its overarching sense of cultural cause. To this end the government must direct departments, counties, and districts to accumulate the necessary resources and capitals to pay for the return of cultural sites and artifacts to the people according to an overall plan for preserving them. This project will require, again, that the various government departments and agencies departments coordinate their efforts and work together. Third, based on the resource conditions and regional features of Beijing’s culture industry, we should establish a group of key projects, create several industrial brands related to the protection of the culture industry, and cultivate some of the strongest, most competitive, and most influential culture businesses and corporations. We should do so in the name of the principle of giving prominence to those key industries that have the ability to stimulate additional economic development. That is, we need to make them strategic investment partners in, and thus the main force behind, the protection of historical sites. At the same time, we should encourage small enterprises to become “professional, refined unique, and novel” – that is, to become part of a leading edge culture industry cluster. Fourth, we should form a comprehensive strategy and set of policies for the development of the culture industry and the protection of cultural sites. We should offer a tax reduction to qualified cultural enterprises. We should create a financial mechanism for guaranteeing loans to business that advance the cultural cause. We should attract venture capital investment for the purpose of encouraging private loans to businesses involved in the culture industry. Within the limits of the law, we should make preferential real estate arrangements for businesses that would be willing to relocate or set up in a city zone dedicated to the culture industry or to undertake major renovation and new construction projects. We should also speed up the establishment of a regulation system in culture industry. Fifth, we should set up a special fund for the protection of Beijing’s historical sites. We should undertake direct investment in and special subsidies of preservation efforts and major construction projects. We should establish “Beijing’s Culture Industry Development Fund Regulation,” which would set forth the procedure for applying for these investment monies and subsidies and for guaranteeing that the funds are used for their intended purposes and that the purposes accord with Beijing’s cultural aims. Finally, we should cultivate a professional cadre of culture industry workers. Human resources are a key factor in the ongoing expansion of the culture industry, especially when it comes to the protection of historical sites and artifacts. It is important to fully utilize the educational, cultural, and historical research being done in Beijing. To this end we should set up programs (majors) in university study related to historical preservation. In addition, we should strengthen in-service training and combine theoretical study with practical training. We should actively train students and workers in an interdisciplinary manner and promote those who are both knowledgeable of China’s cultural heritage and are adept in contemporary business, financing, and management practices. We should also bring in national and international experts in historical preservation.

10 References:

AnMin, Sun. (2005). Cultural industry: Theory and practice. Beijing Publishing House.

BoJun, Jiang. (2006). Overview of Beijing-styled creative –culture industry. www.chuangyi.org.cn. daShen, Kuai. (2006). Focus on China’s creative-culture industry from seven key points. www.dangjiancn.com/zcjd/ShowArticle.asp.

HuiYin, Lin. (2004). Analysis of Chinese buildings. ShanXi Model University Publishing House.

XiaoWen, Wang. (2006). Creative-culture industry in England. blog.daqi.com/article/7123.html.

11 12 THE TRADE PATTERN OF THE INTERNATIONAL EDUCATION SERVICE AND ITS THEORETICAL INTERPRETATION

Bai Yuan School of International Economics and Trade Beijing International Studies University

Abstract

As a result of relaxation of restrictions on the education sector, education service has accelerated its process of internationalization, globalization, and commercialization. In the context of commercialization of international education service, this paper will, in its first section, examine the trade pattern of the international education service. Based on the findings, the second section attempts to analyze sources of competence of those large education exporters by applying the existing international trade theories and the theory of competence. The paper will take the United States, the number one host country, and China, the number one home country, as its two case studies.

Introduction

In the General Agreement on Trade in Services (GATS) reached by the WTO members in 1994, education service is one of the 12 service sectors regulated by GATS. As a result of relaxation of restrictions on the education sector, education service has accelerated its process of internationalization, globalization, and commercialization. International service trade in education, particularly in tertiary education, has become the focus of growing attention. The process of commercialization of international education service started in 1979, when the United Kingdom took the initiative in having international students make full payment for their education in the country. Following UK’s example, Australia, New Zealand, and Canada adopted the same policy, and later the United States, Holland, Malaysia, and even Hong Kong (SAR) followed suite, giving up financial aid policy to international students (Hans de Wit., 2002). In the context of the commercialization of international education service, this paper will, in its first part, examine the trade pattern of the international education service. Based on the findings, the second part attempts to analyze the source of larger tertiary education exporters’ competence by applying existing international trade theories and the theory of competence. For analytical purposes, the top ten host countries and top twenty home countries (including twelve developing countries) will be compared. The paper will also take the United States, the number one host country, and China, the number one home country, for the case study. According to GATS, education service products include primary education, secondary education, tertiary education, adult education, and other types of education; however, the paper gives sole attention to tertiary education since international service trade in education occurs mostly at this level. This paper only examines education as consumption abroad because cross border supply, commercial presence, and the movement of natural persons are not yet significant. The magnitude of education service trade could be measured either by number of internationally mobile students or by balance of payments recording the value derived from the related expenditure by mobile students. However, with no reliable sources for the needed data, it is hard to make cross-comparison of the students’ expenditure in the host countries. Given the fact that the expenditures of a student will cause outflow of capital from home country to host

13 country, the inflow and outflow of students can be viewed as import and export of education service, with the following caution: using number of students as the measurement of the trade has the disadvantage of not taking into account the difference between the cost for a Chinese student studying in the United States and the cost of an American student studying in China. The paper will in most cases use the data for number of internationally mobile students. The data are mainly from Global Education Digest (UIS, 2006), and other UNESCO reports, China’s Ministry of Education, and other reliable sources as noted.

1. The Pattern of International Trade in Education Service:

The internationalization of the tertiary education is demonstrated by the dramatic rise in the number of mobile students worldwide as the new millennium started. According to the Global Education Digest 2006, “at least 2.5 million tertiary students studied outside of their home countries compared to 1.75 million just 5 year earlier, representing a 41% increase since 1999.” Looking closely at the flow of mobile students, a pattern can be drawn: (1) Developed countries are the major education exporters. Eight of the top ten education exporting countries are from the developed country group. “Six countries host 67% of the world’s mobile students: the United States (23%), the United Kingdom (12%), Germany (11%), France (10), Australia (7) and Japan (5)” (Global Education Digest 2006). Table 1 shows that Russia and South Africa are the only two developing countries in the list. Among the exporting countries, some can be viewed as global level education exporters, such as U.S., U.K., and Germany, and some other as regional level exporters, like Japan, Russia and South Africa (Table 1).

Table 1: Top ten education exporters at the tertiary level (receiving mobile students) by regions in 2004

Top ten Number Regions of origin education of mobile Arab C E E Central East Latin North South Sub- Un- exporters students State Asia Asia, America, America West Saharan Spec Pacific Caribbean West Asia Africa Europe US 572,509 17,631 36,176 3,078 229,577 70,235 78,477 99,115 33,583 4,637 UK 300,056 13,270 9,257 903 93,639 8,793 117,713 25,041 23,569 7,871 Germany 260,314 16,572 105,371 6,986 40,402 7,424 55,946 12,317 10,783 4,513 France 237,587 76,273 20,831 1,151 21,715 9,427 37,295 2,558 41,430 26,907 Australia 166,454 2,481 1,536 158 102,575 1,911 16,115 13,347 5,344 13,487 Japan 117,903 600 1,206 885 107,854 1,157 3,093 2,591 488 29 Russia 75,786 … 18,047 28,955 … … … … … 28,780 S. Africa 49,979 … … … … … … … 36,203 13,776 Italy 40,641 2,227 15,791 118 1,038 3,285 14,429 1,067 2,363 323 Canada 40,033 3,359 1,223 44 10,949 3,636 13,117 2,284 3,742 1,679

Source: Global Education Digest 2006

Table 1 shows that all major exporters (except for Japan, Russia, and South Africa) are the destinations of students from all over the world, while Russia and South Africa receive students from a small number of neighboring countries. Japan’s mobile students are from rather diversified regions but 91.5% of them are from the East and Pacific region, which means that Japan is no more than a regional level exporter. The observation suggests the importance of locality and cultural factors in mobile students’ choice of destinations as well as economic links between the countries. Other reasons for some countries being regional level exporters include of the lack of tertiary education supply and sufficiently wealthy mobile students. In absolute terms, 1,107,000, or 46% of all mobile students are from East Asia and the Pacific and Western Europe, but in

14 relative terms (measured in outbound mobility ratio: mobile students/all tertiary students), it is Sub-Saharan Africa (5.9%) and Central Asia (4%) that have the highest outbound mobility ratio as compared to Western Europe (2.8%), East Asia and the Pacific (1.98%), and North America (0.4%). The very high outbound mobility ratio in Sub-Saharan Africa and Central indicates that these developing countries either lack or are short of tertiary education supply. However, a high outbound mobility ratio does not necessarily translate into the affordability of expensive higher education service in those developed countries. Therefore, the students from the two regions who want to pursue higher education with a relatively small budget choose to study in South Africa and Russia, where tertiary education supply is sufficient and relatively economical. (2) Developing countries are the major education importing countries. China is the single most important country of origin, accounting for 14% of the total number of outbound students. Next to China is India (4.9%) and South Korea (3.8%). Developed countries enjoy large trade surpluses in education service with only a few exceptions, while developing countries have large trade deficit in the number of students. Table 2 shows that almost all developed countries receive more students from other countries than they send out, while in most developing countries the inflow of students is greater than the outflow. It is obvious that developed countries are strongly competitive in education service trade.

Table 2: Top 10 Education exporting and top 20 importing countries at the tertiary level and their trade balance in 2004

Top 10 US UK Germany France Australia Japan Russia S. Africa Italy Canada Exporters Inbound 572,509 300,056 260,314 237,587 166,954 107,030 75,786 49,979 40,641 40,033 Outbound 41,181 23,542 56,410 53,350 6,434 60,424 34,473 5,619 38,544 38,847 Balance 531,328 276,514 203,904 184,237 160,520 46,606 41,313 44,360 2,097 1,186 Top 20 China India S. Korea Japan Germany France Turkey Morocco Greece U.S. Importers Outbound 343,126 123,559 95,885 60,424 56,410 53,350 52,048 51,503 49,631 41,181 Inbound 24,353 7,738 7,843 12,729 6,395 12,456 Balance -318,773 -11,5821 -88,042 -39,319 -45,110 -37,175 Importers Malaysia Canada Italy Russia HK, Indonesia Poland Kazakhstan Spain Ukraine (continue) China Outbound 40,884 38,847 38,544 34,473 34,199 31,687 28,786 27,356 25,691 25,188 Inbound 27,731 3,270 377 7,608 8,690 15,051 15,622 Balance -13,153 -30,929 -31,310 -21,178 -18,666 -10,640 -9,566

Source: Global Education Digest 2006, China Education Statistic Year Book 2004

East Asia and Pacific (29% of the world total) and Western Europe (17%) contribute the most to the strong increase in international mobile students from 1999. A reason for East Asia taking the largest share of mobile students is its largest population (Global Education Digest, 2006); however, a still more significant factor is the rise of per capita income, resulting from rapid economic growth, and thus rising demands for higher education on the one hand and the deficit of the domestic education supply at the tertiary level on the other. China’s case provides a good example. Economic factors also explain the large number of outbound students to other developing countries from the top 20 importing countries. These countries share a few characteristics: (1) they are all among the most active economies in their own regions (the annual average growth rate of China, South Korea, India, Turkey, Indonesia, Malaysia and Kazakhstan is more than 7% in 2005). (2) Many of them are rated as the most attractive destinations for foreign investment. According to the World Investment Report (2005), China, India, Hong Kong, Poland, Kazakhstan, and the Ukraine are among the countries that either have high FDI performance and potential or are the most attractive global business locations. (3) The per capita incomes of the countries are among the highest. The dynamic economic development, further integration into the world economy, and increasing demand for internationalized human

15 resources for domestic economic development are the key forces driving students to choose to study abroad in these countries; meanwhile the increasing income makes it financially possible. One reason Western Europe receives the second largest share of mobile students is the desire for gaining the experience of studying and living abroad as preparation for an increasingly globalized world (GED, 2006). Another reason is the desire for differentiated education products that developed countries can typically offer. The fact that the majority of students from this region (77%) and North America (80%) choose to stay in the regions of origin and other developed countries and that the major exporters from developed countries are at the same time the major importers support this argument. This trade pattern is of the same nature as intra- industry trade in manufactured goods, where intra-industry trade occurs most frequently between developed countries (see Table 3).

Table 3: Destination of outflow students from top 20 at tertiary level (2004)

Countries Students Top 5 destinations (host countries) for outbound mobile students China 343,124 US(87943), Japan(76130), UK(47738), Australia(28309), Germany(25284) India 123,559 US(79736), Australia(15742), UK(14625), Germany(4237), New Zealand(1205) S. Korea 95,885 US(52484), Japan(23280), Germany(5488), Australia(3915), UK(3482) Japan 60,424 US(40835), UK(6395), Australia(3172), Germany(2547), France(2337) Germany 56,410 UK(12096), US(8745), France(6698), Switzerland(5823), Austria(5657) France 53,350 Belgium(12458), UK(11295), US(6818), Germany(6678), Belgium(6238) Turkey 52,048 Germany(27582), US(11398), France(2273), UK(1960), Austria(1820) Morocco 51,503 France(32,802), Germany(8,305), Belgium(2579), US(1835), Netherlands(1664) Greece 49,631 UK(22826), Germany(7577), Italy(7159), France(2288), US(2126) US 41,181 UK(13381), Canada(4394), Australia(3439), Germany(3419), France(2687) Malaysia 40,884 Australia(16094), UK(11806), US(6483), Japan(1841), New Zealand(831) Canada 38,847 US(27017), UK(3890), Australia(3100), France(1267), Germany(556) Italy 38,544 Germany(8111), Austria(6149), UK(5251), France(4686), Holy See(4103) Russia 34,473 Germany(11462), US(5532), France(2597), Kazakhstan(2177), UK(1878) HK(China) 34,199 Australia(13165), UK(10577), US(7353), Canada(1852), Macao(746) Indonesia 31,687 Australia(10184), US(8880), Malaysia(4731), Germany(2572), Japan(1474) Poland 28,786 Germany(15417), France(3270), US(2913), Austria(1172), Italy(1002) Kazakhstan 27,356 Russia(20098), Kyrgyzstan(3635), Germany(386), Turkey(781), US(538) Spain 25,691 UK(6105), Germany(6014), France(3928), US(3631), Belgium(1042) Ukraine 25,188 Germany(7618), Russian(6841), US(2004), Poland(1809), Hungary(1005)

Source: UIS Global Education Digest 2006

2. Theoretical Interpretation of the Trade Pattern in Education Service:

It can be inferred from the trade pattern in education service that developed countries have competitive advantages in tertiary education service because developed countries are the destinations for both students from developed as well as developing countries, and because they enjoy large trade surplus in education service. Where, then, does the developed countries’ competitive advantage come from? Why do a few countries, such as the United States, the United Kingdom, Germany, Australia, and France, become the most popular countries for mobile students? The question will be discussed from the perspective of both importing and exporting countries.

2.1 Application of Classical International Trade Theories on Education Service Trade

The widely applied international trade theories include Adam Smith’s absolute advantage theory, David Ricardo’s comparative advantage theory, and H-O production factor endowment theory. Some basic theories are powerful in explaining some aspects of education service trade behavior. For example, absolute advantage theory explains why Korean students come to China to learn Chinese medicine and why Chinese students go to Harvard to pursue

16 MBA degrees. It is because of the uniqueness of Chinese medicine in the former and the inability of other countries to duplicate the Harvard MBA in the latter. Comparative advantage theory explains why more and more Chinese students prefer to go to Germany, Italy, Norway, Swiss, and Russia for their tertiary education. The answer is the relatively lower price for similar education service products in these countries than in other developed countries like the U.S., U.K., and Australia. Factor endowment theory specifies the sources of comparative advantage in that when a country is abundant in a production factor relative to another country, then the country will have comparative advantages over the other country for producing and exporting the product. However, factor endowment theory seems unable to explain the fact that even though the U.S. is abundant in tertiary education resources, its tertiary education products are among the most expensive and that the U.S. is the number one hosting country accounting for 23% of the world total of mobile students. Table 4 shows factor abundance in tertiary education in the U.S. and other developed countries as compared with that of developing countries; it looks at the ratio of teaching personnel/total labor force. Table 5 makes a cross comparison between developed countries and developing countries in enrollment ratio and student/teaching staff ratio indicating education product factor intensity.

Table 4: Educational personnel at tertiary level as a percentage of labor force aged 25 to 64 (1999)

Country Teachers & Other Educational Total Educational Academic Staff Personnel Personnel Australia 0.8 n n Canada 1.0 n 1.1 France 0.6 0.3 0.8 Germany 0.9 n n Italy 0.4 n 0.4 Japan 0.9 0.4 1.3 UK 0.4 n n US 0.9 1.3 2.2 Average 0.74 0.7 1.16 Indonesia 0.3 0.1 0.4 Malaysia 0.2 0.0 0.2 South Korea 0.8 0.3 1.1 Thailand 0.2 n n Turkey 0.4 n n Average 0.4 0.2 0.6

Source: OECD/UNESCO WEI

Table 5: Tertiary Education/ISCED 5 and 6/ Enrolment and Teaching Staff

Top 10 Host Total Gross enrollment Teaching Students/ Countries enrollment ratio Staff Teaching staff 1999 2004

US 16,900,471 73 82 1,174,831 14.4 UK 2,247,441 60 60 111,830 20.1 Germany NA NA NA 290,429 12.3(1999) France 2,160,300 52 56 135,783 15.9 Australia 1,002,998 66 72 11.8(1999) Japan 4,031,604 45 54 496,370 8.1 Russia 8,622,097 n 68 601,354 14.3 S. Africa 717,793 14 15 43,023 16.7 Italy 1,986,497 47 63 91,937 21.6 Canada 1,192,570 59 57 131,320 9.1 Average 41.6 52.7 14.5 Top 10 Home Countries from developing group China 19,417,044 6 19 850,227 22.8 India 11,295,041 n 11 428,078 26.4 Rep. of Korea 3,223,531 66 89 172,572 18.7 Turkey 1,918,483 22 28 76,090 25.2 Morocco 343,599 9 11 18,593 18.5 Malaysia 6632,309 23 29 34,955 18.1 Hong Kong 155,761 n 32 n n Indonesia 3,441,429 n 16 233,359 14.7 Poland 1,983,360 44 59 93,988 21.1 Kazakhstan 664,449 25 48 40,972 16.2 Average 27.8 34.2 20.2

Source: UIS GED 2006, UNESCO

At least 3 points can be concluded from the tables. First, developed countries are abundant in tertiary education resources, which are 0.4 percent higher in educational personnel/labor force than those of developing countries. The same is true for the high intensity of teaching staff in tertiary product in developed countries, with 6 percent lower than that of the developing countries in the average student/teaching staff ratio. Second, the gross enrollment ratio, another important indicator, is much higher in developed countries (52.7% on average) than in the developing countries (34.2% on average), indicating the tendency of idle resources in tertiary education in developed countries and the lack thereof in developing countries. The U.S. has the highest student enrollment ratio (82%), largest teaching staff (1,174,831), and a student/staff ratio (14.4%) that is lower than the average of the developed group. Third, the real situation in the U.S., however, is that the price of its tertiary education (tuition fees plus living expenses, estimated at $20,000/year on average) is 2 to 3 times higher than the price in non-English speaking developed countries and 11 times higher than in China. It seems that American’s rich educational resources and high intensity in educational products do not explain the source of the U.S. advantage in education service. Surely, high international demand for U.S. tertiary education service products helps inflate the education price and keeps approximately 3.4% of job opportunities in the tertiary education sector.

18 It can be concluded that classical international trade theories are useful in explaining tertiary education trade (absolute and comparative advantage) in some situations but unable to explain educational trade in some other situations (factor endowment). The inability of the classical international trade theory to account for educational service trade is due to the fact that this theory usually examines the comparative advantage from an inherited view of a product, such as labor population, natural resources, land, etc., which is applicable to tangible goods. Since education is a very special kind of service product, the supply of which is not simply affected by the suppliers (universities, teachers, and government) but much influenced by the government policy and social and cultural factors, a different theoretical tool is necessary to better analyze the nature of education service trade.

2.2. Competitive Theory and its Implication to International Education Service Trade

The evolution of competitive theory can be traced back to the time of Mercantilism; however, it is Michael Porter (1997) who made the great contribution to the development of modern competitive theory. His Competitive Advantage of Nations offers a model that can help explain the comparative position of a nation in global competition. His diamond model lists four factors for competitive advantage: strategy, structure and rivalry of firms, demand conditions, related supporting industries, and factor conditions. The fourth factor includes two types – key factors (skilled labor, capital and infrastructure) and non-key factors (low skilled labor and raw materials). Porter argues that key factors are the sources that provide sustained advantage because they involve heavy input of capital and the other elements that are difficult to duplicate. What is more, he views the government as a catalyst or pushing force for raising companies to higher levels of competitive performance. The other two influential persons in developing competitive theory are Gary Hamel and C.K. Prahalad (1990), who put forward the concept of “core competence” in “The great future for competence.” Hamel and Prahalad did not specify what constitutes the core competence of firms but put forward three tests to identify such competence – providing potential access to a wide variety of markets, making a significant contribution to the perceived customer benefit of end products, and making it difficult for competitors to imitate. Although they adopt different approaches to determine the competitiveness of firms, Porter (1997) and Hamel and Prahalad (1990) nevertheless agree that in order to keep its competitiveness, a firm should try to set up barriers to prevent its competitors from imitating their products. The competence of a country’s tertiary education service products is actually the combination of the comprehensive power of the country (as determined in terms of Porter’s key factors), specialized and other skilled labor, capital, and infrastructure. Based on the spirit of competitive advantage and core competence, three core elements contribute to the sustained competitiveness of a country’s education service trade: (1) Competence in human and physical resources, which refers to the qualifications of educational personnel, facilities, reputation, and the brand name of educational institutions in a country. Famous universities well-known for their professoriate, history, and advanced teaching, research, and recreational facilities and attractive courses contribute tremendously to their competitiveness. In the service sector, human resources are the single most important input, even for tertiary education. Prominent professors and researchers are the most valuable and rare resources, which are impossible for other competitors to imitate. (2) Competence in the overall management ability of educational institutions, which refers to technical creativeness, research expertise, technical transfer ability, and the quality of its services and management. An educational institution with strong management is able to keep the lead in research and technical innovation and maintain its dynamics and liveliness. It is not easy to achieve and maintain this second set of competencies, which can strengthen the competitiveness and position of a university in the international education market.

19 (3) Environmental competence, which refers to the possibilities for economic advancement, government policy and regulations, the quality of the educational system, cultural factors and languages, and geographical locations. Environmental competence may not have direct impact on the education trade, but its indirect influence should never be overlooked. For example, a large number of students from developing countries choose to study in developed countries for the chance of immigration. As a result, economically dynamic countries that accept immigrants become more competitive than non-immigrant countries or countries that permit immigrants but are economically inactive and offer very limited job opportunities. Language is another very important element. English speaking countries are more competitive than non- English speaking countries because of the dominant position of English language in communication in whatever fields. In combination with cultural factors (language, religion, way of living, economic ties), geographic locations influence the choice mobile students make. In short, the first two elements constitute the core competence of an educational institute, and the third element helps further strengthen the core competence. None of the elements can work well without other elements. Those educational institutes strong in all three elements of competitiveness are the most competitive and can attract more mobile students even when studying in these countries is expensive.

3. Analysis of American Universities’ Competitiveness from Host and Home Country Perspectives:

With the strongest comprehensive competitiveness in tertiary education, the dominance of the U.S. in tertiary education service trade is indisputable: it has been the largest host country for decades, and it has the largest share of the world education market. In spite of high tuition fees, American universities are still among the most popular ones for international mobile students to consider. American universities are attractive because of their excellent educational resources, world famous professors, advanced facilities, leading position in technology innovation, remarkable achievements in academic fields, attractive courses, and efficient management. With all its strength in education service, it is not surprising that America has become the most popular country for international mobile students. One important fact that supports the argument that American universities are highly competitive in tertiary education, in addition to the largest share of the world education market, is the large percentage of degree- seeking mobile students. Of all the mobile students, 44% pursue master or Ph.D. degrees, 37% pursue bachelor degrees, 11% are in pre-bachelor degree programs, and only 3% in non-degree program (Jin Xibin, 2005). In short, American institution competitiveness is in its contribution to the perceived benefit rather than any competitive pricing. For students from developing countries, the present input in their human capital formation can bring about much higher return in the future. To have a better understanding of American university competence, it is necessary to look at the other side of the picture – the situation of the countries sending students. China holds the largest share of the world mobile students (14%) and sends the largest group of students to the U.S. (e.g. 70,000 students in 2004). The rapid increase in the number of Chinese students studying oversee started in the late 1990s, when incomes kept rising as a result of continuing economic growth in China and people demanded more higher education. Since late 1999, the number of students in higher education in China has been growing from 6% to 19%, placing China on the top for having the largest number of tertiary students in the world (19 million, GED; 2004). China’s domestic supply of tertiary education, prominently at ISCED level 6, falls behind the increasing demand. China’s lower than world average outbound mobility ratio (1.8 against 1.9) may imply that Chinese students do not choose to study abroad but rather are pursuing their education in general in increasing numbers. Since the mid 1980s, the U.S. has been the most important destination for Chinese students. The fundamental reason for Chinese students to go to U.S. is the serious shortage of

20 domestic supply for tertiary education in China and rich resources in high quality tertiary education supply in the U.S. The enrollment ratios in both countries (6% in China, and 73% in the U.S. in 1999; GED 2004) can support the argument. There are, of course, other reasons for the U.S. to become the top choice over other countries for Chinese students. The first is the high quality education products offered at the tertiary level in the U.S., especially at the master’s and doctoral levels (the number of individuals with Ph.D.s is low in China). In the year 2001, 59,939 Chinese students studied in the U.S., of whom 48,029 pursued masters degrees, 8,252 pursued bachelors degrees, and 3,658 were pursuing other programs. According to the American International Educational Research Institute (November 13, 2001), there were another 14,772 visiting scholars and researchers engaged in post-doctoral projects. Chinese students in the U.S. study the following subjects (in rank order): engineering, natural science, biology, mathematics, computer, international economics, management, health science, sociology, law, agriculture, education, art, and English. The influence of American scholars cannot be easily duplicated and for this reason attracts a high percentage of Chinese students to pursue their degrees at the masters and PhD levels. With an American diploma or certificate in science and technology, management, or finance, with their experiences living in a cross-cultural environment, and with fluent English, Chinese graduates returning home are chased by employers from both multi-national corporations and home companies, central and local governments, universities, and research institutes. In China’s oversupplied job market, graduates from the U.S. are highly competitive and well paid. The motive for students seeking educational opportunities outside their own country is also driven by the different price of labor. International mobile students are a potential labor force for host countries. As measured by per capita GDP, Americans earn 17 times as much as the average Chinese worker. Not surprisingly, those Chinese students who can afford to go to the U.S. would prefer to stay in the U.S.

4. Conclusion:

The competitiveness of American universities in international education service trade is derived from several sources: the educational institutions’ core competencies and policies, cultural factors, social environment, and economic opportunities. The core competencies of an educational institution change over time as other institutions become more competitive, particularly when governments play a part in enhancing their educational institutions by launching incentive policies. In addition, some economically dynamic developing countries have begun to share in international tertiary education service market through price competition. It is foreseeable that the competition at future international education service market will be much intensified.

References:

de Wit, Hans. (2002). Internationalization of higher Education in the United States of America and Europe: A Historical, comparative, and conceptual analysis. Greenwood Press.

Hamel & C. K. Prahalad. (1990). The great future for competence. Harvard Business Review.

Jinxibing. (2005). International education service trade. Fuzhou: Fujian Education Publishing House.

Porter, Michael. (1997). Competitive advantage of nations. Beijing: Huaxia Publishing House.

21 Wushong. (2002). WTO and development of Chinese education. Beijing: Beijing University of Science and Industry Press.

OECD/UNESCO WEI. www.unesco.org.

UNESCO Global Educational Digest. (2006). www.uis.unesco.org.

World Investment Report. (2006). www.unctad.org.

22 INVESTMENT DEVELOPMENT OF CHINA’S SERVICE INDUSTRY UNDER THE CONDITION OF OPENING DUAL ECONOMY

Yuhong Wang School of International Economics and Trade Beijing International Studies University

Abstract

China’s rapid and sustained economic development has attracted world-wide attention. China is transitioning from a planned economy to a market economy, from fast growth to sustainable growth, from manufacturing to agricultural development, from an unbalanced to a balanced model, and from a dual economy to a uniform economy. Moreover, confronted with shortages in energy and other resources, China’s economy is undergoing profound structural adjustments, which require modifications to current economic models to understand. This paper posits that, with the opening of the dual economy, China has been developing both in rural as well as in urban areas; that it has used its nationwide markets as a spur to strengthening its industrialization; that it has introduced foreign capital to push its services industry to develop more quickly the quality of management; and that it has continued to support the exporting of its mature services, such as Chinese restaurants and arts services, as a way to improve its balance of trade. In sum, this paper posits that China is taking advantage of both foreign capital and domestic capital to strengthen its investments in its services industry in order to bring about a more balanced economy that will also contribute to the stability and harmony of the world economy.

1. Background:

China’s strong and sustained economic development for more than 20 years has attracted the attention of the world. Especially after its entry into the WTO, China’s economy has grown rapidly (see figure 1) while the standard of living has raised gradually (see Figure 2).

Figure 1: China’s Economic Growth 2001-2006 (%)

15 10 % 5 9.57 9.62 9.92 10.51 7.72 7.82 0 2001 2002 2003 2004 2005 2006

year

Source: China’s Statistics Bureau

23 Figure 2: Nominal Growth Rate of Total Retail Sales of Consumer Goods in Domestic Market

100

% 10 12.05 13 12.8 9.28 8.22 9.42

1 2001 2002 2003 2004 2005 2006 year

Source: China’s Statistics Bureau

China’s emerging economy has three major characteristics. The first is that it is transitioning from a planned economy to a market economy. China’s government has been calling individuals and firms to participate in the market exchange of their products and services. To support access to the market, China’s government has been helping individuals and firms to construct the necessary transportation and information networks as well as other infrastructure (see figure 3). The Chinese saying – “government constructs stages and people dance on them” underscores the key role of the China government in facilitating the accumulation of fixed capital as a way of stimulating growth by encouraging more and more individuals and small and medium sized firms to enter the market economy.

Figure 3: Nominal Growth rate (%) of Total Investment in Fixed Assets 40 35.25 35 30.08 28.25 28.57 30 25 22.25 18.62 20 15 10 5 0 2001 2002 2003 2004 2005 2006

Source: China’s Statistics Bureau

24 Second, China’s opening-up policies since the end of the 1970s have encouraged individuals and firms to use their product and service advantages to acquire more domestic and international resources and thus to develop their businesses. The Chinese have exported commodities for foreign currencies and imported advanced technologies to upgrade their production capacities, efficiencies, and profitability (see Figure 3). At present, the development of agriculture lags far behind that of manufacturing. Third, because of China’s enormous labor force and the low cost of labor, both Chinese businesses and transnational corporations with production facilities in China are able to make a profit. As a result, the energy and environmental constraints are becoming more and more serious concerns with regard to China’s future growth and development. Another result is that trade frictions with other countries are rising. China needs to adjust its growth model from one centered on manufacturing to one emphasizing even development in manufacturing, agriculture, and services.

2. The Opening of China’s “Dual Economy” Facilitates the Rapid Expansion of Service Investments:

China’s dual economy originated in the 1950s when China instituted a “great leap forward” policy that encouraged the development of heavy industry and sacrificed agricultural development. The policy was influenced by the industry-fundamentalism theory that spread from developed countries to developing countries. After economic reform in late 1970s, China continued the policy of industry-fundamentalism until the late 1990s, when there was a general consensus in China that if the nation’s productive capacity were used to supply more and more goods overseas,1 then the disparity between rich and poor within China would become a potential problem for China’s subsequent economic development (see Figure 4). More and more analysts agree that for too long agriculture has supported the development of China’s economy and urbanization and that it is time to use industrial resources to support the development of agriculture and the nation’s rural communities in order to reduce the gap between rich and poor. At present, China’s government is pursuing policies that facilitate “the construction of a new socialist agriculture.” This change in macroeconomic focus is creating an expanding space for the development of services to bridge the gap in the development of industry and agriculture. Emergence of the service market is inevitable.

2.1 China’s “dual economy”

“Dual economy” is a professional term used to describe the coexistence of fast growing industries and backward agriculture in a developing economy. China is a dual economy. Table 1 shows the volume of production (in billions of RMB and as a percentage of total GDP) in China’s Eastern, Middle, and Western Areas. The total production of the Middle areas and the Western areas is less than that of the Eastern. Figure 5 shows that total social investment in fixed assets in the urban area is much greater than that in the rural areas. Figure 6 shows the size of the gap in disposable income per person between urban and rural areas. The disparities between these regions with respect to the Engel Index are existing higher in rural and lower in urban. Figure 7 shows China’s Geni Coefficient on average which indicated that people’s food expending has taken larger proportion of the total income in 2001, when the coefficient reached 0.459, China exceeded for the first time the international security threshold of 0.4.

1 For example, in 2005 China supplied nine billion pairs of shoes to the world market.

25 Figure 4: China’s import and export 2001-2006 (billion dollars)

1800

1600 1593 1400 1422.1

1200 1154.7 1000

$ 851.2 800 600 620.7 509.7 400 200 0 2001 2002 2003 2004 2005 2006* year

Total Import Total Export Total Volume

*Based on prediction.

Source: Ministry of Commerce, China.

Table 1: The Volume of production in China’s Eastern, Middle, and Western Areas

The Eastern The Middle The Western Year Volume of Total Volume of Total Volume of Total (b. RMB) (%) (b. RMB) (%) (b. RMB) (%) 1991 11624.29 53.9 605.12 28.0 344.79 15.9 1995 3361.54 57.5 1586.76 27.1 814.03 13.9 2000 5773.97 64.6 2626.62 29.4 1320.35 14.8 2001 6362.44 66.3 2867.04 29.9 1447.15 15.1 2002 7874.44 59.9 3138.50 26.6 1589.13 13.5 2003 8155.24 69.9 3535.20 30.3 1804.40 15.5

Source: China’s Statistics Bureau

Figure 5: Total Social Investment in Fixed Assets in Urban and Rural Areas

70000 Figure 6: The Disposable Income Per person in Urban and Rural Areas 60000 50000 40000 26 Urban 30000 Rural 20000 10000 0

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 1995

Figure 6: The Disposable Income Per person in Urban and Rural Areas

10000

9000

8000

7000

6000

RMB 5000

4000

3000

2000

1000

0 1978 1985 1990 1992 1994 1996 1998 2000 2002 2004

year

Urban Rural

Figure 7: China’s Geni Coefficient (1988-2001)

0.459 0.5 0.417 0.389 0.397 0.4 0.34 0.343 0.3 1 0.2 0.1 0 1988 1990 1995 1999 2000 2001

year

27 China’s dual economy faces several problems in the new century, such as: Domestic demand difficultly increased in late 1990s; With China’s entry into WTO, the huge population in rural areas would face a serious competition of western commodities. Due to the enormous energy consumption by industrial manufacturing needed to supply to the international market, China’s is facing a domestic energy and environmental pollution crisis.

2.2. China is an open dual economy

China differs from the traditional dual economy in that China is opening up both externally to the world and internally to its provinces. This is especially the case since China entered the WTO in 2001. With its commitments to the WTO, China has gradually lowered tariffs for more and more products and services imported from the rest of world. Factors of production, such as capital, labor, and land are also moving more freely to and from other provinces inside China as well as to and from foreign countries. Economic resources are being reallocated efficiently both at home and abroad. The difficulty with China’s widespread economic growth and development is that, motivated by foreign trade, manufacturing has developed much more rapidly than has agriculture, and the result has been to widen the economic and developmental gap between urban and rural areas. Manufacturers are importing advanced technologies to produce goods not only to satisfy domestic demand but also to meet the needs of the rest of world. Not surprisingly, more and more stores in international cities sell a high percentage of products, sometimes as much as 90% or more, that are “made in China.” In contrast, sales in China’s rural areas are low. Indeed, services in many poor rural areas are inadequate for meeting basic needs. China must find ways to rectify this imbalance between its supply of goods for its foreign markets and for its own domestic markets, which remain largely untapped though potentially enormous. With the aim of establishing a uniform market domestically and of integrating markets internationally, the Chinese government is using its macro policies to benefit the development of rural areas. In particular, the government is carrying out a policy of tax- deductions for the cultivation of farmland, a policy that allows farmers to make planting decisions themselves and that shifts responsibility of meeting market demand to them. In some areas not suitable for cultivation, farmers are allowed to plant trees and otherwise diversify their operations in business or services without paying taxes. Simultaneously, the government has attached much importance to service industries, which often employ the greatest number of workers from rural areas and contribute more added value to the productions of goods and services. Since then the services industry— including transportation, telecommunications, finance, insurance companies, commercial marketing, and so on—has increased dramatically. As a result, between 1978 and 2003, the distribution of employment by sector has changed dramatically (see Table 2).

Table 2: The Distribution of Employment by Sector

Year Primary sector (%) Secondary sector(%) Tertiary sector(%) 1978 70.5 17.1 12.2 2003 49.2 23.0 28.8

Source: China Statistics Yearbook 1979-2005

28 2.3. Transferring China’s productive capacity from urban to rural areas

The technologies and capital that were developed early in urban areas were small in scale and easy to learn now need to be transferred to rural areas, where the need for investments in consumer products and services is great. Figure 5 shows that the total social investment in fixed assets in rural areas fall far behind the investment in urban areas. Since 2003 macroeconomic policies have intended to promote such transfer by encouraging small and medium sized firms and township firms to develop and support agricultural banking. In particular, policies have encouraged banks to make small loans to profitable projects and programs in rural areas. These policies have also directed financial support to the program, “The Construction of New Socialist Country-sides,” which has endeavored to develop information services, television and computer programming, plant disease-prevention, construction of planting and irrigation systems, and construction of roads and public facilities, all in rural development. According to the Chinese Ministry of Commerce, the total social investment in fixed assets in 2006 represents a growth rate of 26.6%; of the 7.9 trillion RMB total investment, and 4.5 trillion RMB was for services and agriculture.

2.4. From “big” to “strong” – Exporting China’s innovations

Although China’s fast GDP growth, has created a double surplus (in both its balance of trade and its foreign reserves, which amount to $76.9 million), China is still a developing country. With its GDP per person at over $1,000, the cost of living is much higher (according to its Engel Index) than in other developed countries. Moreover, its standard of living is seriously affected by pollution because of the influx of manufacturing since the 1980s. Most of China’s export products are labor-intensive; what is more, they are not goods created by Chinese firms themselves but by foreign brands. China has a long way to go to become economically “strong.” It needs more innovations in many fields; it needs sustained accumulation of capital and human resources, it needs development of agriculture, science and technology, and industries; and it needs environmental protection.

3. China’s Opening Dual Economy and Service Investments: Challenges and Opportunities:

With the opening-up of its dual economy, China is facing many challenges and opportunities. Investing in China’s service industry benefits China’s workers, saves its energy resources, and protects its environment.

3.1 Challenges to China’s economic development

Rapid economic growth and development in China brings such problems as a rising unemployment rate, a growing disparity between rich and poor, serious shortages of energy, and a deteriorating environment with detrimental effects on people’s health. These challenges mean that China must change its model for economic growth. China must be both industry- and agriculture-centered; in addition it must rapidly modernize its services industry. Doing so will enable China to sustain the growth of its market economy and to address the gaps between rural and urban areas with regard to the network of services, including science and technology, banking and financing, information and consulting, food services and entertainment, etc.

29 3.2. Opportunities for services investments

The opening-up of China’s economy will stimulate more efficient allocation and reallocation, domestically and internationally, of production resources. China currently has a saving surplus over 1.1 billion RMB potentially available for investment. Given some preferential policies for service investment, the saving surplus can be used to promote the development of rural areas. Presently, China is following macro policies to encourage capital to flow from urban areas to rural areas in order to balance the development of China’s three major economic sectors and to promote sustained and sustainable growth. To facilitate this reallocation of resources, China’s government has expended an increasing among of money on its rural infrastructure, such as roads and railways, in order to facilitate rural development. In addition, China is pursuing macro-policies that promote labor- and talent-intensive services, that ease the burden on and to stimulate those private businesses that are easy to set up with small amounts of capital and that reduce unemployment. Figure 9 shows the composition of China’s GDP, about 30% of which comes from the tertiary industry, which is not enough to meet the demand for consumer services.

Figure 9 Composition of China's GDP

30 %

7 4 8 0 9 002 0 1984 1 1989 1992 1994 1997 1999 2 2 year

Primary Industry Secondary Industry Tertiary Industry

Source: National Statistics Bureau

Figure 10 shows that the contribution of services to China’s overall GDP is much lower than is the contribution of manufacturing, which means that there is much room for services investment to absorb the surplus in saving and human resources. Compared to some developed nations, in which the services industry constitutes about 70% of GDP, China has a large potential service market.

30 Figure 10: Contributing Rate of the Three Industries to China’s GDP

80 70 60

50 Tertiary Industry 40

Percentage Secondary 30 Industry Primary Industry 20 10 0

0 2 4 8 0 2 4 9 9 9 0 0 0 9 9 9 0 0 0 1 1 1 1996 199 2 2 2

Source: China’s Statistics Bureau

China has opportunities to make choices that will help it sustain its economic growth and development, create a more balanced economic base of strong industrialization (achieved by utilizing economic resources rationally but not overexploiting them), strong service businesses, strong protection of its natural environment, and a reduction of its unemployment rate. In modernizing both its urban and rural regions, China has opportunities to use more advanced science and technologies, to increase its efforts at innovation, and to further its economic self-reliance.

4. Using both Domestic and Foreign Resources, China’s Expanding Dual Economy Benefits Services Investors:

To increase investment in services, China must modernize its production techniques as well as avail itself of international production. To develop its services industry, China must transfer some of its domestic resources (capital, labor, and entrepreneurship) from urban areas to rural areas domestically; to satisfy existing demand, in both urban and rural regions, for services, it needs to import such businesses.

4.1. Balanced development and China’s expanding services industry

There are significant gaps – in capital, technology, and management – between rural and urban areas. China has much to learn from the advanced management practices of western countries and needs significant foreign capital to convert this knowledge into improved services. Table 3 shows that China in the past years has attracted much foreign capital and many services by using foreign management, franchising, and investment techniques. Table 3 also shows that FDI used in the more urban eastern region is much greater than in the middle and western regions, which are mostly rural. The table thus suggests that there are opportunities to develop the market for goods and services in rural areas of China, opportunities that will require more foreign capital. In particular, businesses

31 involved in science and technology, agriculture, market consulting, and banking may be attractive opportunities for both domestic and foreign investors.

Table 3: The FDI （RMB）Attracted in the Eastern, Middle, and Western Areas

The Eastern The Middle The Western Year Volume of Total Volume of Total Volume of Total (b. ¥) (%) (b. ¥) (%) (b. ¥) (%) 1998 1164.29 53.9 605.12 28.0 344.79 15.9 1999 3361.54 57.5 1586.76 27.1 814.03 13.9 2001 5773.97 64.6 2626.62 29.4 1320.35 14.8 2002 6362.44 66.3 2867.04 29.9 1447.15 15.1 2003 7074.44 59.9 3138.50 26.6 1589.13 13.5 2004 8155.24 69.9 3535.20 30.3 1804.40 15.5

Source: China’s Statistics Bureau

Table 4 shows in detail the FDI in China by sector. More and more foreign services – such as Mcdonalds, Kentucky Fried Chicken, Ikea, Karifort, Volmark, Citibank, etc. – have entered China’s market. Some of them have expanded considerably. For example, Carrefour entered the Chinese market in 1995 and established the largest mall in Beijing and Shanghai at that time. Today, Carrefour has set up 45 malls in 23 cities and has 230,000 employees. Clearly, its operating culture – embodied in such slogans as “Happy shopping in Carrefour” and “one-stop shopping” – have been well received by the Chinese consumers. More generally, the influx of foreign services not only changes people’s desires for new products and services and thus their modes of consumption, it also improves the quality of service management, fills capital gaps in large-scale supermarkets, transfers advanced managerial skills and techniques, and provides examples of what domestic service businesses might do differently. The influx of foreign capital has enabled shops and malls to be set up quickly through franchising and chains. In turn, Chinese brands of goods and services have been marketed in these supermarkets both at home and abroad and have promoted an international recognition of Chinese products. In short, the development of the services industry in China has helped render the Chinese market more rational and more balanced, it has helped raise the standard of living for the Chinese people, and it has reduced the disparity between the rich and the poor.

4.2. Characteristics of services industry in China:

Characteristics of the services industry in China are as (a) of a small scale in terms of investments, (b) labor- and talent-intensive, (c) able to gear up quickly, (d) more and more private-owned, (e) and easy to set up in either urban or rural areas. Since Chinese economic reform has taken the system from a planned economy to a market economy, capital accumulation for industry growth has come mainly from agriculture and commodities trade with foreign countries, a circumstance made possible by macro-policies giving preferential treatment and consideration to the development of manufacturing. To develop its agriculture and services sectors, China will have to depend partially on state- owned firms at first but more and more on private resources that can respond more flexibly to changes in the domestic and international market.

32 Table 4: Foreign Direct Investment by Sector (2004)

Actual Number of Contracted Sector Utilized Projects Value Value (unit) (USD 10,000) (USD 10,000) Total 43,664 1,5347,895 6,062,998 Agriculture, Forestry, Animal 1130 327,096 111,434 Husbandry and Fishing Mining 279 115581 53800 Manufacturing 30,386 1,0973,576 4,301,724 Production and Distribution of 455 396,049 113,624 Electricity, Gas and Water Construction 411 176,889 77,158 Transport, Storage and Post 237,290 127,285 Information Transmission, Computer 1,622 202,137 91,609 Services and Software Wholesale and Retail Trade 1,700 250,053 73,959 Hotel and Restaurants 1,174 216,887 84,094 Financial Intermediation 43 57,541 25,248 Real Estate 1,767 1,348,802 595,015 Leasing and Business Services 2,661 674,248 282,423 Scientific Research, Technical 629 100,641 29,384 Service and Geologic Prospecting Management of Water Conservancy, 164 82,209 22,911 Environment and Public Facilities Services to Households and Other 251 54,251 15,795 Services Education 59 17,274 3,841 Health, Social Security and Social 21 14,720 8,738 Welfare Culture, Sports and Entertainment 272 101,281 44,776 Public Management and Social 2 1,370 180 Organization

Source: China’s Statistics Bureau

4.3. Advantages of more investment in China’s services industry

More investment in China’s service industry may help selling goods and services in rural areas based on their consumer needs. It may help in the transfer of the science and technologies that are crucial to agricultural development. It may also help China balance its economic development in all its regions and move its surplus labor from rural areas to those urban areas experiencing a rising demand for service industries. Table 5 illustrates how foreign capital is producing a win-win outcome.

33 Table 5: Foreign Capital in China in the Last Five Years

By End of June 2006: • Foreign Operating Banks in China: 71 • Funds Joint Ventures in China: 23 • Securities Brokerage Joint Ventures in China: 7

By end of 2005: • Foreign Commercial Businesses in China: 341 • Share of Foreign Supermarkets in China: more than 25%

During 5 years After China entered the WTO • Foreign Capital Repatriation from China: $57.94(b.) • Value of China’s Import of Commodities: $2400(b.)

China’s economic contribution to the world economy: 13%

Source: Ministry of Commerce

5. Advantages of China’s Service Industry and China’s International Investments:

Entry into the WTO means that China is allowed to enter more markets in the rest of world because of the principle of equality. In this regard one of the China’s opening-up policies is to encourage individuals and firms “going abroad.” In order to successfully meet its opportunities and challenges, Chinese businesses must have a clear understanding of the comparative advantages of their services when they draw up plans to “go out.” Products original or native to China– brands like “Hair,” “Lenovo” services, Chinese foods (“Quanjude,” roast duck, “Fangshan,” or Chinese food for emperors), Chinese medicines and medical care services (“Tongrentang”), commercial services (“Wangfujing”), Chinese culture (arts，sculptures and architectures, China’s history, Confucian philosophy, and its natural tourist sites) – are all immensely attractive to both the Chinese consumer and consumers around the world. China has begun to develop its comparative advantages in new areas and provinces –culture resources in Beijing, Tianjin, Xian, Xizang, Xinjiang, Yunnan, Shanxi, Sichuan, Fujian, for example, and any number of wondrous natural tourist resources in Hainan, Xizang, Guizhou, Jiangxi, Anhui, Guizhou, Shandong. All in all, when Chinese businesses intend to “go abroad,” they have significant opportunities to be think through the advantages of their goods and services. In sum, with the opening up of its dual economy and its membership in the WTO, China has acquired an enormous services market. In consequence, domestic and foreign investments in its services industry are expanding rapidly. This development is extremely promising, for service industry investment is a bridge that will quickly connect China’s urban and rural regions, and that connection in turn will benefit China’s construction of a more rational economy. To make the further transition from a dual

34 economy to a uniform and integrated economy, China needs a balanced development, which will enable the nation to avoid unhealthy disparities of wealth, shortages of energy, and other disruptions in the process of modernization. More investment in services industries, especially in talent-intensive services, will help China move from being simply a “big” economy to a “strong” economy.

References:

Chen, Jiagui. (2007). Blue book of China’s economy: Analysis and forecast on China’s economy. China: Social Sciences Academic Press.

Meier, Gerald M. & Seers, Dudley Seers. (1984). Pioneers in development. Oxford University Press.

36 THE STATUS OF CHINESE ECONOMIC POWER AND INFLUENCE: OBSERVATIONS FROM STATISTICAL DATA

Xiaoning Ni School of International Economics and Trade Beijing International Studies University

Abstract

This paper analyzes the influential power of China’s economy by examining statistical data, according to comparisons of the whole economy, the international goods market, flows of the direct foreign investment, and the internationalization of the RMB. The data observation discloses several situations. For example, the Chinese economy can smooth the fluctuation of the world economy; the Chinese economy has a quite limited influence on international investment; and the Chinese economy has a much more important position in the Asian economy.

Introduction:

Now and for the foreseeable future, China’s economy occupies a central position in the world economy. Against the backdrop of the opening up of China’s market and its economic reforms as well as of the complicated nature of specialized production around the world and the increasingly information-based nature of the global economy, by the end of 2005 the Chinese GDP ranked fourth in the world and its international trade ranked third. Over the past 29 years, GDP in China grew at an annual rate of 9.6%.1 Moreover, the GDP per capita grew rapidly from $168 in 1978 to more than $1,700 in 2005. The total GDP rose sharply from 0.4 trillion RMB in 1979 to 13.8 trillion RMB in 2005. As every coin has two sides, China is facing challenges and pressures from such sky- rocketing growth. This paper discusses China’s complex economic situation by analyzing recent data, which show either a powerful economy or some of the difficulties the Chinese economy faces in an era of openness.

1. Observations on the GDP Scale:

Two indices and two clues underscore the size of China’s economy. The two indices are the GDP index based on the U.S. dollar price and the GDP index based on the Purchasing Power Parity (PPP). The two clues are the time serials comparison of Chinese GDP as a percentage of the gross world product and of Chinese GDP in comparison with the GDP of Japan, India, and the U.S. Figure 1 shows that how the Chinese economy has more than doubled in size as a percentage of the world economy. In 1980 it was 1.85% of the world economy; it was 1.6% in 1990; four years later it was over 2%; in 1997 it was over 3%; and in 2003 it was 3.9%. In terms of incremental proportions, China’s increases are irregular due to fluctuations in the global economy. In fact, because economic growth in China has been rapid and steady, China’s economy has helped smooth out fluctuations in the world economy. Figure 1: Proportion of Chinese GDP to the World Domestic Products

1 Except as noted, all data come from International Statistics Yearbook (2005).

) 20 18 15 13 10 of world(% of 8 5 3 the sum the 0

Chi na' s pr opor GDP t i on i n Year 0 2 8 99 99 996 99 002 1980 1 1 1994 1 1 2000 2 Scal e propor t i on Increment propor t i on

The total Chinese PPP ranked second in the world and was only smaller than that of the U.S. Table 1 shows that the proportion of the Chinese GDP in terms of PPP jumped to 12.4% in 2003; in terms of dollars it increased to 3.9%.

Table 1: Proportion of GDP in the World Gross in 2003

Proportion of GDP in the sum of world (%) China Japan India USA In dollars 3.9 11.8 1.8 30.0 In PPP 12.4 6.9 5.9 21.1

2. Observation of the International Goods Market:

Two indexes (Chinese imports and exports as a percentage of total world imports and exports and as a percentage of total Asian imports and exports) and two clues (the time serials comparison and the comparison among some countries) also help clarify the size of China’s economy. The size of Chinese imports and exports in relation to the world gross and to the Asian gross has increased steadily since 1990. Thus, in 2004, Chinese exports constituted 22.6% of the Asian gross and 6.5% of the world gross (see Figure 2). Moreover, Figures 2 and 3 show that the increase is significantly higher than the increase for the world in general and for Asia in particular. Thus, both figures underscore how important the Chinese economy was to both the world goods market and especially to the Asian goods market. Both figures also suggest that China was more and more tightly connected to and dependent on the world economy. Table 2 provides a breakdown comparison between China on the one hand and India, Japan, and the U.S. on the other hand with respect to the size of their respective exports in relation to the sum total of world exports and the sum total of Asian exports. These figures clearly show that the Chinese influence was far more significant than India’s and somewhat stronger than Japan’s in both the world and Asian goods market. Not surprisingly, the Chinese economy has an enormous influence on the Asian economy.

38 Figure 2: Export Proportion in the World and Asian Sum

) 30 25 20 15 Pr opor t i on( % 10

5 0 Year 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Chi na' s expor t pr opor t i on i n t he sum of Asia Ch i n a ' s expor t pr opor t i on i n sum of worl d

Figure 3: Import Proportion in the World and Asian Sum

Pr opor t10 i on（％）

5 Year 0 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Chi nese i mpor t pr opor t i on i n t he Asi an gr oss Chi nese i mpor t propor t i on i n t he wor l d gross

Table 2: Comparison of Export Proportion in 2004

Proportion of China’s export Occupation in the world Occupation in Asia (%) China 6.5 22.6 India 0.8 2.8 Japan 6.2 21.5 USA 9.0 －

Table 3 clarifies that the main export product of China is finished products. In 2003, finished products were 90.6% of total Chinese exports. Table 4 shows that among China, India, Japan and the U.S., China imported the largest amount of raw and processed materials, minerals, metals, and finished products in 2003. The amount of these imports

39 terms was approximately equal to the amount of China’s finished export products in the same period. Clearly, China’s economy has significant influence on the international raw and processed materials and finished products markets.

Table 3: Export Goods Structure (%) in 2003 Raw and Countries and Minerals and Finished processed Foods Fuels regions metals products materials World 1.9 8.1 7.4 2.8 76.5 China 0.6 4.4 2.5 1.6 90.6 India 1.3 11.3 5.7 4 76.5 Japan 0.5 0.5 0.4 1.4 93.1 USA 2.6 8.7 2.1 2.1 80.4

Table 4: Import Goods Structure (%) in 2003 Raw and Countries and Minerals and Finished processed Foods Fuels regions metals products materials World 1.8 7.6 10.3 2.8 74.7 China 3.8 3.6 7 5.3 80 India 3.3 5.8 31.5 4.3 54.3 Japan 2.5 12.3 21.1 4.9 57.6 USA 1.3 4.7 12.5 1.7 76.1

Table 3 and Table 4 also show that China imported significantly more basic materials – such as raw and processed materials, minerals, and metals used in manufacturing industries – than did the rest of the world in general and other Asian countries in particular. It also imported much less fuel than did India and Japan and even the U.S.

3. Direct Foreign Investment:

Figure 4 shows that many international companies were attracted by China’s geographic size and the enormous potential domestic demand that might be tapped in a population of 1.3 billion. For this reason the total direct foreign investment accepted by China was accelerating. Indeed, in 2003 foreign investment in China was almost twice the foreign investment in the U.S. From 1990 to 2003, foreign investment in China grew five- fold; in the same period, there was nearly no change in the foreign investment in Japan. Also in the same period, investment in India lagged far behind investment in China. Most strikingly, investment in the U.S. dropped dramatically.

40 Figure 4: Proportion of the Foreign Direct Investment Accepted

A A 25 US ) US

15 Pr opor t i on( % na hi 10 C

A US na 5 hi C i a an hi na i a i a an p C d apan d p nd a n J n I J I I Ja 0 Year 1990 2000 2003

Figure 5 shows that Chinese capital investments in other countries has remained negligible compared with the foreign capital investments absorbed by China while the percentage of total U.S. investment in foreign nations as opposed to itself continued to rise.

Figure 5: Proportion of Chinese Capital Invested in the World

30 )

SA U 25

Japan 20 Pr opor t i on( %

15 USA USA

10 n

n Japa 5 Japa na na i di a Chi na India Ch India Chi In 0 Year 1990 2000 2003

Together, figures 4 and 5 indicate that, although China has been a huge international factory, its foreign investment was perhaps much, much smaller than people might have realized.

4. Observation on the Internationalization of the RMB:

At present, the RMB is partly convertible and is not an international currency. But it is circulating in the neighboring countries and regions and sometimes in place of their own primary currencies. According to the estimation of Li Jing et. Al. (2004), the total RBM circulating across the country’s border was about 3.4 billion RMB in 1994 surging to

41 321.9 billion RMB in 2003. Figure 6 shows that the turning point in this sharp increase was 1998, when Asia’s financial crisis occurred. This evidence shows the impact of China’s economy in Asia. With the future internationalization of the RMB, the position and the influence of China will be strengthened.

Figure 6: Scale of RMB Circulating Over Country Border

350 300 250 200 150

Scale（billion yuans） Scale（billion 100 50 Year 0 1992 1994 1996 1998 2000 2002 2004

Notes: The data are from Li, Jing et al. (2004).

5. Conclusions

Based on the statistical data analyzed above, with its strong steady growth, the Chinese economy is smoothing fluctuations away in the world economy. Those who think China is a menace are terribly wrong. The Chinese economy plays a significant role in the world in general and Asia in particular in the finished products as well as in the raw and processed minerals, metals, and other materials it supplies. China is economically vulnerable, since its finished product industry relies heavily on the overseas markets and its heavy industries on the international material markets. In other words, China’s rapid growth has unintended consequences – namely, mounting economic insecurity. However, the course of internationalization of RMB is good for China and its expanding role in the financial markets is most likely to continue. It will solidify the Chinese economy position in Asia and throughout the world. Clearly, the influence of China will continue to become stronger.

References:

Huang, Haizhou. (2006). China’s economic development and the global economy. Comparative Studies (Chinese edition), 23, 87-94.

International Statistics Yearbook. (2005). China Statistics Press.

Li, J., Guan T., & He F. (2004). The situation of RMB circulating over country border and its influence on China’s economy (Chinese edition). Management world, 9, 45-52.

42 ANALYSIS OF THE SHORTCOMINGS OF CHINESE CORPORATE GOVERNANCE WITHIN A PARENT- SUBSIDIARY FRAMEWORK – EXAMPLES FROM 196 LISTED COMPANIES CONTROLLED BY THE SASAC

Zhao Yuhua School of International Economics and Trade Beijing International Studies University

Abstract

Through the analysis of industry stage and industry distribution for 196 listed companies and their parent companies, it is found that many of the institutional arrangements for regulating the controlling shareholders are insufficient. In consequence, the issue of how to tackle the problem of the subsidiary company going public should be of significant concern. This paper’s contribution is to analyze Chinese corporate governance in the parent-subsidiary organization structure and to provide some data about listed companies and their parent companies.

Introduction:

The improper behavior of controlling shareholders of listed companies in China has been a matter of great concern. Scholars have focused on analyzing the equity ownership structure (EOS) on the basis of modern theories of the firm (Denis, 2003). However, current research mainly concerns the characteristics of EOS for free-standing firms, characteristics such as concentration or dispersion, financial organization, or insider shareholder control. Little research concerns the unique characteristic of Chinese listed firms, 91.4% of which are controlled by other commercial firms.(Liu, 2003). In consequence, two questions arise. First, what is the mode of corporate governance within the parent-subsidiary organization structure? Second, is the institutional arrangement to regulate controlling shareholders of free-standing firms, learned from Western countries, still applicable to the parent-subsidiary organization structure? The research about parent-subsidiary corporate governance identifies three generic types of control: financial control, strategic planning, and strategic control. In the form of financial control, the subsidiary company is autonomous with the parent company mainly concerned about the subsidiary company improving its investment performance. In contrast, in the other two types of control, the parent company often adopts a series of controlling mechanisms (Doz & Prahalad , 1981; Gupta & Govindarajan, 1991) with the subsidiary company in effect losing its independence as a free-standing firm, a situation that is hard to avoid by law or by market force (Brudney & Clark,1981; Bebchuk, 1989). What is the key factor influencing parent-subsidiary governance structure? Goold and Campbell (1988) revealed, on the one hand, that among corporations that own many diverse businesses, the parent company tends to exert financial control and, on the other hand, that among corporations that own similar businesses in a state of rapid change, the parent company prefers to strongly coordinate and supervise strategy and action, and even to drive the subsidiary company’s strategy in order to ensure the interests of the corporation. Many empirical studies in Western countries about divestiture also show that subsidiaries going public tend to occur when the parent company is in a stage of maturity or decline and aiming to promote a new growth opportunity (Powell and Yawson, 2004). In this regard, very important questions are: what are the industry characteristics of the Chinese listed

43 companies and their parent companies, and what is the best type of corporate governance for ensuring the independence of the listed companies through regulation of the controlling shareholders? For a long time the condition of parent companies has been a black box for the public investor, and scholars have been limited to conducting individual case studies rather than cross-company, qualitative analyses. Following the establishment in 2003 of the State- Owned Assets Supervision and Administration Commission of State Council (SASAC), the disclosure of information about state-owned parent companies improved, providing opportunities to do some quantitative analysis. The rest of this paper will analyze the specific characteristics of Chinese corporate governance for the 196 listed companies and their parent companies controlled by SASAC. To this end this paper will (i) characterize the listed companies controlled by SASAC, (ii) review the differences between parent companies and their subsidiaries, and (iii) draw several conclusions.

1. Basic Conditions of Listed Companies Controlled by SASAC:

The number of business groups controlled by SASAC as of December 30, 2003, is 189, 107 business groups which have no listed subsidiaries, and 82 groups have a combined total of 196 listed subsidiaries. Most are listed on the Shanghai and Shenzhen securities exchanges; some 27 companies are listed on the Hong Kong exchange.

1.1 The high incidence of pyramiding

Among the listed companies controlled by highly centralized business groups, an obvious characteristic is the high incidence of pyramiding. There are 23 groups each of which controls more than three listed companies, and 11 groups each of which controls two listed companies. In sum, 33 business groups control 126 (or 64.29% of) listed companies (see Table 1).

1.2 The separation of cash flow rights and control rights

From the viewpoint of the control chain, another obvious characteristic of central government-controlled listed companies is that none of those 196 listed companies is directly owned by SASAC. In addition, 82 listed companies (41.84%) are controlled through two tiers; 94 (47.86%) are controlled through three tiers; 18 (9.18%) are controlled through four tiers; and only two listed are controlled through either five or six tiers (see Table 2). Statistical inspection of the separation of cash flow rights and control rights (see Table 3) reveals that there is no great difference, since many intermediary holding companies are entirely owned ,which is different from the case of East Asian corporations and privately owned Chinese companies (Claessens, Diankov, Fan., & Lang, 2000; Zhang et al., 2004).

44 Table 1: Situation of Pyramiding for Central Government-Controlled Business Groups

Number of listed Number of Number of Name of business group companies business group listed companies

15 1 15 China Petrochemical Group Corporation

13 1 13 China Merchants Group Corporation

12 1 12 China Resources Group Corporation

8 3 24 China North Industries Group Corporation, China Aviation Industry Corporation II, China-aerospace Science and Industry Corporation 6 1 6 China Telecommunications Corporation

5 2 10 China National Petroleum Corporation, China Potevio Co.Ltd 4 4 16 China Ocean Shiping Company, China Aerospace Science and Technology Corporation, China Worldbest Group Corporation, China Greatwall Group Corporation 3 10 30 China National Offshore Oil Corporation, China Aviation Industry Corporation I, China Power Investment Corporation, China Aluminum Group Corporation, China Faw Group Corporation, China South Industry Corporation, China State Shipbuilding Corporation, China Shipping Group Company, China National Bluestar Group Corporation, 999 Group Corporation 2 11 22 Shanghai Baosteel Group Corporation, China Dating Corporation, Dongfeng Motor Corporation, State Development and Investment Corporation, China Guodian Corporation, China National Foreign Trade Transportation Group Corporation, China National Building Mterial Group Corporation, China Telecom Science and Technology institute, Dongfang Electric Corporation, Union Developing Group of China Co.LTD, China Textile Material Group Corporation 1 48 48 China National Pharmaceutical Group Corporation and other 48 business groups 0 107 0 China National Seed Group Corporation and other 107 business groups total 189 196

Source: annual report of listed companies

45 Table 2: Tiers of Control Chain for Central Government-Controlled Listed Companies

Tiers of control chain Number of listed companies Percent 1 0 0 2 82 41.84% 3 94 47.96% 4 18 9.18% 5 1 0.51% 6 1 0.51% sum 196 100.00%

Source: 2003 annual report of listed companies

Table 3: Separation of Cash Flow Rights and Control Rights for Listed Companies Controlled by Central Government

Control rights Cash flow rights Cash flow rights/control rights STDEV 17.17 17.86 104.01 Minimum 8.45 8.45 100.00 Maximum 90.00 90.00 100.00 Average 50.41 45.33 89.92 Mean 53.29 45.20 84.83 1st quartile 38.66 30.33 78.43 3rd quartile 62.31 60.00 96.29

Source: 2003 annual report of listed companies.

2. Analysis of Industry Distribution of Listed Company and Its Parent Company:

In terms of an industry’s growth stage, many empirical studies use either CR4, 2 CR8, or HI indexes to reveal that the concentration index of most Chinese industries is very

1 CR4, CR8 and HI are indexes to analyze industry concentration. N N 2 CRN = ∑ Si ; H N = ∑ S i=1 i=1 Where: CRN =Concentration ratio for N firms; HN = Herfindahl index for N firms th 2 th N = Number of firms; Si = i firm’s share; S = i firm’s share squared

46 low, which means that they are in an initial or growing stage (Wei, 1995). In other words, the institutional arrangement leading to the subsidiary company going public is typically not the result of a mature parent company aiming for new growth opportunities. Since as of 2005 SASAC has characterized the core business for only 98 business group, we are in the position of relying on a limited sample for the following industry distribution analysis. By SASAC arrangement (except for the China Energy Conservation Investment Corporation, the China Chengtong Group), State Development and Investment corporations belong to pure holding corporations while others belong to operating holding companies. Further analysis of the core business of listed companies and their parent companies shows that, except for Baosight Soft Corporation and its parent company, Shanghai Baosteel Company, the subsidiary companies belong to the same industry as the core company. A close inspection of 34 business groups each of which controls more than two listed companies indicates that most of them do business in the same or related industry; the subsidiary companies of only six business groups are in totally different industries; the subsidiary companies of ten 10 business groups are partly in the same industry and partly in different industries (see Table 4).

Table 4: Industry Distribution for Listed Companies and Its Parent Company

Industry Number of Name of business group distribution businesses in group Same or related 18 China Petrochemical Group Corporation, China National Petroleum Corporation, China Dating Corporation, China Power Investment Corporation, Dongfeng Motor Corporation, China Faw Group Corporation, China Guodian Corporation, China Aluminum Group Corporation, China Shipping Group Company, China Potevio Co.Ltd, China National Building Material Group Corporation ,China Greatwall Group Corporation, China Telecom Science and Technology Institute, Dongfang Electric Corporation, Union Developing Group of China Co.LTD, China Textile Material Group Corporation, China National Foreign Trade Transportation Group Corporation, China National Offshore Oil Corporation Partly different 10 China North Industries Group Corporation, China Aviation Industry Corporation II, China-aerospace Science and Industry Corporation, China Telecommunications Corporation, China Merchants Group Corporation, China State Shipbuilding Corporation, China Worldbest Group Corporation, China National Bluestar Group Corporation, 999 Group Corporation, China Resources Group Corporation Totally different 6 Shanghai Baosteel Group Corporation, China Aviation Industry Corporation I, China Ocean Shiping Company, China Ocean Shiping Company, China Aerospace Science and Technology Corporation ,China South Industry Corporation

Source: website Of SASAC and listed companies

In sum, most Chinese business group are still in the initial or growing stage of the industry life cycle, which means that the best strategy for the development of a business group is to make horizontal or vertical mergers in pursuit of economies of scale rather than to promote the operational independence of the subsidiary companies. Because there is a high correlation between listed companies and their parent companies in terms of being in the same industry, parent companies should prefer to choose the types of strategic planning or strategic control that would enable them to pursue the interest of their business group rather than the interests of the listed subsidiaries alone.

3. Conclusion:

Our analysis of 196 listed companies and their relation (same as or different from) the core industry of their parent companies indicates that, in their current (initial or growing) stage of development, the best strategy for the parent business group is to pursue the overarching interests of the parent group rather than the interests of the listed companies alone. This implies that mechanisms to regulate the controlling shareholders will be at cross-purposes to the interests of the parent groups. Because the history of U.S. and U.K. equity ownership structure (EOS) reveals the importance of transparent EOS for listed companies, Chinese government and scholars should promote the formation of companies the organizational structure of which is independent of the parent company’s control.

References:

Bebchuk, Lucian A. (1989). Limiting contractual freedom in corporate law: The desirable constraints on charter amendments. Harvard Law Review 102, 1820-1860.

Brudney, Victor., & Robert Clark. (1981). A new look at corporate opportunities. Harvard Law Review 94, 997-1062.

Classens, S., S. Djankov., & L. H. P. Lang. (2000). The separation of ownership and control in East Asian corporations. Journal of Financial Economics 58, 81-112.

Denis., Diane K. & John J,Mcconnell. (2003). International corporate governance. Journal of Financial and Quantitative Analysis 38, 1-36.

Doz, Y.L., & Prahalad,C.K.(1981). Headquarters influence and strategic control in MNCs. Sloan Management Review 23(1), 15-29.

Franks, Julian, Colin Mayer., & Stefano Rossi. (2004). Spending less time with the family: The decline of family ownership in the United Kingdom. National Bureau of Economic Research (NBER) working paper No.10628. Retrieved May 22, 2006 from http://ideas.repec.org/p/sbs/wpsefe/2003fe15.html.

Goold, Michael, & Campbell, Andrew. (1988). Strategies and styles: The role of the centre in managing diversified corporations. Blackwell. Graemek. Deans, Fritz Kroeager, Stefan Zeisel，2004, Winning the merger endgame: a playbook for profiting from the industry consolidation, China Machine Press, Beijing, China.

Gupta, A.K.,& Govindarajan,V. (1991). Knowledge flows and the structure of control within multinational corporations. Academy of Management Review 16, 4, 768-792

Hua Zhang, Junxi Zhang, & Min Song.(2004). The effect of separation between ownerhip and control on firm value: an empirical study on private listed companies in China, China Economic Quarterly，Vol. 3, supp.1-14.

Morck, Randall. (2004). How to eliminate pyramidal business groups: The double taxation of inter-corporate dividends and other incisive uses of tax policy. National Bureau of Economic Research (NBER) Working Paper No. W10944. Retrieved June 22, 2006 from http://ideas.repec.org/p/nbr/nberwo/10944.html.

Powell, Ronan., & Yawson, Alfred. (2005). Industry aspects of takeovers and divestitures: Evidence from the UK. Journal of Banking & Finance 29, 3015-3040.

Zhuojia Liu, Pei Sun & Naiquan Liu.(2003). The principal of ultimate ownership, equity structure, and firm performance, Economic Research journal, issue 4, 51-62.

49 50 MEASUREMENT OF BANKING SERVICE TRADE LIBERALIZATION IN CHINA

Xue Tong School of International Economics and Trade Beijing International Studies University

Abstract

This paper intends to measure the opening level of China’s banking service trade in terms of three issues: the opening degree committed in GATS, the opening level permitted by domestic policies, and the real market opening level. The conclusion is that the liberalization of China is lower than that of many developing countries so that too much worry is not necessary.

Introduction:

Back in 2001, when China entered the WTO, she signed a series of agreements, including the General Agreement on Trade in Services (GATS) and the Financial Services Agreement (FSA), which ensure that financial services trade in China will open gradually according to WTO’s rules. Due to the importance of the banking sector, it was worried that the commitment of liberalizing financial services would lead the banking sector to open too quickly and too liberally, a development that would adversely influence financial safety and economic stability. According to some academics, the commitment of China to the banking sector is rather liberal and the opening pace is relatively fast compared with other developing countries (Liu, 2005; Wang, 2003; Wang & Tian, 2002). As the transition period of five years is coming to an end, limitations on foreign banks – such as geographic location and customers – will be removed, which means the opening level of banking sector will increase further. It remains to be seen whether the opening level is too great compared with other developing countries. This paper intends to measure the opening level of China’s banking sector in terms of three issues: the opening degree committed in GATS, the opening level permitted by domestic policies, and the real market opening level.

1. Measuring China’s Openness of the Banking Sector Committed in GATS:

China’s WTO commitments concentrate on Mode 3 – i.e. commercial presence. Most commitments are about the extent of liberalization in the five years after entry into WTO by which limitations on the geographic location, customers, and the scope of business would be removed gradually. We intend to use the methods of Mattoo (1999) to measure the opening level to which China committed in signing GATS. Mattoo (1999) created a Liberalization Index to measure the opening level of the banking sector in 105 developing and transit countries1committed to GATS. His method was as follows: First, different weights were given to three modes of banking services2

1 China was not included since China was not a member of the WTO at that time,. 2 In order to capture the essential elements of these commitments without complicating the analysis unduly, Mattoo focuses on the first three modes – that is, cross-border supply, consumption abroad, and commercial presence not including the presence of natural persons. For banking services, he focuses on the market access commitments on acceptance of deposits and lending of all types.

51 according to their relative importance. Then, with respect to each mode, a numerical value of zero was attached to entries of “Unbound” and a value of one to entries of “No Limitations.” In the case of the first two modes, no distinction was made and a value of 0.5 was attached in all cases of restrictions. With respect to commercial presence, a more sophisticated approach was adopted: (1) “No new entry or unbound for new entry” received a value of 0.10. (2) “Discretionary licensing for new entry” was assigned a value of 0.25. (3) “Ceiling on foreign equity at less than 50%” was weighted at 0.50. (4) “Ceiling on foreign equity at more than 50%” received a value of 0.75. (5) “Restrictions on the legal form of commercial presence” also received a value of 0.75. (6) Finally, “Other minor restrictions” was weighted 0.75 as well. Under these weightings, the liberalization index is the modal weighted average of the value of the most restrictive measure applied by a country to each mode in the sector. Higher values of the liberalization index indicate that commitments have a greater liberalizing content. Following this method, the liberalization index of China when it committed to GATS at the time of accession to the WTO and five years later can be calculated respectively (see Table 1).

Table 1: Calculations of Liberalization Index of China’s Banking Sector Committed in GATS

Index Modal After Mode 3 Commitments Upon Weights Transition Accession Period Cross-border 0.16 Unbound 0 0 Supply Consumption 0.04 No Limitations 1 1 Abroad No limitations on geographic coverage and clients for foreign currency business. As for local currency business, restrictions on geographic coverage and clients exist upon accession and will be phased out within five years after accession. Commercial 0.80 Within five years after accession, any 0.25 0.75 Presence existing non-prudential measures restricting ownership, operation, and juridical form of foreign financial institutions, including on internal branching and licenses, shall be eliminated. Overall Index 0.24 0.64

As shown in Table 1, the calculations under modes of cross-border supply and consumption abroad are very clear. As for mode of commercial presence, since upon accession to WTO, there are limitations of clients and geographic coverage on a foreign banks’ RMB business; therefore, the value of the index under this mode should be 0.25. In

3 Mattoo gives different modal weights to deposit and lending business. Since there is no difference between the openness of deposit and lending business in China’s commitments, we just make a simple average of the weights.

52 that case the weighted average liberalization index is 0.24 upon accession. After the transition period, since China makes no specific commitment to or limitation on foreign ownership participation, the value of index should be 0.75 for Mode 3. In this case, after the transition period the opening degree will be much greater; the overall liberalization index will be 0.64. The liberalization indices4 of other countries’ banking sectors, as calculated by Mattoo (1999), are shown in Table 2. Compared with developing countries of other continents, the average liberalization level in Asian countries is relatively low. China’s opening level upon accession is lower than the average level of Asian countries but higher than some countries, such as Korea, India, Thailand, etc. After the transition period, the opening level of China will be at almost the same level with some developed countries. (The liberalization index is also 0.64 in the U.S., in EU countries, and in Canada).

Table 2: Liberalization Indices of Banking Sector Committed in GATS of Other Countries or Areas Countries/ India Korea Indonesia Thailand Malaysia Hong Kong Areas Liberalization 0.20 0.20 0.29 0.09 0.16 0.64 Index Countries/ Philippine Pakistan Hungry Bulgaria Poland Romania Areas Liberalization 0.24 0.20 0.20 0.60 0.60 0.99 Index Countries/ Argentina Brazil Chili Mexico EC Switzerland Areas Liberalization 0.84 0.20 0.20 0.41 0.64 0.84 Index Countries/ East Latin Developed Asia Africa All Areas Europe America Countries Liberalization 0.30 0.58 0.61 0.37 0.64 0.64 Index 5

Source: Mattoo (1999)

2. The Opening Level of Banking Sector Permitted by China Domestic Policies:

For various reasons, the required opening level of the banking sector in one country might be different from that permitted by domestic policies. In some countries the opening level permitted by domestic policies has actually been higher than the commitments required under GATS. For example, Philippine domestic law required 60 per cent foreign equity participation in commercial banks whereas GATS required 51 per cent. More usually, the opening level permitted by domestic policies is lower than that required by GATS. This is generally for the sake of protecting the domestic financial system, the

4 For simplicity, we make a simple average of liberalization index of deposit and lending business for each country. 5 They are GDP weighted averages of liberalization indices of countries in each area.

53 member countries might put forward measures to lower the real opening level If they do so for the purpose of prudential regulation, GATS permits it. What about the real opening level of China’s banking sector? Will the opening level be similar to that of developed countries after the transition period? We analyze these problems following the approach of Mattoo et.al. (2001). Based on the domestic policies of different countries, Mattoo et. al. (2001) ranks the openness of financial services of each country in relation to market structure, foreign equity permitted, and capital control. Market structure and foreign ownership permitted can reflect the openness of a country to commercial presence, while capital control can reflect the openness of cross-border supply because this mode often involves capital flows. If one country imposes no limitation on cross supply but puts restrictive control on capital flows, the real opening level would be lower than that required by GATS. The rankings range from 1 to 8 with higher values of the ranking indicating more banking openness. According to this approach, since limitations on the access of foreign banks exist upon China’s entry into the WTO, the market structure should be noncompetitive (see Table 3). And since the highest foreign participation allowed is 20 per cent, since this figure is much less than 50 per cent, and since the Dailami index is 1.37, which is smaller than 1.6, the liberalization rank of China is 1, which is the lowest level. After the transition period, even if all of limitations on foreign banks are removed so that the market structure becomes competitive, the liberalization rank will be 5 at most since the limitations on foreign ownership participation and capital flows will still exist.

Table 3: Methodology for Ranking Openness of Financial Services in Mattoo et. al. (2001)

Capital Controls (Dailami) Rank Market Structure Foreign Equity Permitted Index 6 8 Competitive ≥50% ≥1.6 7 Competitive ≥50% < 1.6 6 Competitive < 50% ≥1.6 5 Competitive < 50% < 1.6 4 Noncompetitive ≥50% ≥1.6 3 Noncompetitive ≥50% < 1.6 2 Noncompetitive < 50% ≥1.6 1 Noncompetitive < 50% < 1.6

Source: Mattoo et.al. (2001)

The liberalization rankings of other countries are shown in Table 4. Although China’s liberalization index when it committed to GATS (0.24) is higher than the indices of Korea, India, and Thailand upon their respective accessions, the liberalization rank permitted by domestic policies is lower than in these countries. Even if the liberalization index rises to 0.64 after the transition period, the liberalization rank will be at the same

6 The Dailami index, constructed by Dailami (2000), is a composite index based on a coding of rules, regulations, and administrative procedures affecting capital flows for a total of 27 individual transactions in the current and capital account of the balance of payments for each country. A higher value of the Dailami index indicates fewer restrictions on the current and capital account transactions. The Dailami index for China is 1.37 (Dailami, 2000).

54 level as in most of the developing countries and at a lower level than for developed countries.

Table 4: Liberalization Rank Permitted by Domestic Policies of Other Countries

Countries India Korea Indonesia Thailand Malaysia Hong Kong Rank 5 5 7 5 5 8 Countries Philippine Pakistan Hungary Poland Argentina Brazil Rank 5 3 3 8 8 5 Countries Chili Mexico Columbia Uruguay Kenya Belgium Rank 7 6 7 4 7 8 Countries U.S. U.K. Germany Switzerland Canada Australia Rank 8 8 8 8 8 8

Sourse: Mattoo et. al.(2001)

As mentioned above, due to the importance of financial service trade, GATS set up some protective provisions in order to address the worries of member countries. Among these provisions, the most important have been prudential measures by which host country governments can protect their domestic financial systems, and the participants in these systems, by applying prudential standards of the host countries. In principle, these prudential measures do not have to comply with the national treatment, market access commitments, and most favored nation responsibilities. Since no definition or indicative list of prudential measures is provided, regulators would seem to have considerable discretion in their choice of such measures. Therefore such “carve-outs” could be potentially used as restrictions to or barriers against foreign entry to lower the real opening level. According to our analysis, the main reason for the difference between China’s opening level under GATS and the level required by domestic policies concerns the issue of foreign equity participation. China did not make any commitment on this issue7 since in the Administrative Rules Governing the Equity Investment in Chinese Financial Institutions by Overseas Financial Institutions; the China Banking Regulatory Commission (CBRC) stipulates that the equity investment proportion of a single overseas financial institution in a Chinese financial institution shall not exceed 20 percent. Thereafter, the real opening level was reduced. Furthermore, other prudential measures which a nation might impose on foreign banks can also slow down the opening speed. For example, when a solely foreign-funded bank or a joint-equity bank applies to establish a branch, it must have been operating in China for more than three years and must have been profitable for two consecutive accounting years prior to the application. When applying for RMB business, the applicant also must have been operating for three years and have been profitable for two years. Recently, in the drafted amendment of Administrative Rules for Foreign Banks, foreign bank branches currently operating in China may not automatically be given the rights to a full services business. To provide RMB services to Chinese citizens, foreign banks must register in China as independent legal entities. Without this legal status, foreign bank branches cannot provide bankcard services and can only provide time deposit services to

7 According to WTO’s rules, restrictive measures are prohibited unless they have been inscribed by a Member in its schedule. Limitations on the participation of foreign capital are one of six types of limitations.

55 Chinese citizens with a minimum of 1 million RMB. Therefore, even after the transition period, RMB services are not opened fully to all of the foreign banks.

3. Measuring the Real Opening Level of Banking Sector:

The real opening level of the banking sector in one country might be lower than that permitted by domestic policies. The reasons might be as follows: Although the opening level required in one country is quite high, foreign banks are reluctant to enter the market due to concerns about the investment environment. Or perhaps it is quite difficult for foreign banks to enter because the domestic banks are very competitive. In either case, it is necessary to analyze the real opening level of China’s banking sector. We use the share of foreign bank assets in total banking assets to measure the real opening level. Until October 2005, a total of 71 foreign banks had set up 238 operational entities in 23 Chinese cities. The total assets in China amount to $84.5 billion, which accounts for 1.89% of total banking assets. The share of foreign bank assets in other countries is shown in table 5. Compared with other developing countries, China’s opening level is clearly quite low now. Some countries have a faster opening speed.

Table 5: Share of Foreign Bank Assets in Total Banking Assets (%)

Countries India Korea Thailand Malaysia Hong Kong Singapore Share 40.0 32.3 5.8 25.2 88.6 76.0 Countries Hungry Poland Argentina Brazil Mexico Columbia Share 90.4 67.4 41.6 21.5 81.9 16.4

Source: Mareno and Villar (2004) Note: The data are for the end of 2002. A foreign bank is defined to have at least 50 percent foreign ownership.

For example, in 1990, the assets of foreign banks in Mexico accounted for only 0.3%, rising dramatically to 54.6% in 2000 and then to 81.9% in 2002.

4. Conclusion:

In conclusion, the opening level of China’s banking service trade is lower than that of many developing countries. Even after the transition period, China has the authority to use certain prudential measures to control the opening level and opening speed. Nevertheless, foreign banking institutions and other businesses should not worry too much. As financial reforms continue and as supervision and other monitoring strengthens, we are very confident that China’s progress in liberalizing its banking service trade will further enhance competition, foster efficiency, and boost economic growth.

References:

Liu, Li-gang. (2005). The impact of financial service trade liberalization on China. RIETI Discussion Paper Series, 05-E-024.

Mareno & Villar. (2004). The increased role of foreign bank entry in emerging markets. BIS Working Paper, 23.

56 Mattoo, A. (1999). Financial services and the World Trade Organization: Liberalization commitment of the developing and transition economies. Policy Research Working Paper, 2184.

Mattoo, A., Rathintran, R., & Subramanian, A. (2001). Measuring services trade liberalization and its Impact on economic growth. Policy Research Working Paper Series 2655, The World Bank.

Wang, Wei-an. (2003). Opening up of banking industry and financial security of the state. Journal of Finance and Economics, 29, 12.

Wang, Shuyu & Tian, Hua. (2004). Liberalization of financial service trade of China under FSA. Economic Tribune, 9.

57 58 INNOVATION, EFFICIENCY AND RISK: THE OPENING-UP OF CHINESE FINANCIAL SERVICE AND RISK PREVENTION

Chunming Ye School of International Trade and Economics Beijing International Studies University

Abstract

The opening-up of China’s financial service has proceeded into a new stage after China’s entry into the WTO. The financial opening-up intensified competitions between Chinese and foreign financial institutions, shattered the original monopoly of domestic finance, sped up reform and innovation of Chinese financial institutions, and strengthened the core competitiveness and efficiency of financial enterprises. However, financial risks incurred by innovation and efficiency improvement have increased at the same time. How to take measures to effectively control financial risks has become the principal problem awaiting solution in the process of Chinese financial opening-up.

Introduction:

The opening up of China’s financial service market has occurred in tandem with the opening up of its entire financial system. With China’s entry into the WTO in December 2001 as a watershed, the opening-up process can be divided into two phases. The first phase entails China’s financial opening-up before entry into the WTO, when the task was to introduce foreign-funded services in general with the opening-up of banking services as the specific manifestation of this larger development. The second phase is the five-year period after China’s accession to the WTO, during which China has fully honored its commitments to opening up its financial services, thus ushering in a new era of still greater financial opening-up. By the end of 2005, 72 banks from 21 countries and regions had established 254 operational institutions, and the total assets owned by foreign banks in China reached $84.5 billion, accounting for 2% of the total assets of China’s banking and financial institutions. Also by the end of 2005, 40 foreign-funded insurance companies had opened in China. Of the 46 insurance companies included in the world’s 500 most influential enterprises, 27 of them have established institutions in China, and 29 out of the world’s largest 50 insurance companies have opened operations in China. Concerning the securities service industry, by the end of 2004 five joint-venture securities firms have opened in China, 27 overseas institutions had become the Qualified Foreign Institutional Investors (QFII), and 13 joint-venture fund management companies had received permission to open their business. The rapid expansion of finance has deepened financial reform, shattered the original monopoly of domestic finance, sped up innovation in Chinese financial institutions, and strengthened the core competitiveness and efficiency of financial enterprises. However, financial risks incurred by innovation and efficiency improvements have increased at the same time. How to take measures to effectively control financial risks has become the principal problem awaiting solution in the process of Chinese financial opening-up.

1. Financial Structural Transition in the Opening-Up of Financial Services:

China’s economy has undergone significant change in the context of globalization. The comparative advantage of cheap labor has enabled China to be the center of international manufacturing. Therefore, in the new allocation of global resources, China’s export and import trade has experienced a rapid increase and China has become the third largest trading country in the world. Receiving an annual FDI inflow of $60-70 billion for several consecutive years, China has witnessed a great leap in its foreign exchange reserve. Now China has the largest foreign exchange reserve in the world, totaling $900 billion. In addition, China has become one of the major driving forces in the expansion of the world economy. Correspondingly, great changes have also taken place in China’s financial service industry, the most important of which is the transformation of its financial structure.

1.1 Structural changes in the financial industry

At present, China’s financial industry is a multifaceted structure with administrative, commercial, and policy-oriented financial institutions in various businesses, such as banking, insurance, and securities, which have developed unevenly. In 2004, the total assets of China’s financial institutions were 33133.168 billion RMB, and the asset proportion of the three sectors – banking, insurance, and securities, respectively – were 95.04%, 3.58%, and 1.38%, with banking assets predominating. There is an imbalanced development even within the banking industry itself: state-owned commercial banks, despite declining for three consecutive years since 2003, still account for 50% or more of the total and play a dominant role. In addition, the assets of joint-stock commercial banks have grown rapidly, from 12.7% market share in 2003 to 15.5% in 2005. Moreover, other financial institutions also increased their market share, from 25.9% in 2003 to 26.2% in 2004 to 26.6% in 2005. Finally, the assets of foreign banks, although a small percentage of the market, showed an upward trend by growing from 1.8% in October 2004 to 2% in October 2005.

1.2 Structural change of the financial market

With the opening-up of the financial service industry, China’s financial market system has matured rapidly. As is shown in table 1, the size of the inter-bank lending market had been expanding before 2003 and shrank for the first time in 2004. The proportion of foreign institutions in the borrow-in market grew from 2.37% in 2003 to 6.46% in 2004, while the lend-out market grew from 0.59% to 2.31% in the same time period. Since 1998, with the support of China’s central bank, the business of banker’s acceptance bills and other commercial bills have enjoyed rapid growth. By the end of 2004, the cumulative commercial bills issued in the bill market had hit 3400 billion RMB, accounting for 24.84% of the GDP. In addition, the foreign exchange market has also experienced rapid growth in recent years. Since 2000, the inter-bank foreign exchange market has been growing by double digits for five consecutive years. Foreign currencies besides the U.S. dollar and Hong Kong dollar – the Japanese Yen and the Euro – have been introduced into the market, as have forward transactions and swaps. Moreover, the structure of the securities market has changed, too. Since 2000, while the total market value of the stock market diminished, the bond market has kept expanding, and the issuance of national bonds has been growing for several consecutive years, with the issuance value in 2004 reaching 592.39 billion RMB, 5.06% of the GDP. The futures market has developed rapidly since 2000, and the total volume increased eight times, from 1.61 trillion RMB in 2000 to 14.69 trillion RMB in 2004. With respect to transaction products, the situation of single product exchange (agriculture futures) has altered and become much more diverse. Although insurance is still in its infancy on a relatively small scale, it has also developed rapidly.

60 Table 1: An overview of China’s financial market structure (in units of 100 million RMB)

2000 2001 2002 2003 2004 Inter-bank Loan amount 6728.07 8082.02 24113.41 14420.33 lending Loan amount/ 0.0752 0.0831 0.1151 0.2054 0.1063 market GDP Inter-bank Turnover 16322 40940 106254 151300 127849 bond market Turnover/ GDP 0.1824 0.4207 1.0103 1.2889 0.9344 Accumulative 7442 12843 13914 27797 34000 issuance value Paper market Accumulative issuance 0.0832 0.1320 0.1323 0.2368 0.2484 value/GDP Foreign Turnover 3491.4 6210.5 8044.3 12509.2 17314.4 exchange market Turnover/ GDP 0.0390 0.0638 0.0765 0.1066 0.1265 Market 48090.94 43522.2 42457.72 38329.12 37055.57 capitalization Stock market Market capitalization/ 0.5375 0.4472 0.3617 0.3644 0.2707 GDP Issuance value 4657.00 4884.00 5934.30 6280.10 6923.90 Bond Issuance 0.0521 0.0502 0.0564 0.0535 0.0506 value/GDP Policy- Issuance value 1645.00 2590.00 3075.00 4561.40 4148.00 oriented Issuance 0.0184 0.0266 0.0292 0.0389 0.0303 financial bond value/GDP Turnover 16082.29 30144.98 39490.28 108396.59 146935.32 Future market Turnover/ GDP 0.1798 0.3098 0.3755 0.9234 1.0735 Premium income 1599.7 2112.3 3054.2 3879.7 4318.1 Insurance Premium market 0.0179 0.0217 0.0290 0.0330 0.0315 income/GDP

Source: data about the paper market are collected from Report on China’s Financial Development 2005; data of 2002-2003 about futures market are collected from Statistical Yearbook of China’s Securities and Futures, and data of 2004 are from Report on China’s Financial Development 2005; data about national bonds and policy-oriented financial bond are from Chinese Statistical Yearbook; data of 2000-2003 about other markets are from Chinese Financial Statistical Yearbook, and data of 2004 are from Report on China’s Financial Development 2005.

1.3 Structural change of financial assets

With the development of the financial industry and the financial market, the composition of China’s financial assets has also undergone changes. In general, monetary

61 financial assets have maintained their dominant role in terms of total assets, but the proportion is declining; despite a relatively small proportion, securities and insurance keep expanding.

1.4 Changes of financing structure

Table 2: China’s financial market financing (unit: 100 million RMB)

Total financing amount Proportion % 2002 2003 2004 2002 2003 2004 Total value 2,3976 37,909 29,796.80 100.0 100.00 100.00 financed in domestic financial market Loans 19,228 29,936 22,600.00 80.20 78.96 75.85 National 3,462 6,280 53,43.20 14.40 16.56 17.93 bond Business 325 336 342.70 1.40 0.90 1.15 bond Stock 962 1,357 1,510.90 4.0 3.58 5.07

Source: Report on China’s Financial Development 2005, page 53

As can be seen from Table 2, in China indirect financing is still the principal channel for Chinese enterprises, although its proportion has been decreasing steadily, from 80.20% in 2002 to 78.96% in 2003 to 75.85% in 2004. With regard to the internal structure of direct financing, bond financing plays a dominant role, and its proportion keeps rising; corporate bonds and stock financing are also rising to a modest extent. Generally speaking, although China has improved its financing structure to a certain degree, the disproportions between direct and indirect financing in its financial system, between stock financing and bond financing in direct financing of enterprises, and between government bond and corporate bond in the bond market still exist.

2. Financial Innovation in China’s Financial Structural Transition:

Of the many factors that influence China’s financial structural changes, financial innovation is the most important. At present, considering the considerable scale of China’s total financial volume and certain defects in its financial structure, further opening-up and diversification in financial structure have become important ways to promote China’s financial reform and development. Therefore, to further the process of financial opening-up, policies should be aimed at resolving the financial structural conflicts and promoting the upgrade of the financial structure. These policies should identify the direction of industrial structure development, encourage the innovation of financial products, institutions, and technologies, and improve the capacity, speed, and efficiency of China’s on-going financial structural transformation. China’s finance industry is a service industry, and in today’s competitive market, the quality and public appeal of financial institutions directly determine their market share. Meanwhile, differences in efficiency and target customers will directly affect the profitability of financial institutions. In the wake of an influx of foreign financial institutions, competition for good customers has become fiercer among foreign companies, joint-venture companies, and state-owned and private enterprises with excellent

62 performance records, and has motivated different thinking among Chinese financial institutions. In order to meet the challenges mentioned above, Chinese financial institutions need to be more innovative with respect to institutional security, organizational establishment, the introduction of financial products, and financial business development.

2.1 Innovation concerning service targets

Service targets innovation underlies other service innovations. Specialized service innovation is possible only when specific targets are defined. When determining their own development strategies, financial institutions should take into account the differences among regions in terms of indigenous characteristics, economic growth rate, and customer composition. Therefore, defining one’s customer group according to its market positioning so as to provide specialized service is the premise on which an effective service is based.

2.2 Innovation in service instruments

Innovation in service instruments, in particular, is a necessary means of service innovation in general. With rapidly advancing science and technology, services based on manual and counter operations are no longer attractive to customers. The entry of foreign banks into Chinese market after the opening-up of the financial sectors has provided customers with access to advanced, scientific, and highly efficient service instruments. Clearly, only by employing such service instruments can Chinese financial institutions provide efficient, convenient, and comprehensive service for customers. This has two consequences. First, on the basis of financial service innovation, Chinese financial institutions should improve the existing service instruments such as internet infrastructure, counter equipment, and so on. At present, based on telecommunications network improvement, banks are starting to provide services where deposits and withdrawals can be processed at any branch bank nationwide. Moreover, they are starting to introduce many products, such as credit cards, debit cards, joint cards, deposit books, deposit receipts, etc. In addition, some banks (China’s Merchants Bank, for example) have introduced comprehensive instruments (like the Golden Sunflower VIP card) targeting VIPs. Second, new and advanced service instruments should be introduced to facilitate transactions, gain more market share. and reduce human costs. Under the circumstances where old service instruments can no longer properly meet the market’s needs, customers will favor those who introduce new instruments earlier. Under the pressure of competition from foreign financial institutions, which have the advantage in financial instruments innovation, Chinese financial institutions are accelerating their introduction of many innovations.

2.3 Innovation in service content

Innovation of service content is a key way to attract customers, who have increasingly complex banking service needs. Therefore, banks must enlarge and renew their service content to accommodate such needs, including account transfers and personal loans. Clearly, financial institutions that can lead the competition in content innovation will obtain a larger market share and gain a stable position.

63 2.4 Service approach innovation

Service approach innovation is an effective way to improve profitability. So far, China’s banking service has been basically passive. Bank staffs often lack the initiative and the attitude necessary to wanting to help customers find what they need. Approach innovation involves replacing passive services with active services, conducting general as well as public relations service, exploiting the comprehensive advantages of Chinese banks so as to attract customers and create more comprehensive profits. In recent years, Chinese banks and financial institutions have introduced various innovations to improve their hardware and software resources, and they have also developed specialized services to strengthen their appeal in the market and thus to generate more profits. These innovations include the following financial products: RMB monetary management, foreign exchange management, gold management, foreign exchange forward transaction, foreign exchange swaps, currency swaps, asset securitization, short-term corporate financing, general bonds of commercial banks, secondary bond of commercial banks, RMB bonds of international development agencies, bond futures, credit default swaps, options, enterprise annuities, credit trust structures, and a large number of insurance products. In view of the trend of China’s financial products innovation, the introduction of RMB derivative products and international offshore business has and will continue to affect China’s financial products structure and total volume.

3. Efficiency Changes in the Opening-Up of China’s Financial Industry:

During the process of opening up financial services, intensified competition and active innovations have improved China’s financial efficiency, which is manifested in the improved efficiency of financial intermediary agencies. In addition, the active role played by financial institutions has stimulated the demand and supply of financial service, which has further deepened financial reform.

3.1 Efficiency changes in the banking industry

(i) The number of Chinese banks included in the list of the world’s 1000 largest banks increases every year. As the most prestigious ranking of commercial banks “The 1000 world’s largest banks list” released by the British magazine The Banker is widely recognized as a touchstone of a bank’s overall competency. As Table 3 indicates, the general strength of the Chinese banking industry has grown considerably as the numbers of Chinese banks listed in the ranking increases every year (See Table 3). (ii) Indictors such as owner’s equity, capital adequacy ratio (CAR), and risk resistance ability show the improvement of a bank’s performance. By the end of 2005, the owner’s equity of Chinese major banks had hit 1.1 trillion RMB19.2%; banks with CAR higher than 8% numbered 40; 10 more banks had been added since the beginning of 2005; qualified bankers’ assets accounted for 73% of the total, growing by 25% from the beginning of 2005; the nonperforming loan balance of domestic commercial banks totaled 1313.36 billion RMB at the end of 2005, a decline of 587.21 billion from the beginning of the year; the percentage of nonperforming loans was 8.61%, a decline of 4.25% from the beginning of the year; and nonperforming loans in the banking industry had experienced a “double decline” for 4 consecutive years.

64 Table 3: Ranking of Chinese Banks among the World’s 1000 Largest Banks

2004 2003 2002 2001 2000 1999 1998 1997 1996 Bank of 11 29 15 11 18 21 18 27 15 China China Construction 25 21 37 28 29 32 -- 56 66 Bank ICBC 32 25 16 10 7 10 -- 22 25 China Agriculture 37 36 25 23 21 20 -- 79 78 Bank Number of Chinese 19 16 15 15 14 9 -- 6 6 banks in the list

Source: collected and complied from The Banker (1996-2005)

3.2 Efficiency changes in the insurance industry

China’s insurance has experienced rapid development since its reform and opening-up. As is shown in Table 4, insurance depth (proportion of the premium income of GDP) and insurance density (per capita premium income calculated with the permanent resident population) experienced persistent growth since 1980. In 2004, Chinese insurance depth reached 3.4%, which is 34 times the number in 1980; the insurance density is 332 RMB, 692 times the number in 1980. However, when compared with other countries, Chinese insurance depth and density are still low. In 2003, the insurance depth in South Africa was 15.88%, ranking first in the world; the average insurance depth in industrialized countries was 9.2%, 2.7 times that of China; and the insurance depth for the U.S. and Japan was 9.61% and 10.81% respectively. Still bigger gaps exist between China and developed countries in terms of insurance depth. In 2003, Switzerland’s insurance depth was $5660.3, ranking first in the world, but the average level in industrialized countries was $2764, 68.9 times that of China, while the numbers for the U.S. and Japan were $3637.7 and $3770.9 respectively. That indicates China’s insurance industry still lags behind the world and has huge room to improve.

Table 4: China’s insurance depth and density

Insurance Insurance Depth of Density Depth of Density depth( %) density(RMB property of life of life per capita) insurance property insurance insurance insurance 1980 0.10 0.48 0.100 0.48 - - 1982 0.20 1.01 0.190 1.01 0.010 0.00 2001 2.20 162.90 0.710 52.91 1.476 109.93 2002 3.00 234.60 0.778 59.90 2.275 174.99 2003 3.33 287.40 0.746 64.40 2.584 223.04 2004 3.40 332.00 0.800 83.80 2.360 248.30 Source: collected from the insurance yearbooks published in relevant years

65 4. Financial Risk Control in the Opening-Up of Financial Services:

The improvement of financial efficiency has had a dual effect. Along with the efficiency improvement of financial institutions and enhanced effectiveness of financial resource allocation, financial risks have also expanded. The financial risks are three fold: The first risks, incurred by accelerating financial innovation, are from both inside and outside China, and they are the major form of financial risk. On the one hand, financial innovation prompts improvements in financial efficiency and strengthens the profitability and core competitiveness of financial institutions. However, it also enlarges operational risks. As finance becomes more marketable and globalized, the increased fluctuation in interest rates and exchange rates cause financial demands to change, which in turn requires higher levels of new product development and risk control from Chinese financial institutions. Especially when the Chinese financial service industry lags behind its counterpart in developed countries in terms of financial derivatives management, Chinese financial institutions still have a long way to go. The second risk involves international financial risk. With more and more opening-up, the link between Chinese and international financial markets is strengthened, and fluctuations in international financial market and capital flow have an intensified influence on China, which incurs the external risk. Especially when further opening-up provides international hot money with a much easier access to Chinese financial market, the influx of short-term and indirect investment may cause financial assets foam, with a higher likelihood of triggering a financial crisis in the event of a sudden loss of foreign funds. Meanwhile, considering the indivisibility of international financial markets and the immaturity of the Chinese financial market, there is a higher chance of financial crises being transmitted from other countries to China. Moreover, the risk could be even higher considering the vulnerability and imperfect operation of Chinese financial institutions. For example, at present, Chinese financial institutions have problems with low capital adequacy ratios, high percentage of nonperforming assets, and immature risk aversion and control mechanisms. These problems have risk-magnifying effects and may raise the likelihood of system crisis when China’s financial system is integrated into the international financial system. Evidence shows that the overflow effect of economic and financial globalization has caused new uncertainties in China’s financial stability. There are many uncontrollable factors in today’s international economic and financial environment, including, for example, the oil price and interest rates hikes in the world, the depreciation of U.S. dollars, international political conflicts, regional wars and conflicts, etc. While China is making more profits from its greater participation in international production, trade, and money circulation, uncertainties and risks are also increasing. The third risks are with financial supervision and regulation. Currently China has a separate financial supervision and regulation system, which was established on the basis of separate operations of domestic banks and insurance and securities companies. In the process of financial opening-up, most foreign financial institutions entering Chinese market have been comprehensive. With the model effect of these foreign-funded financial institutions, Chinese financial institutions may turn to adopting mixed operations. In this new financial environment, if the current supervision and regulation system is continued, the introduction of a new business will require the coordination of many sectors and will incur relatively high policy coordination costs. Meanwhile, the emergence of multiple operations within a single institution may lead either to duplicated supervision and regulation or to their absence. Moreover, facing the large number of transnational corporations and financial institutions, which are experienced in avoiding the regulation of the host country, China still has a long way to go to establish an effective financial law and

66 regulation system. In this process, the absence of effective financial regulation will lead to regulation risks. China’s entry into the WTO presents great opportunities as well as daunting challenges for its economic development, the most serious of which is the management of economic and financial risks. Bad management of these risks will threaten China’s financial stability and development and perhaps even the overall economic landscape. With a new international financial structure and the requirements of WTO rules, China faces the urgent problem of adapting to the new situation and effectively avoiding risks. International experiences show that financial instability and crisis can lead to grave and devastating harm in social, political, and economic terms, which is what all countries in the world are trying to avoid. Therefore, in order to effectively handle financial risks and safeguard its financial security, the Chinese finance industry has opportunities to adopt concrete measures. To this end they can:

4.1 Perfect relevant laws and regulations

Certain laws and regulations are needed to incorporate the activities of Chinese and foreign financial bodies into the legal framework. Such laws and regulations should ensure the orderly functioning and development of China’s financial activities, avoid the shock to China’s financial market and system caused by adverse factors, and safeguard financial and economic security in the opening-up process. Otherwise, China cannot resort to legal measures in response to adverse factors influencing domestic financial and economic security. Although a series of important laws and regulations have been formulated, given the current situation these efforts are far from being sufficient to achieve the desired goals. Therefore, it is high time that China conducts a comprehensive clearing away of certain laws regarding financial security, and continuously revise and apply certain laws and regulations so to set up a legal framework in line with the international trend and China’s financial development needs. In addition, China needs to clarify the relationship among government, enterprises, and financial institutions, strengthen market rules and relevant regulations, and protect the interests of financial institutions, thereby putting finance regulation into a virtuous cycle.

4.2 Reinforce supervision and regulation of financial activities both home and abroad

China’s financial supervision and regulation agencies need to keep an eye on potential pitfalls in the process of financial opening-up. They should regulate finance within the legal framework; that is, they should implement and enforce appropriate financial laws and regulations regarding market access, practitioner qualifications, information revelation, and risk control. More specifically, they should strictly implement the supervision rules, improve their approach to and their means of supervision, and otherwise strengthen their system by modifying in timely ways their modes of supervision and regulation. Meanwhile, they must change the ideology that has governed supervision and regulation agencies. Their focus should be switched from inspection and ratification to supervision and regulation of financial enterprises and the financial markets. Financial supervision and regulation agencies should have qualified personnel with a strong command of the relevant laws and regulations and familiarity with financial operations. By the same token, supervising agencies should be acutely attuned to the ultimate goal of achieving financial security.

67 4.3 Establish a financial security alarm system and rescue measures

In the process of financial opening-up, the absence of risk supervision and control measures within the financial system will lead to asymmetric risk revenue among different financial bodies and businesses. Moreover, risk-neutral or risk-averse individuals will become risk lovers, thus exacerbating the accumulation of financial risks. Once the market mechanism produces symmetry of revenues and risks, the already accumulated risks will emerge and lead to financial crisis. Therefore, in order to safeguard financial security, supervision and control mechanism should be perfected, and a sensitive and efficient financial market alarm system and appropriate rescue measures should be established to create a defense against excessive speculation and financial risks. Such a financial risk alarm system should consist of the existing three regulatory agencies in China (China’s Banking Regulatory Commission, China’s Securities Regulatory Commission, and China’s Insurance Regulatory Commission); together, they should take charge of inspecting and notifying the appropriate institutions of nationwide financial risks. The three agencies should undertake to analyze those indicators that can precisely reflect the alarm targets. Generally speaking, these indicators include: (i) Foreign fund structure (the shorter the duration of foreign fund inflow, the more vulnerable foreign structure is, and more risks there are). (ii) Exchange rate level (the change in real exchange rate indicates the change in the value ratio of one’s own currency to foreign currency, and continuous decline in real exchange rate means appreciation of one’s own currency). (iii) The non-performing assets ratio (the rise in nonperforming assets ratio indicates the decline of operational efficiency of banking assets and the increase of financial risks). (iv) Capital adequacy rate (banks failing to live up to the minimum capital adequacy rate for a long time will inevitably fail to withstand the risks occurred in economic opening-up). (v) Stock price changes (The fluctuation of stock price in the short term can reflect the stability of domestic stock market.) Once the alarm indicators are chosen, the three regulatory commissions will inspect and assess these indicators. When the divergence of a certain variable from the standard value approaches a certain critical value, this can be seen as a signal of potential financial risks in the coming period. In that case, the inspection bodies need to inform the affected financial institutions about the risks and offer possible solutions.

4.4 Reform micro financial system to shape market participants

Experience shows that problems of nonperforming assets, low capital adequacy of banks, lack of competitiveness in financial institutions, or even the inborn defects of stock market can all be boiled down to essentially the imperfection of the micro financial system, which makes it hard to eradicate the accumulation of nonperforming assets and even harder to normalize the behavior of financial enterprises. Therefore, in order to eliminate the instability and insecurity in China’s financial operation and development under the new situation of the nation’s financial opening-up process, micro financial system reforms need to be phased in. Most importantly, the core of the reform lies in the establishment of a modern financial enterprise system, which involves improving property system and management mechanisms. Property system reform should focus on thoroughly separating ownership from management and resolving the problem of owner absence with respect to implementing the owner’s functions of supervision and regulation. Meanwhile, as the owner representative of state-owned assets, the government must be limited to sharing operational revenues as an investor and never permitted to intervene in the operational

68 activities of financial enterprises. In this regard, in order to retain their independence, financial enterprises should shrug off burdens of public administration and pursue profit maximization. The core of improving management systems is to establish and implement appropriate internal control mechanisms. Sound internal control mechanisms can effectively avoid the problem of insider control, in which operators abuse their authority; such protections which will greatly reduce the principal-agency cost and prevent financial crisis. The micro reform should further rationalize the corporate governing system in financial institutions; it should establish effective incentive, risk-control and capital- constrain mechanisms; and it should encourage qualified financial bodies to go public in domestic and foreign capital markets, to strengthen the constraints of shareholders on the management of financial organizations, and to stimulate financial organizations to perfect their operational mechanisms.

4.5 Enhance the effectiveness of risk control in financial institutions

Under conditions of fierce market competition, Chinese financial institutions face various pressures and incentives to conduct comprehensive financial innovation, which involves both benefits and risks. In tapping into new markets and seeking to acquire more high-quality customer resources, Chinese institutions must adopt new technologies, introduce new products, and take on new organizational forms according to market demand. To counter the resulting risks and to meet the resulting challenges, Chinese financial institutions must strengthen their operation and management, perfect their internal control mechanisms, adopt advanced risk identification and control technology, and enhance risk- control levels to avoid failure of risk control and the subsequent losses.

5. Avoid Structural Risks Through Adjusting Financial Structure

Chinese institutions can avoid structural risk, first, by accelerating structural optimization in the financial market. At present, Chinese financial market still have an imbalanced structure with excessive indirect financing and little direct financing. Therefore, we should take five actions. (i) We should accelerate the development of direct financing, reasonably divert banks’ savings, and avoid the systematic risks with the situation where banks are taking excessive responsibilities of social funds allocation. (ii) China should change the monotonic savings structure and actively develop monetary market fund, bond fund, insurance fund, and other substitutes of savings. (iii) We should also change the monotonic asset structure, actively promote securitization of credit assets. (iv) China should change the monotonic financing structure, actively promote corporate bond market and over-the-counter market, expand direct financing channels for enterprises especially middle and small sized ones. (v) Finally, China should break down market blockage and promote the orderly flow of financial resources among different markets. Chinese institutions can avoid structural risk, second, by continuing to perfect the structure of financial transaction participants. China can do so in four general ways. (i) China can further open up the market, allow more market participants of more types, encourage marketization of the participants’ behavior and diversification of their demand, and avoid the lack of vibrancy or excessive fluctuation because of behavior convergence. (ii) China can develop institutional investors, cultivate awareness of risk and credibility among them, and improve their abilities of risk management and analysis. (iii) China can also expand the scope of financial transaction participants, take measures to provide easier financial market access for individual investors, and provide possibilities for enterprise annuity, social security funds and other collective funds. (iv) Finally, China can vigorously support development of middle and small-sized financial institutions open up the market to

69 both domestic and foreign financial institutions, stably promote the development of private- funded financial institutions, and regulate and perfect private credibility.

References:

China Securities Regulatory Commission. (2004). China securities and futures yearbook Baijia Press.

China Society for Finance & Banking. China finance yearbook (2003-2004).

Jiao, Jinpu. (2002). Research on China’s banking competitiveness. Beijing, China: Modern Economic Publishing House.

Li, Jian & Ma, Ya. (2005, July). Reflections on China’s financial structure adjustment and pptimization. Xi’an Finance,7, 1.

Li, Yang. (2005). Report on China’s financial development. Beijing: Social Sciences Academic Press.

National Bureau of Statistics of China. China statistics yearbook (2004-2005). China Statistics Press

Zhang, Wei. (2004). Financial service trade and financial development. Beijing, China: Financial & Economic Publishing House.

70 ON THE DEVELOPMENT OF CHINA’S TRAVEL SERVICE TRADE: AN ANALYSIS ON CHINA’S BALANCE OF PAYMENT BETWEEN 1985 AND 2004

Xiaomu Li School of International Trade and Economics Beijing International Studies University

Abstract

In recent years, with the upgrade of China’s opening-up, cross-border tourism has gained more and more popularity, and the importance of travel services trade to China’s balance of payment has begun to show. According to the latest statistics, travel services trade ranks first in terms of total export and import value, total export value, and trade surplus in China’s services trade balance, amounting to $24.12 billion, $14.22billion, and $4.32 billion respectively (The State Administration of Foreign Exchange, 2005). With this context, the paper tracks the development of China’s travel services trade from 1985 to 2004, attempting to generalize some ruling characteristics, analyze the macroeconomic factors that influence its development, and point out some problems with related areas and corresponding solutions, so as to provide references to China’s trade administrative bodies who are responsible for the future strategic planning of China’s inbound, outbound, and domestic tourism market.

Introduction:

According to the Balance of Payment Manual released by the IMF, travel is the second item in the 11 categories of services trades under current account (IMF, 1994). Its importance is obvious. In recent years, with the upgrade of China’s opening-up, cross- border travel has gained more and more popularity, and the importance of travel service trade to China’s balance of payment has begun to show. According to the latest statistics, travel service trade ranks first in terms of total export and import value, total export value, and trade surplus in China’s services trade balance, amounting to $24.12 billion, $14.22billion, and $4.32 billion respectively (The State Administration of Foreign Exchange, 2005a). Within this context, the paper keeps track of the development of China’s travel service trade from 1985 to 2004, attempting to generalize some ruling characteristics, analyze the macroeconomic factors that influence its development, and point out some problems with related areas and corresponding solutions, so as to provide references to China’s trade administrative bodies who are responsible for the future strategic planning of China’s inbound, outbound, and domestic tourism market.

1. Characteristics of the Evolution of China’s Travel Service Trade Balance:

The sample range in this paper begins in 1985, since the Chinese Balance of Payment Statistics Reporting System was jointly established by National Bureau of Statistics and National State Administration of Foreign Exchange in November 1984 and was put into formal execution in 1985 (Xu, 1995).1 During the two decades in question –

1 The data in the rest of this paper are all collected from the annual reports of the State Administration of Foreign Exchange on China’s Balance of Payment.

71 1985-2004 – the emphasis in China’s economic system reform was switched from countryside to urban areas as China gradually began its overall transition to a market economic system. During this period, China’s opening up accelerated, punctuated by China’s entry into the WTO. At the same time, with the consistent growth of the macro economy, the size of the Balance of Payment transactions in China continued to grow rapidly, rising from $54 billion to $1.91 trillion, with an average annual growth rate of 31.6%, or from 19% to 115% of the GDP. In the two decades (except for 1988), China’s balance of payments consistently enjoyed a “double surplus” in both current accounts and capital & financial accounts (State Administration of Foreign Exchange, 2005b). Statistical analysis indicates that from 1985 to 2004 the evolution of China’s travel service trade balance, as a secondary account under current account, has included the following characteristics:

1.1 The overall size of travel service trade has risen sharply, and importation growth is remarkably faster than exportation growth in travel service trade. The size of China’s travel service trade (total volume of exportation and importation) has grown from $1.564 billion in 1985 to $44.888 billion in 2004, and 15 out of 19 years have witnessed annual growth rates of double digits. However, the fluctuations have been large. Due to the impact of political instability along with the SARS epidemic, 1989 and 2003 witnessed negative growth rates of -21.0% and -9.0%, respectively. All the other years saw positive growth rates, which reached as high as 93.0% in 1992; 2004 witnessed the third peak in the sample range, with the growth rate at 38.0% (see chart 1).

Chart 1: Size and Growth Rate of China’s Travel Service Trade

Siz Growth rate 50,000,00 10 0 0

45,000,00 0 8 0 40,000,00 0 6 35,000,00 0 0

30,000,00 0 4 0

25,000,00 % 0 2 20,000,00 0 0

15,000,00 0 0 thousand dollars

10,000,00 0 - 5,000,00 20 0

0 - 40 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 200 200 200 200 200 5 6 7 8 9 0 1 2 3 4 yea5 6 7 8 9 0 1 2 3 4

Source: State Administration of Foreign Exchange.

The exportation volume of travel services amounted to $1.25 billion in 1985 and $8.73 billion in 1995. The figure in 2004 is $25.74 billion, 20 times of that of 20 years before, surpassing the accumulative volume in the first 9 years in the sample range. The importation of travel services amounted to $314 million in 1985 and $3.69 billion in 1995.

72 The figure in 2004 is $19.15 billion, 60 times of that of 20 years before, approaching the accumulative volume in the first 13 years in the sample range. The importation had been growing considerably faster than exportation.

1.2 Travel service trade is a major item in the balance of payment of services trade. China is a developing country, and current account activities make up a major part of China’s economic interaction with other countries. In the past 10-plus years, the size of China’s current account was 67.0%-80.0% of the overall size of China’s economic and financial exchanges with foreign countries. And the services trade ratio in the current account was 10%-14%. The ratio showed a declining trend after 1997 (Wang, 2004). Inbound and outbound travel has constituted a major part of the travel service trade. In this paper’s sample range, the ratio of travel service trade in services trade (TOURIRATIO) is between 18% and 44% (see chart 2).

Chart 2: China’s TOURIRATIO (%)

TOURIRA 5

% 2

0 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 200 200 200 200 200 year

Source: State Administration of Foreign Exchange

What needs to be pointed out is that the data of the travel service trade size before 1996 was collected from balance of the non-trade items in the balance of payments of the same period released by the State Administration of Foreign Exchanges. In order to make this internationally comparable after 1997, investment income and some other items must be reduced. Taking account of this factor, China’s TOURIRATIO should be at 30%.

1.3 The surplus in travel service trade has contributed to remarkably reducing the overall services trade deficit. For 20 years, China has had a surplus in trade in tourism services – that is, the foreign exchange earnings from tourism have outweighed foreign exchange spending. On January 1, 1994, China embarked on a reform of its foreign exchange management system, and the RMB’s sharp devaluation, the travel service trade surplus then increased by 1.27 times compared to that in 1993, surpassing 4 billion U.S. dollars for the first time. The favorable balance has been maintained since then, and the

73 value all surpassed $3 billion in all years except in 2003. In 2004, the surplus reached a record high of $6.59 billion (chart 3). This is in sharp contrast with China’s service trade deficit after 1992, which averaged $7 billion and reached as much as $17.87 billion in some years. The reason is that other services trade items – including transportation, communications, construction, insurance, financial services, computer and information services, exclusive of fees and royalties, and commercial services of various kinds (consulting, advertising and other), personal cultural entertainment services, government services, and other non-tourism services trade – have created deficits for years,2 and the deficits are still expanding (Wang, 2004). Chart 3 clearly shows that tourism is the source of long-term trade surpluses which have effectively reduced China’s overall service trade deficit.

Chart 3: China’s Travel Service Trade Balance and Services Trade Balance travel services trade service trade balance 10,000,00 balance

5,000,00

0 thousand dollars 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 200 200 200 200 200

- year Source: State Administration of Foreign Exchange

2. Analysis of the Macroeconomic Factors that Influence the Development of China’s Travel Services Trade:

To further investigate the reasons for the above-mentioned evolution of China’s travel services trade, relevant macroeconomic factors must be analyzed. In reality, economic changes in the balance of travel services trade caused by various macroeconomic factors are very complicated and mutual influential. For this reason the following theoretical framework concerning open-economy macroeconomics is helpful in studying the macroeconomic factors that have influenced the development of China’s travel services trade. If we use TT to express the travel services trade balance, q to express the real exchange rate, Y* and Y to express foreign and domestic national income, respectively, then under relevant economics theory we have the following expression:

2 Telecommunications, construction, financial, computer, advertising, government services, and other business services had surpluses in some years.

74 TT= TT (q, Y*, Y)

Because q=eP*/P, where e stands for the nominal exchange rate, P * and P stand for foreign and domestic price levels, Expression 1 can be rewritten as:

TT= TT (e, P* , P, Y*, Y)

For the five variables influencing TT, if we exclude P * and Y* can be treated as exogenous nature; P is assumed to affect TT indirectly through its influences on the real exchange rate q. With the assumption that the nominal exchange rate is unchanged, under circumstances that meet the Marshall-Lerner Condition, a rise of P will bring a decrease in q, which inhibits exports and promote imports of the travel services trade and, worsen the travel services trade balance. Conversely, a rise in national income Y would lead to an increase in imports, which can further lead to the deterioration of the travel services trade balance. We use correlation analysis to study the statistical relationships between GDP (Y), Consumer Price Index (P), and imports and exports in travel services. The data on 3 GDP and Consumer Price Index (P1985=100) came from the same statistical sampling range and are using the correlation coefficients for Y and travel services imports and exports which are 0.935982 and, 0.994108 respectively.. The first coefficient is consistent with theoretical prediction; the second coefficient suggests that in developing countries infrastructure improvements brought economic growth and the rise of national income and can also promote travel service export growth through increasing tourism supply. For the pair of correlation coefficients between P and the travel services imports and exports, which are 0.914880 and 0.964536 respectively, only the first could be in line with the economic theory. The second runs against theoretical prediction: it could be because P *, or especially, the nominal exchange rate (e) is not controlled for. For this reason, we can compare Renminbi nominal exchange rates and China’s travel services import and export in the following table (see Table 4). Analysis of the table shows that almost every time in either the year of or the year following the RMB’s devaluation, there was an increase in travel service trade surplus, particularly in 1990 and 1994, when devaluations of more than 20% brought about a significant increase in payments surplus. Further analysis finds that among the nine devaluations during the statistical sample range, eight caused increases of exports in the current year, nine caused increases of exports in the subsequent year, only two caused declines in imports in the current year, and one caused declines in imports in the subsequent year. Based on the above analysis, we can conclude that the RMB’s devaluation has favorably influenced China’s balance of travel services trade (sometimes with a time lag of a year), mainly through the promotion of travel services exports. The travel imports cannot be reduced because China’s import demand elasticity of travel services is low, and because China cannot acquire all the natural resources it needs due to importation and lack of import substitution. The growth of travel services export is mainly because China’s exported products are mostly middle- and low-end quality items that have higher price elasticity of demand, and because China is abundant in compatible labor resources. The supply of travel service export also plays an obvious role in promoting the growth of China’s travel service export. As for the impact of the appreciation of the nominal exchange rate of Renminbi, since there are only two small margined appreciations in the analyzed year range, statistical

3 Source: State Administration of statistics.

75 Table 4 China’s Travel Trade Balance and the Nominal Exchange Rate of RMB ($1000)

Year Export Import Differences Changes in the RMB exchange rate (%) 1985 1,250,000 314,000 936,000 -14 1986 1,531,000 308,000 1,223,000 -17 1987 1,845,000 387,000 1,458,000 -8 1988 2,247,000 633,000 1,614,000 1989 1,860,000 429,000 1,431,000 -1 1990 2,218,000 470,000 1,748,000 -27 1991 2,840,000 511,000 2,329,000 -11 1992 3,947,000 2,512,000 1,435,000 -4 1993 4,683,000 2,797,000 1,886,000 -5 1994 7,323,000 3,036,000 4,287,000 -50 1995 8,730,000 3,688,000 5,042,000 3 1996 10,200,000 4,474,000 5,726,000 1 1997 12,074,140 8,130,100 3,944,040 1998 12,601,740 9,205,440 3,396,300 1999 14,098,450 10,864,480 3,233,970 2000 16,231,000 13,113,687 3,117,313 2001 17,792,000 13,908,826 3,883,174 2002 20,385,000 15,398,416 4,986,584 2003 17,406,000 15,187,272 2,218,728 2004 25,739,000 19,149,296 6,589,704 Note: the RMB’s devaluation in 1994 refers to the exchange rate combination in the reform of the foreign exchange management system. analysis would not be reliable. Further analysis, using samples after the exchange rate system reform in July, 2005, should provide more useful results.

3. Conclusions and Suggestions:

In a manner similar to exported goods and foreign direct investment, China’s travel services trade has developed rapidly over the past over 20 years. With its size and surpluses, the travel services trade is playing an increasingly important role in the current account of the balance of payments, especially with respect to services trade. As China’s opening up continues and reform deepens, the macroeconomic variables that determine national economies will remain influential to the development of China’s travel services trade. In sum, the following two areas deserve special attention from academics and relevant policy-makers. First, for the present and near future, there is an urgent need to establish an economically rational and scientific “concept of export and import” that can support a sustainable development. The traditional concept of export and import is formed in relation to a country’s stage of economic takeoff and is deeply rooted in a wide variety of social environments in developing countries. It generally holds that exports are better than imports because exports can “create” foreign exchanges while imports would drain already scarce foreign exchange resources. Clearly, a surplus is better than a deficit. Even when one country has to import resources, it should focus on those natural resources that can promote the production of future exportable capital goods. Applied to travel services trade, such

76 traditional concepts lead to the view that “China’s international tourism has become an industry that causes balance of payments deficit . . .” and that “without active intervention, it may offset China’s entire current account surplus in the balance of payments” (Dai, 2005)! Some scholars have even suggested the introduction of outbound tourism consumption tax to curb the growth in travel services import (Dai, 2006). This paper does not want to discuss to what extent the estimates released by the State Foreign Exchange Administration are dependable, but to identify that China’s travel services imports indeed show rapid growth since 1997, when outbound travel was officially opened up. It should be recognized that behind this rapid growth is a demand for outbound travel that had long been artificially suppressed. The release of the demand not only reduced the pressure on the domestic tourism market supply4 but also greatly satisfied the outbound travel demand produced by the differences in tourism and cultural resource endowment. In fact, even the increasing outbound travel has mainly led to outbound shopping spending, which merely reflects the strong domestic demand for overseas “originally-manufactured” commodities under the circumstance that outbound travel is a more direct and economical means of purchasing imported goods. There is evidence that such demand is rigid and that the counterpart goods have low domestic substitution rates, which is hard to convert to effective domestic demand. Second, we should actively change our ways of thinking and generate new strategies and tactics for developing China’s travel services trade while facing the RMB’s appreciation. According to various observations and analysis, the Renminbi has entered a long period of appreciation, which will further reduce the cost of outbound travel and make inbound travels more expensive. Therefore, we should, on the one hand, continue to take a rational view of the growth of imports and divert tourist imports; on the other hand, we must focus on measures to expand our travel services export, for example, by; 1. Strengthening the construction of lodging, food, transportation, and other areas that will increase effective supply to raise foreign tourists’ non-fundamental spending ratio in China. 2. Carefully planning and supervising the construction and management of scenic spots, including building cultural and entertainment facilities showcasing putting traditional Chinese culture in order to enhance the ratio of foreign tourists’ spiritual spending. 3. Reducing the proportion of sightseeing foreign tourists and updating the tourist product mix with more products of high value-added and advanced resource processing. 4. Strengthening the service tourism enterprises offer, clarifying long-term marketing goals, and promoting advanced marketing techniques to create good brands and corporate images to deal with the fierce competition at home and abroad.

References:

Dai, Xuefeng. (1005, March 18). Thoughts on the increase of the international balance of payments deficit of tourism. China Tourism.

Dai, Xuefeng. (2006, February 18). Proposals on the introduction of outbound tourism consumption tax. Retrieved from Dai, Xuefeng travel blog.

IMF. (1994). Balance of payments manual. (5th ed.) Beijing: China Finance Press.

4 According to reports on “Golden Week” in recent years, the pressure has caused damages to cultural facilities in many cases.

77 The international balance of payments analysis team of State Administration of Foreign Exchange. (2005). Report on China’s international balance of payments in the first half of 2005. Retrieved from the official website of the State Administration of Foreign Exchange.

State Administration of Foreign Exchange. Balance of Payment (first half of 2005). (2005, November 1). Financial Times, p. B5.

Xu, Bin. (1995). An introduction to China’s international balance of payments. Beijing: China Finance Press, p. 40.

Wang, Tong. (2004). China’s international balance of payments (new version). Beijing: China Economic Publishing House, pp. 15-17.

78 TANG INCORPORATED: THE COMMODIFICATION OF HISTORY AND THE REBIRTH OF TANG CHANG’AN IN THE 21ST CENTURY

Norman Harry Rothschild Department of History University of North Florida

Abstract

This paper illustrates how recent efforts in urban development in modern-day Xi’an, the traditional capital of thirteen Chinese dynasties formerly known as Chang’an, have consciously marketed images of a past Golden Age, the cosmopolitan and multi-ethnic Tang dynasty. Evoking this historical epoch—whether in business names or theme parks— provides an aura of luster and prosperity that may help transform 21st century Xi’an from a dusty, provincial second echelon city to a flourishing and diverse center of culture and commerce, like Chang’an of the past.

Introduction

Despite its glorious past as an “ancient capital” of thirteen dynasties, modern- day Xi’an 西安 is a city searching for an identity, lagging five to ten years behind cosmopolitan, east coast cities like Beijing and Shanghai in terms of development. In his controversial work, Abandoned Capital (Fei du 废都), Jia Ping’ao 贾平凹 depicted Xi’an as a provincial mire of corruption, nepotism, lust and lies, even while the city and its residents retained a misguided nostalgic fascination with its grandiose past and attendant sense of inflated self-importance. Today, in the midst of China’s surging economic prosperity, this city of seven million is still seeking to reconcile its illustrious past as a milling international cosmopolis with its mediocre present as a dusty, parochial industrial midwestern city. Ironically, the skillful marketing and commodification of its splendid past may be one of the keys to the prosperous future development of Xi’an in the 21st century. Back in the Tang dynasty, the Silk Road that linked China, Central Asia and India was filled with merchant caravans, where heavily-laden Bactrian camels carried goods to and from Chang’an 长安, as modern-day Xi’an was then known. Chang’an, the grand capital of the Tang, was the largest city in the world at the time. With a population of two million, it was the political, economic and administrative heart of a huge empire that stretched west along the Silk Road into modern-day Kazakhstan, south into Vietnam, and north well into Siberia and North Korea. Markets overspilled with Malayan patchouli and pepper from India, aromatic camphor from Java, pine seeds and rainbow carpets from Korea; Uygyrs lent money; Iranian waitresses served liquor; Persians sold pilaf, figs and pistachios and Turks sesame buns and nang-bread 囊 (Benn, 2002, and Schafer, 1963). The internationalism of the age was also reflected in the religious tolerance that characterized much of the first half of the Tang dynasty. Buddhism linked India, Central Asia, China, Korea and Japan in a larger cultural continuum. In addition, Chang’an was home to many Muslims, Zoroastrians, Manicheans, and Nestorian Christians. An inclusive aura existed in the early Tang, an embracing sense that “the empire is open to all,” (tianxia wei gong 天下为公) (Wechsler, 1985). It is precisely this aura of internationalism and cosmopolitanism that city government and private entrepreneurs alike are trying to reinvent in the 21st century.

1. Remains and Vestiges of Tang Chang’an in 21st century Xi’an

Some real physical remnants of the Tang dynasty are still extant. In the northern suburb, one can find the foundations of Daming Palace 大明宫, including the Danfeng Gate 丹凤门 and the Linde Basilica 麟德殿, which are currently undergoing reconstruction. There is a modern stele marking the site of former Mingde Gate 明德门, the central gate of the south outer wall. However, there is little to see. The former site of Xingqing Palace 兴庆宫 has become a pleasant city park. Two Islamic mosques originally built in the Tang still stand in Chang’an, though they have been rebuilt several times in subsequent centuries. Set between a coal plant and a recycling factory not far from the Shaanxi Television Tower along South Chang’an Road 长安南路 is the Sui and Tang Altar of Heaven 隋唐天坛, virtually unknown but largely intact and nearly a millennium older than its Ming-Qing counterpart in Beijing. The road that runs past the site where the Sui and Tang Altar of Heaven still stands is named Altar of Heaven Road 天坛路 (Baldwin, 2006). Also south of the Ming city walls, which still stand, are two famous Buddhist pagodas constructed in the early Tang, the Big Goose Pagoda 大雁塔 and the Little Goose Pagoda 小雁塔. Many administrative districts and streets in modern-day Xi’an still bear their names of more than a millennium past, or carry the names of city gates that once stood close by. For instance, the central north-south axis of the city is called Chang’an Avenue, echoing the name borne by both the Han and Tang capitals. There is also a Chang’an district in the southern suburb. Vermilion Bird Road (Zhuque Lu 朱雀路) is named after the South Gate of Tang Chang’an. Parallel Hanguang Road 含光路 is named after the southwest gate of the imperial city. In Shaanxi Normal University 陕西师范大学, the foreign students’ dormitory is called Qixiayuan 启夏苑, for it stands on the former site of the Tang capital’s Qixia Gate 启夏门.

2. Marketing the Golden Age

Both government and private entrepreneurs have long known that the glorious past can give business a boost. Billed as the “Eighth Wonder of the World,” the vaunted terracotta warriors of the First Emperor of Qin in nearby Lintong have drawn vast numbers of tourists from within China and abroad since opening to the public in the early 1980s. As the original and reconstructed historical sites of greater Xi’an draw an ever greater volume of domestic and foreign visitors, local businesses have affiliated themselves with ages of past grandeur by incorporating names that echo tradition. This reflects what some call a new “Tangization movement” (xin Tanghua yundong 新唐化运动) On the road connecting the Xi’an-Xianyang International Airport to Xi’an, there are several leisure villas including the Han-Tang Leisure Retreat (Han-Tang fanzhuang 汉唐饭庄), paying homage to both great eras of traditional China. Along South Chang’an Avenue is the Han-Tang Bookstore 汉唐书店. The Tang Imperial Bathhouse (Tang

80 Yugong 唐御宫) is a five-story building with faux imperial red and gold flair and curved eaves. Outside the western gates of the recently-reconstructed Ming city walls, one passes a garish Flourishing Tang Foot Massage (Sheng tang zu liao 盛唐足疗). It is as though the proprietors hope that the name instills in customers a sense, whether real or imagined, of the residual luster of Tang glory. Just inside the southern gate of the city walls next to the Bell Tower 钟楼—featuring as its centerpiece an enormous McDonald’s--is the modern Kaiyuan mall. Its name, Kaiyuan 开元, echoes the famous Kaiyuan reign era (712-741) of renowned Tang dynasty emperor Xuanzong 玄宗. The Kaiyuan period is often referred to as kaiyuan shengshi 开元盛世, “the flourishing age of Kaiyuan.” South of the Ming walls along Chang’an Avenue, one finds the Tang Paradise Performance Theater, where full- costumed dances and songs are performed along with dinner. For a fleeting instant, to the strains of Tang court music, eating a sumptuous banquet, one can imagine he is a dignitary being feted by the Tang court. A forty-acre Tang dynasty theme park, the Great Tang Hibiscus Garden 大唐芙蓉苑, was built in 2004 on the site of the original Hibiscus Garden and Qujiang Lake 曲江, in the southeast corner of Tang Chang’an. The park includes Qujiang River, a stock image in many Tang poems, now an artificial lake on which water image movies are projected by night. Tang dances and court music are performed in the Purple Cloud Terrace 紫云台, a palatial centerpiece of the entire park. In a tower devoted to Tang women, there are lively court scenes from the reign of female emperor, Wu Zetian 武则天; and an entire floor devoted to voluptuous beauty Yang Guifei 杨贵妃, who bedazzled Emperor Xuanzong. Elsewhere, there are images of the six famous horses of Emperor Taizong 太宗 (r. 627- 649), recalling his “glorious age of Distant Vision” (Zhenguan zhi zhi 贞观之治), an epoch of civil brilliance, grand expansion and equestrian splendor. There is an ensemble of bronze sculpture featuring famous Chinese Buddhist pilgrim, Xuanzang, and his unorthodox band of disciples immortalized in the Ming dynasty novel Journey to the West 西游记, Monkey (Sun Wukong 孙悟空), Pig (Zhu Bajie 猪八戒) and Friar Sand (Sha Wujing 沙悟净). Xuanzang’s 玄奘 fourteen-year journey to India to fetch Buddhist scripture in the mid-7th century is the stuff of legend. The Great Tang Hibiscus Garden also contains a marketplace geared to simulate the two flourishing hubs of commerce in Chang’an, the Eastern 东市 and Western Markets 西市. There, one can buy Monkey’s weapon of choice, the “as-you- will gold banded cudgel” (ruyi jingu bang 如意金箍棒) made of plastic. However, a much larger Western Market, built on the site of its original Chang’an counterpart, is currently under construction and is scheduled to be completed prior to the 2008 Olympics. Hu Ji 胡戟, a retired Professor of Tang History at Shaanxi Normal University, is one of the chief designers and architects of this 21st century West Market. He boasted that the new Western Market capture the essence of the original—a free-wheeling bazaar featuring a tremendous array of Indian, Persian, Arabian and Central Asian goods—and that “people will be able to buy anything there short of an atomic bomb”(Hu, 2006). Next to the Great Tang Hibiscus Garden one finds Qujiang Number Six Auto Body Parts. Along Wei’er Road 纬二路 in the southern suburb is a block named Anyi

81 Ward 安邑坊, after one of the blocks of Tang Chang’an (Xiong, 2000). The street is lined with the ubiquitous faux traditional architecture, recently constructed. Among the many souvenir shops, there is an Indian restaurant—perhaps an effort to offer a glimpse of the Tang’s vaunted cosmopolitanism. Also, outside the western city walls, a statuary caravan of Silk Road pilgrims heads westward, having just set out from Chang’an laden with precious silks and other goods.

3. A New Monumentality: Tradition and Modernity Coalesce in the Big Goose Pagoda

As a cultural site, Big Goose Pagoda has transformed dramatically in recent years. A taxi cab driver, a Xi’an native, informed me that when he was young there were no walls around the temple, no entry fee, and local children used the overgrown temple grounds as a playground in the late 1960s and early 1970s (Zhang, 2006). When I first visited the temple in late 1988, it was surrounded by souvenir shops containing the usual assortment of tourist knick-knacks. Now, on the southern end of the pagoda complex there is a huge bronze statue of Buddhist pilgrim Xuanzang, erected in 2002. Along the eastern margin, there is a broad promenade connecting the southern and northern squares, large public spaces created in the past five years. The promenade is lined with stall after stall of free marketeers selling everything from carved chops to kids’ shoes with wheels in the heel, from spinning tops with whips to feicui jade 翡翠, from glow-in-the-dark halos to Shaanxi paper cuts, from Pepsi, Budweiser and Nestle’s ice cream to scroll paintings of the eight frisky colts, the Four Beauties and ghostbuster Zhong Kui 钟馗. Periodically there are bronze sculptures of Tang scenes: non-Han Chinese merchants, wrestlers, or Confucian court ministers. In the northern square, along the eastern margin, red lanterns reading “Tang” hang from the eaves of the Xi’an Visitors’ Center and Kentucky Fried Chicken. Centered on the 216-foot Big Goose Pagoda in the background, there are five huge thirty by one hundred meter fountains, set like steps, each slightly more elevated than the last (Nepowada, 2006). Every evening, the fountains are illuminated and there is a synchronized water dance that fuses an eclectic blend of Communist party anthems, classical, pop and traditional Chinese music. Natives of Xi’an have long since grown weary of the performance, so the audience of 10,000 to 30,000 that gather nightly is composed of gawking provincials (waidi ren 外地人), domestic tourists—for there has been a sunburst in domestic tourism over the last decade--and foreigners. The new vision of monumentality reflected in Big Goose Pagoda and contiguous public spaces, in short, is a carefully calculated hybrid of modernity and tradition. Is this nightly celebration in the newly-created public space just north of Big Goose Pagoda a tribute to a proud history or simply an effort to commodify history, to market Tang Sanzang and Sun Wukong, tidily packaging them for the carnivorous consumerism of China’s new millennium? This question has no simple answer. Indeed, it opens up an imbroglio of thorny issues: the relationship between past and present (is the past an anchor hindering China’s development or a rich source of pride?), the transition from so-called “Socialism with Chinese characteristics” 有中国特色的社会主义 to capitalism, and, perhaps most significantly, the collective identity of the Chinese. Probing the tortuous tendrils of this vast briar patch, however, is a task far beyond the parameters of this essay.

82 References:

Baldwin, John (2006), “The Forgotten Altar.” Student paper written for Summer 2006 “Sui- Tang Chang’an” course, unpublished, department of History, University of North Florida.

Benn, Charles (2002). Daily Life in Traditional China: The Tang Dynasty. Westport, CT: Greenwood Press.

Hu Ji (2006, June 3). Personal communication.

Nepowada, Steven (2006), “Kentucky Fried Chicken and the Commodification of Traditional Chinese Culture in Xi’an China.” Student paper written for Summer 2006 “Sui- Tang Chang’an” course, unpublished manuscript, department of History, University of North Florida.

Schafer, Edward (1963). The Golden Peaches of Samarkand: A Study in T’ang Exotics. Berkeley: University of California Press.

Weschler, Howard (1985). Offerings of Jade and Silk: Ritual and Symbol in the Legitimization of the T’ang. New Haven, CT: Yale University Press.

Xiong, Victor Cunrui (2000). Sui-Tang Chang’an: A Study in the Urban History of Late Medieval China. Ann Arbor: Center for Chinese Studies, University of Michigan Press.

Zhang Weidong (2006, May 13). Personal communication.

83 84 PERSPECTIVE ON CHINESE RELATIONS WITH THE UNITED STATES

Thomas M. Leonard Department of History University of North Florida

Abstract

During the past few years, United States policymakers and public analysts have presented China as a growing threat to international political and economic stability. For its part, the government in Beijing disputes this assertion stating only that it wants to be welcomed into the family of nations and allowed to pursue its own self interests peacefully. Based upon sources in the United States and the personal experience in a faculty seminar entitled “China Confronts New Security Issues” at the China Foreign Affairs University in Beijing, this paper will analyze the differences in perceptions.

Introduction:

From June 12 to 16, 2006, sixteen academics from Australia, Western Europe, and the United States convened at the Foreign Affairs University in Beijing, China, for an intensive seminar on contemporary Chinese foreign policy. The seminar participants varied from China experts to neophytes. Founded by Chou En-lai, the university is a branch of China’s Ministry of Foreign Affairs and is responsible for the training of Chinese diplomats and others preparing for international careers. Nine university faculty led seminars on a wide range of topics that included Japan, North Korea, Taiwan, global economic strategy, ASEAN, global energy needs, global arms control, and so forth, too many to cover in this short presentation. Because many of the accompanying papers focus on international economic issues, this paper focuses upon China’s “neighborhood” in East Asia where political issues are at the forefront. Unless otherwise noted, the interpretations given in the paper’s first section represent the author’s understanding of the collective thinking of the seminar presenters.1

2. China’s Foreign Policy:

2.1 Framework of Policy

As we sit at the dawn of the twenty-first century, a new paradigm applies to the international order. Rather than the spheres of influence by which Europe colonized the world from the sixteenth through the nineteenth centuries, or the spheres of influence that dominated much of United States foreign policy in the twentieth century, a natural geo- gravitational pull developed in the post Cold War world. Simply put, it means that within identifiable geographic regions of the globe, one nation emerges as the strongest in economic, political and military terms and that other nations within the region are drawn to

1 The faculty leaders included professors Su Hao, Zhang Haiwen, Quin Yaqing, Zhang Qingmin, Li Genxin, Yang Jian, Yang Yi, Yao Yunzhu, and Wang Yizho, the Deputy Director of the Institute of World Politics and Economics at the Chinese Academy of Social Sciences. it. According to this theory, the geo-gravitational states are the United States for North America; Brazil for South America; Western Europe for the European Union; Russia for the Commonwealth states; India for South Asia; China for East Asia; Australia for Oceania; and potentially Indonesia for Southeast Asia. As globalization replaced the Cold War in the 1990s, the underdeveloped world shed its history of being dominated by the industrial world and came to understand that it has much in common with those nations and peoples in the same region (see www.mfa.gov.ch; Deng and Wang,1999; Giles, 2004; Lampton, 2001; Robinson, 1998; Pollard and Young, 1998). Despite vast changes in the international order over the past 15 years, today one must still admit that a single super power remains: the United States. While it has the power to dominate any one of the regions, the United States should recognize the shifting global landscape and permit each region to develop its own priorities, deal with its own problems, and work cooperatively in international venues to cope with issues that affect the entire world, such as the impact of globalization, terrorism, and pollution. This ideal does not rule out the Clauswitzian idea that military force may be needed to maintain peace within the geo-gravitational region or between regions (von Clauswitz, 1978).2 The basis of China’s contemporary foreign policy is found within the parameters of today’s changing international order.

1.2 East Asia

In the 1980s, China shed the spirited nationalism that guided its past for the more “cooperative” approach that guides its foreign policy today. China’s “aggressive” and “self-interested” nationalistic spirit that dated to 1949 are gone. No longer does China reject foreigners and their ideas or work only on behalf of its own self-interest. Instead, China now pursues a “cooperative nationalism” within its region and as a member of the world community. In other words, China’s primary interest lay within its own geo-gravitational area, East Asia, where it considers itself the focal point. Beyond East Asia, China’s international activities are related to the region or, as a geo-gravitational power, to serve as an “honest broker,” in helping to settle disputes. To the Chinese, U.S. foreign policy makers do not always understand Beijing’s dual role. Clearly, the United States does not share China’s view of its own relationship with East Asia. In its bi-lateral relations with Beijing, Washington focuses largely upon its trade imbalance with China but at the same time appears not to understand the significance of China’s unfavorable trade balance with its East Asian neighbors. Nor does Washington seem to understand that China serves as the assembly point for the component parts produced in East Asian nations that are shipped on to the United States. These facts alone closely link China to East Asia. On a broader scale, China’s foreign trade, as part of its total economy, grew from 12.6% in 1980 to 70% in 2004. The financial benefits from this trade help to fuel China’s economic and industrial development, or, to put it another way, meet the rising expectations of its population. In this sense, China’s search for external markets is no different than that of Europe and the United States in the late nineteenth century. China’s rapid domestic development fueled its recent increased demand for oil. Only thirteen years ago, in 1993, China had no need to import oil. But today, like the United States and comparable to other East Asian nations, China imports 50% of the national needs. Of significant note is the fact that 70% of the oil transiting through the Malaccan Straits is delivered to China, Japan, and South Korea. Oil consumption, when coupled with the value of China’s exports, clearly indicates that China and East Asia are

2 Karl von Clausewitz is considered one of history’s most important military philosphers. A Prussian by birth, he gained fame in the Napoleonic wars and subsequenty headed the Germany military academy.

86 integrated into the global economy and, some would say, are dependent upon it. In dealing with Beijing, the United States fails to accept China’s integration into the world economy, instead focusing upon adverse consequences thereof, such as the loss of U.S. jobs and increased petroleum prices. China’s “dependency” upon the global economy, the Chinese scholars explained, affects Beijing’s position on international questions. For example, China’s need for petroleum explains its attitude regarding Iran’s development of nuclear power, including potential weapons. Beijing’s representatives at the United Nations are hesitant to cooperate with the United States in seeking the imposition of sanctions upon the government at Teheran unless it ceases its nuclear program. Simply put, China fears a cut off of Iranian oil should it cooperate in U.S. sponsored sanctions on Iran. The same need for oil has sent China to Latin America with investments and trade agreements with Ecuador, Venezuela, Mexico, and more recently Cuba, long suspected of possessing offshore oil reserves (Leonard, 2004). While these are legitimate foreign policy initiatives to Beijing, Washington views them as threats to U.S. interests. In addition to its role in the global economy, China must have peace within the East Asian neighborhood in order to sustain its economic growth. East Asia includes Japan, North Korea and Taiwan and, China has troubling political relations with each. The problem with Japan dates to Japan’s war of aggression against China that began with the 1933 Manchurian invasion and developed into all-out war after the 1937 Shanghai Incident. Japan’s refusal to acknowledge the devastation that the war brought to China or to compensate, among other things, the thousands of Chinese women carried off to service Japanese troops is most grating. Japan’s insensitivity to the matter was magnified in 2001 when Prime Minister Juichiro Koizumi commenced his annual visits to the Yasukuni Shrine3 (Onishi, 2005; Safier, 1996), a monument dedicated to the military who have fought on behalf of the Emperor, including the generals found guilty at the Tokyo war crimes trials following World War II. The relationship is further exacerbated by Japan’s inability to recognize that it cannot be at the geo-gravitational center of East Asia. Its dependence upon the outside world for energy and other natural resources essential for industrial development continue to threaten the viability of Japan’s economic condition. According to the Chinese scholars, World War II should have taught the Japanese this lesson (see Duss, 1996; Rees, 2001). Finally, the Chinese believe that Japan’s recent expanded defense relationship with the United States has a double meaning. Ostensibly designed to meet North Korea’s nuclear threat, Japan’s military modernization further challenges the Chinese defense capabilities and, in so doing, serves the larger U.S. policy objective to contain China. Despite these obstacles, China and Japan reached an agreement on sharing energy technology and China seeks Japan’s cooperation in combating pollution (see Austin and Harris, 2001; Tsai and Pekkanen, 2005). China’s concerns about the future of North Korea go beyond the Pyongyang government’s potential nuclear threat. The collapse of Kim Jong Il’s dictatorship threatens to inundate China with hundreds of thousands of ill-fed, ill-clothed, and unskilled North Koreans, who would strain China’s society, its fragile social safety net and its workforce. To stem the tide of a potential collapse, China pursues a policy of local job creation in North Korea by investing in manufacturing plants to absorb unemployed North Korean workers. For similar reasons, China is pleased to play a major part in the six power discussions regarding the dismantling of North Korea’s nuclear capabilities but recoils at U.S. public assertions that China can and should be doing more to help solve the problem. The Beijing government is further frustrated by the Bush administration’s refusal to hold

3 The Yasukuni Shrine is a Shinto memorial in Tokyo dedicated to soldiers who fought on behalf of the Emperor.

87 direct talks with the North Koreans, a step that many analysts, including the Chinese, believe will relieve the tense environment created by North Korea’s nuclear testing (see Chambers and Ally, 2006; Kim and Kim, 2004). Like Hong Kong, Tibet and other areas on China’s fringe, Taiwan has historic roots that link it to mainland China. Taiwan also stands as a Cold War relic. Whatever its cause, China’s demand that Taiwan be restored to the control of the government at Beijing remains the most important singular international issue to the Chinese government and people alike. The Chinese government points to several historic documents that support its case. During the seminar the Chinese scholars emphasized the 1894-1895 agreement that ended the Sino-Japanese War, by which China surrendered Taiwan to Japan, and there it remained until the end of World War II. Then, the 1943 Cairo Declaration proclaimed that Japan must return to China all its “stolen territories.” Nowhere is Taiwan identified in the Declaration, but the Chinese foreign policy establishment consistently understood that was the intention. Taiwan became a Cold War issue in 1949 when Chaing Kai-shek and many of his followers found refuge on the island following their loss in China’s “Civil War.” From then until the end of the Cold War in 1991, Taiwan stood as a bastion against the People’s Republic of China (PRC) in the U.S. global battle against communism. The U.S. promised to defend Taiwan against an external attack, presumably by the PRC. The U.S. also pumped millions of dollars into Taiwan’s economic development, all to the consternation of the Beijing administration. Throughout the fifty years of the Cold War, the PRC continually insisted that the island is part of the national domain and belongs under its sovereignty. The Chinese scholars at this workshop argued that following the end of the Cold War to today the Taiwanese people are increasingly anxious to revert to Beijing’s authority and that the United States is searching for a “face saving” way out of its commitment to the island. In the same 15-year period, the bond between the mainland and Taiwan has tightened through increased cultural and personal exchanges, trade relations and investments. The seminar’s scholars uniformly believe that Taiwan will become part of China within two generations (see Brown, 2001; Wang, 2001; Weller, 1999). The probability that the PRC will use force to incorporate Taiwan into its fold is remote. Using Clauswitz’s logic that war is an extension of diplomacy, the possibility remains but only in western eyes, the seminar participants were told. They were reminded that the Chinese military has never been strong. Since Mao Tse Tung’s victory in 1949, the military’s primary purpose has been to provide for the nation’s defense against an external attack and to provide for internal security. Modernity has not been a characteristic of China’s military machine, and beginning in the 1980s with Deng Xiaopeng’s emphasis upon economic development, the military’s budget was further reduced. The budget cuts limited the growth of troop strength and curtailed advancements in ground, air and sea military equipment and other hardware. At the dawn of the twenty-first century, most analysts agree that China’s military capabilities lagged behind the West by at least a generation. In the changing international environment of the new century and in light of the growing military strength of its neighbors – Japan, Russia, India and Pakistan – along with the 2001 perception that incoming President George W. Bush would pursue a more aggressive foreign policy, the PRC commenced a military modernization program that will be better suited to meet its own security needs in the new century (Bickford, 2004). In sum, the Chinese scholars portrayed a picture of a China primarily concerned with its East Asian neighborhood, starting with a sense of economic interdependence. While North Korea’s recent nuclear adventures and Japan’s program to upgrade its military are viewed as a threat to Beijing, the re-incorporation of Taiwan into its fold remains the primary foreign policy challenge. In many ways the Chinese government is a newcomer to international affairs and those events beyond East Asia. Its role, however, is greatly limited, largely because of the internal challenges presented to the government by the ever-growing industrialization process.

88 2. George W. Bush and Neo-Conservative Policies:

When George W. Bush took office as the forty-third president of the United States in January 2001, he assembled a foreign policy team, save Secretary of State Colin Powell, that reflected the ideology of Neo-Conservatives that represent the far-right wing of the Republican Party. Many of them had been founders of the New American Century, a conservative think tank founded in 1997 and determined to rescue U.S. foreign policy from the “incoherent policies of the Clinton administration.” Dick Cheney, Donald Rumsfeld, I. Lewis “Scooter” Libby, Paul Wolfowitz, and Fred C. Ikle were among the organization’s founders. Other members of the Bush team traced their politics to the Ronald Reagan administration, such as Elliott Abrams and William J. Bennett (see www.neweamericancentury.org). Having led the West to victory in the Cold War, in 2001 the United States stood as the world’s pre-eminent power at the dawn of the twenty-first century. However, to the Neo-Conservatives the nation lacked the vision and resolve to shape the new century in ways favorable to U.S. interests and principles. The Neo-Cons, as they are popularly known, signaled their intentions at the founding of their organization in 1997. Once in political power they intended to build a strong military force prepared to meet both the present and future challenges; to pursue a foreign policy that “boldly and purposefully” promoted U.S. principles abroad; and to present a national leadership that accepted the U.S. global responsibilities. To the Neo-Cons, the twentieth century demonstrated the need for U.S. leadership in global affairs and in the future for the United States to “shape circumstances before crisis surfaced.” In application, it meant that the Neo-Cons, once in power would: • increase defense spending and modernize the armed forces • strengthen ties with democratic allies and challenge regimes hostile to U.S. interests and values • promote the cause of political and economic freedom around the globe • preserve and extend an international order that served U.S. security, prosperity and principles. (see f. www.neweamericancentury.org)

These principles became the basis of George W. Bush’s foreign policy. In application these principles meant that the U.S. correctly interpreted the causes and consequences of events, possessed the correct vision for the future world order, and also justified Bush’s introduction of the concept of “pre-emptive wars.” The administration’s insistence upon sticking to these principles also meant that U.S. foreign policy became characterized by ever increasing unilateralism (Bakefich, 2002; Eisendrath and Goodman, 2004; Moens, 2004; Jarvis, 2005). For China, the Bush administration moved away from the policy of engagement that had characterized U.S. policy towards China since the Richard M. Nixon presidency. _ (Garrison, 2005). Amon the –current advocates for engagement are former secretaries of state Madeline Albright and Henry Kissigner, former Ambassador to China and currently Managing Director of Kissinger Associates, J. Stapleton Roy, and presidential advisor to George H. W. Bush, Brent Snowcroft. This group argues that because the United States and China have more in common than most people realize, the United States should pursue a policy of accommodation not confrontation. They also assert that, with the - increase of globalization over the past 15 years, there no longer exists one superpower and, as the Chinese argue,– China has - emerged as – Asia’s geo-gravitational center. Japan does not have the capabilities. Thus, it is in the interest of all Asia that, as China continues to develop economically, it must maintain domestic tranquility, particularly as it confronts its

89 own “generation of rising expectations”4 (Roy, 2006; Zuckerman, 2006). In other words, -t he People’s Republic of China’s (PRC) - path to domestic tranquility, in part, is – requires a peaceful, not aggressive foreign policy. In the 1990s, the Neo-Conservatives emerged as staunch opponents of the engagement policy. - They argued that Clinton’s engagement policy did not curtail China’s threat to Taiwan, prevent it from seizing islands in the South China Sea, or stop it from increasing its defense spending. Furthermore, they explained that China’s stated long term strategic goal is to “create in East Asia a new security order which would no longer rest on America’s military and economic power.” Given this challenge and the alleged failure of Clinton’s engagement policy, the Neo Cons further asserted that the United States should contain China where it is necessary and reward China when it behaved according to international norms (Schmitt, 1997; Donnelly, 2000; Kagan and Kristol, 1998). The United States would be the final arbiter of that behavior. Once Bush – was entrenched in the White House and the Neo-Conservatives in key policymaking roles, they set about to contain China’s alleged new strategic interests in Asia. In congress, the Neo-Cons pushed through legislation requiring The Pentagon to report annually on the China-Taiwan military balance and for The Pentagon’s National Defense University to establish a new center to study China’s military. Given this policy framework, Bush’s proposed Ballistic Missile Defense System is to serve as a deterrent to the PRC’s fledgling missile program. The Pentagon’s Annual Report on the Military Power of the People’s Republic of China has served to heighten the public concern with the growing strength of the PRC’s military. From their start in 2002, The Pentagon reports cast a doubt over the ability to peacefully resolve security issues between Washington and Beijing because the Chinese military serves as a major threat to U.S. interests in all of Asia. The Pentagon reports further describe Chinese advances in theatre-level weapons management, message interception capability, and direction finding and radio jamming equipment. The modernization program also vastly increased– China’s People’s Liberation Army’s (PLA) - weaponry and missile systems that included purchases from Western European countries and advances in the navy’s submarine fleet via purchase from Russia. The Pentagon estimates that the government in Beijing has spent, not the officially stated $20 billion on its modernization program, but between $75 and $105 billion. The 2006 report concluded that, within ten years and at the current rate of growth, China will achieve the same level of military technology as the industrialized world. The Pentagon also asserted that China already has changed drastically the regional military picture and its continued military growth demonstrates interests beyond homeland security. Still, today, China’s military hardware systems remain a generation behind those of the United States (U.S. Secretary of Defense 2002-2006; Preuer, Brown, and Segal, 2005; Ng, 2005). Generally, analysts agreed with The Pentagon’s assessment. Kurt Campbell, a Pentagon advisor during the Clinton administration, and James Mulvenon, a China analyst at the RAND Corporation, noted that the Bush administration is correct in worrying about the PRC’s military buildup, particularly with missiles. Richard Bitzinger, a researcher at the Asia Pacific Center for Security Studies in Hawaii, noted that the PLA’s strength “complicates Pentagon military planning” for East Asia. One of Europe’s most respected news magazines, The Economist, echoed the warnings about the threat to Asian political

4 The term “generation of rising expectations” refers to an emerging middle class that developed as a result of domestic industrialization and/or the entrance of the host country into the global market place. Comprised largely of better educated individuals, professionals, white collar and skilled workers, small entrepreneurs, students, and the like, this group historically sought entry into the political process in order to better serve their own interests.

90 stability posed by China’s military. William Lind, writing for United Press International (UPI), put an interesting twist on the report, turning the tide on Donald Rumsfeld’s “China is the threat we want, not the threat we face.” What others downplayed, Lind emphasized: that China’s increased capability is to defend itself from outside aggression, particularly a U.S. supported invasion from Taiwan. China’s threat to the United States is nuclear, not conventional, Lind reasoned. Such a conflict would be suicidal for both sides, just as one would have been between the Soviet Union and the United States during the Cold War (USA Today, 7/13/2002; Simeone, 2004; The Economist, 9/03/05; Mount, 2006; and Lind, 2006). To Washington policymakers, China’s military advances pose an immediate threat to Taiwan. Although the United States has long pursued a “One China” policy, it also militates against the Taiwanese from declaring their independence. Such a move, the U.S. believes, invites an invasion from the mainland. So too, does China’s military buildup on the mainland directly across from Taiwan. To The Pentagon and others, the strengthening of China’s military signals the intention to seize the island by force. Why else would China place an estimated 750 short range mobile ballistic missiles in garrisons opposite Taiwan, deploy 400,000 ground troops to the three military regions opposite Taiwan, and station Russian-made submarines in the Taiwan Straits? Apparently, Clausewitz is applicable in the Taiwan case. Should diplomacy fail to bring Taiwan under the Chinese umbrella, the goal will be accomplished by military means. Taiwan’s President Han Nai-kuo couldn’t agree more (BBC International, 4/20/06; Hamilton Spectator, 9/10/05; and China Post 8/30/06). Even before Bush arrived at the White House in January 2001, Neo- Conservatives were pushing for increased arms sales to Taiwan. At the same time Chinese policy makers understood that the Bush team – Cheney, Rumsfeld, Wolfowitz, Libby, and Richard Armitage - held a friendlier view of the Taipei government than did the Clinton administration. Yet, at the start of his term and to the dislike of many Neo-Conservatives, Bush clung to the “One China Policy” and expressed his support for the 1979 Taiwan Relations Act. Bush’s initial ambiguous approach to China and Taiwan led some Beijing officials to hope that some “old friends of China,” such as Henry Kissinger and Brent Snowcroft, would surface to guide the younger Bush’s China and Taiwan policies. Kissinger and Snowcroft did not emerge and, throughout his first presidential term, Bush continued his ambiguous policy, which did not change until the issuance of the 2006 National Security Strategy Report. The report noted a significant increase of Chinese military ships trolling the Taiwan Straits. Subsequently, two U.S. made destroyers purchased by Taiwan arrived in Taipei. That same month the Taiwanese government budgeted $3.6 billion to purchase 66 U.S. made F-16 fighter jets5 (Schmitt, 1998; Kagan 2000 and 2001; Kristol and Bork, 2004; Taiwan Relations Act, whitehouse.gov/nsc. nss/2006/; see also Garver, and Tucker, 2005) The subsequent U.S. military sales to Taiwan reflected the 2006 report on China’s military capabilities and its implied threat to the island. The United States was not the only country caught off guard by the rapid increase in China’s military strength and increased presence in the Taiwan Strait. Japanese Foreign Minister Taso Aso observed that “It’s becoming a considerable threat” (NY Times, 12/23/05). Japan’s concern for East Asian political stability heightened on July 4, 2006, when North Korea tested seven long and medium range missiles, some capable of carrying nuclear warheads. While the tests indicated North Korea’s missile deficiencies, but similar

5 According to the terms of the Taiwan Relations Act, the United States is committed to the defense of Taiwan, to supply it with military assistance for its own defense and to interpret any other threat against Taiwan as a threat to U.S. security interests in Asia.

91 to China’s military growth, the potential is significant. Initially, President Bush played down the significance of the tests, while China, South Korea, and Japan registered greater alarm. Over time, Kim Jong Il’s intentions remained a mystery. Some argued that he wanted to force the United States back to the negotiating table; others suggested he wanted greater prestige as an important player in Asian politics; and still others suggested that he was looking to strike a better deal from foreign aid donors. When President Bush finally acted, he made an unsuccessful attempt to force North Korea back to the six-party negotiating table that includes the United States, China, Russia, Japan, North, and South Korea. Kim Jong Il refused to budge, insisting only on direct talks with the United States (CNN News, 7/05/05; McCarthy 2006; Alberts 2006; The Economist 7/08/06; NYTimes, 7/07/06; Hobart Mercury 7/08/06; Pelofsky 2006; Asia-Africa Intelligence Wire 7/16/06; and newon.uor.edu/Departments&Programs/ AsianStudies/Department/Korea-rel.html). Both events played into U.S. strategic policy towards Japan and those elements within Japan that wish to decrease Japan’s historic dependence on the United States for national defense. The United States envisions a Japan that significantly contributes to the cost of its own defense by increasing the size of its military and increasing its offensive capabilities.6 (Przystup and Saunders 2006; Onishi, 2006; Currie 2006; BBC International 7/05/06 and 8/23/06; Harris, 2006; Vancouver Sun 8/28/06; see also Osius 2002; Ozawi, 1994; Dudley 2003; Lee, et al, 1999; Harrison, 2002) Any increase in Japan’s military structure is viewed in Beijing as a threat to its own security. With regards to North Korea, the U.S. anticipates that Japan will encourage the other members of the Six Party Negotiating Team (the United States, China, Russia, Japan, North Korea, and South Korea) to force Kim Jong Il to end his nuclear program. At the present however, Japan’s influence in East Asia is limited by its strained relations with China and South Korea (Sterling 2006) and, like the others, Japan has no influence over North Korea’s Kim Jong Il. So too, is United States influence in the region greatly limited. The Bush administration refuses Kim Jong Il’s request or demand, depending on your point of view, that Washington and Pyongyang directly settle the nuclear issue, rather than through the regional negotiating team. But Kim Jong Il refuses to participate in such talks unless the United States lifts its embargo against a Macau --based bank that handles North Korea’s international accounts. The bank allegedly is engaged in laundering money for Pyongyang and producing counterfeit U.S. dollars for it (Kristol 2006; Dinsmore 2006; BBC International 7/27/06; Asia-Africa Newswire,7/28/06 and 8/26/06; Lee 2005; Asia- Africa Intelligence Newswire 8/24/06; Deutsche Press 8/24/06) In sum, the Bush administration appears determined to be the sole arbiter of Asian policy, a position that runs head into China’s contention that it is the geo- gravitational center of East Asia.

3. Conclusion:

Although a neophyte to the subject of Chinese-American relations, this author concludes, based on the experience of this conference, that we have two bulls in the proverbial “China closet” and that each believes that is correct. This paper demonstrates that China and the United States have clashing visions and interests over their influence in East Asia. China, as an emerging power, claims that its regional interests are primarily at the expense of outsiders and that its cooperative policy has replaced the self-interest of previous administrations. In practice, however, self-interest is at the heart of its policy regarding Taiwan, Japan, and North Korea. For example, while

6 An excellent reference site for references to North Korea’s forcing relations, its military and current nuclear crisis is: http://newton.uor.edu/Departments&Programs/AsianStudiesDept/nkorea-nuke.html

92 China’s claim to Taiwan has historic roots is correct, but the 1943 Cairo Declaration neither mentioned the island nor does it make any reference to the 1895 treaty by which Japan received the territory. To claim otherwise is simply a matter of self-interest. In seeking to coax the United States to directly settle its differences with North Korea, China wants to avoid the responsibilities of a regional power and open the door to placing blame outside the region for the inevitable collapse of the Pyongyang regime and its adverse impact upon China. To continually criticize Japan’s younger generation for the errors committed by its elders and to dismiss the island nation as a third rate power is to be as insensitive as the Japanese were toward China in refusing to acknowledge the pain and suffering World War II brought to China by the Japanese army and by the visits of Premier Koizumi to the Yasukuni Shrine. Public clamoring over these issues and Japan’s changing military defense posture hinder the negotiation of pollution and energy technology agreements between Beijing and Tokyo. As with the current Iranian problem, where China is hesitant to support international economic sanctions, Beijing is acting in its own self interest. On the other hand, the Bush administration is living in the past regarding the United States ability to influence the policy of East Asian nations. Bush was slow to implement a security policy towards China. His first administration focused upon economic issues that are outside scope of this paper. Only as China’s military strength grew did the Bush administration respond. While many analysts argued that China’s military modernity currently lags significantly behind that of the U.S., all agree that within a generation the two most likely will be equal, at least. But, the Bush administration portrayed the issue as one of the “present,” particularly with regards to Taiwan and, the broader concepts of East Asian security. Thus, the U.S. increased the sale of military hardware to Taiwan and Japan and, it intends to encourage Japan’s further advancements in its military technology and assume an increased role in Pacific security strategies. The U.S. intransigence over negotiations with North Korea contributed to China and South Korea scheduling direct talks with Pyongyang in October. 2007. The unilateralism that characterizes the foreign policy of the Bush administration is applicable to East Asia. And as elsewhere around the globe, the unilateralism has resulted in unwanted consequences – namely, increased tensions in U.S.- Chinese relations. A less confrontational approach would enable China and the United States to deal with mutual problems that have greater significance to the world: energy, the environment, trade practices, intellectual property rights and the like. This paper also suggests a larger question for our consideration: In the twenty- first century, can any one or two superpowers direct global affairs? In light of Chinese rapid emergence, followed by India and Brazil and Chile in Latin America, the European Union that now stretches from the Atlantic Ocean to the Black Sea, and the Middle East’s changing environment, converge to suggest that regionalism, not globalism, will characterize the twenty-first century geo-politics. Historically, within these regions there have been conflicts among the nations over the pre-eminence of one regional power despite the realities of the day. Ask a Mexican his view of the United States, an Argentine about Brazil or Chile, a Frenchman about Germany, and so on. From this perspective both China and the United States need to readjust their regional visions to reflect the reality of the day.

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98 EXAMINING THE RELATIONSHIP BETWEEN EXPORTS, FDI, AND INCOME IN CHINA

Mina Baliamoune-Lutz Jing Yi Ju Department of Economics and Geography University of North Florida

Abstract

We examine the relationship among income, FDI, and exports (after controlling for regional effects) in 30 Chinese provinces. The empirical results provide strong evidence on the important role of exports in promoting income. We also show that there is a significant positive relationship between FDI and income in higher income provinces (coastal region).

Introduction:

The bulk of the empirical work on poverty alleviation concludes that growth is an essential element of the strategy for fighting poverty. Foreign direct investment (FDI) reduces (or may eliminate) the saving-investment gap and is thought to be a significant factor in economic growth, and hence it is considered a major factor in the efforts to reduce poverty. Most theoretical and empirical studies emphasize the important role of FDI in helping economies to grow. It is generally argued that FDI can promote the formation of human capital, trigger technology spillovers, and enhance business competitiveness in the host country (OECD, 2002). However, the bulk of FDI goes to developed countries; only a limited number of developing countries receive significant FDI, of which China has been, for over a decade now, the leading recipient (Table 1). In fact, the poorest countries in the world, including many in Africa, receive almost no FDI. In addition, even those countries that receive significant amounts of FDI may not have enjoyed the expected benefits from inward FDI. Zhang and Markusen (1999) and Dayal-Gulati and Hussain (2000) argue that specific host-country characteristics are critical to the success of FDI in causing economic growth. Similarly, Borensztein et al. (1998) maintain that the level of human capital may limit the absorptive capability of a developing country. Thus, the question of whether FDI leads to higher growth is best addressed through empirical work. Due to its large share of inward FDI and wide income disparities across provinces (see Tables A1 and A2 in Appendix A), China constitutes an interesting case for assessing the impact of FDI. Many studies have documented that FDI is associated with (or has caused) higher regional inequality in China with those regions that receive larger amounts of FDI experiencing, in general, stronger growth in exports and income (see for example, Baliamoune and He, 2002, and Graham and Wada, 2001). Figure 1 indicates that Chinese provinces with higher FDI tend to have higher exports and higher per-capita income. Indeed, the spikes in FDI (lagged one period) indicate that exports and income seem to match.

Table 1: Inward FDI in Developing Countries (Billions of US Dollars)

1990-2000 Top 10 Top 10 2001 (average) China 43.4 China 69.7 Brazil 12.0 Mexico 24.7 Mexico 10.1 Brazil 22.5 Argentina 7.2 Bermuda 9.9 Singapore 7.1 Poland 8.8 Malaysia 4.7 Singapore 8.6 Bermuda 4.7 Chile 5.5 Poland 3.7 Czech Republic 4.9 Chile 3.3 Taiwan 4.1 South Africa 3.2 Thailand 3.8 Top 10 total 99.5 Top 10 total 162.5 Developing countries, total 130.9 Developing countries, total 200.9 Top 3 share 50 % Top 3 share 58 % Top 10 share 76 % Top 10 share 81 %

Source: Gallagher and Zarsky (2006), based on data from UNCTAD, 2002.

Figure 1: Income, Exports and FDI

Exports FDI Per-capita income (Yuan, log)

0.70 12.00

0.60 10.00

0.50 8.00

0.40

6.00

0.30 Income

4.00 0.20 Exports and FDI (% of GDP) 2.00 0.10

0.00 0.00 123456789101112131415161718192021222324252627282930 Provinces

Examining the implications of the important links between FDI, openness to trade, growth and inequality, Baliamoune and He (2002) conclude that [t]he impressive growth of inward FDI in the People’s Republic of China has been the subject of heated debates among economists. On the one hand, increased openness to international trade seems to foster FDI and higher FDI, in turn, is associated with higher growth. On the other hand, the recent decline in

100 the ratio of FDI to GDP causes some concern when we consider the potential adverse effects on growth and economic development in China.

In the remainder of this paper, we first review the empirical literature on the role of FDI and exports in China’s recent growth experience. Second, Using ordinary-least- square (OLS) estimations and 2003-2004 data from 30 Chinese provinces, we examine the effects between exports and FDI, and income per capita. Finally, we outline the policy implications of our results and discuss the potential growth effects of China’s ‘twin surpluses’ (current account surplus and capital account surplus).

1. A brief Review of Recent Empirical Work on FDI and Growth in China:

Baliamoune and He (2002) examine the patterns of inward foreign direct investment in the People’s Republic of China since the introduction of the open-door policy in late 1978 and find strong correlation between FDI, openness, and economic growth when considering the entire period of 1979-1999. Nevertheless, the authors show that while the correlation between FDI and output growth has increased in the 1990s, the association between FDI and openness to international trade has declined. Similarly, Graham and Wada (2001) argue that “much and perhaps most of the growth of China’s exports can be attributed to foreign-invested enterprises and per capita income growth in those regions of China where FDI is concentrated has been significantly higher than in other regions.” Lheem and Guo (2004) use data from 29 provinces covering the period 1995- 2000 and test the hypotheses of growth-driven FDI and FDI-led growth. They find strong empirical evidence that FDI causes growth but also argue that “rapid economic growth and FDI distribution patterns may be associated with a ‘synergistic effect.” In an attempt to explain regional disparities in China, Fleisher et al. (2005) show that FDI is strongly related to total factor productivity (TFP) growth and that “the direction of FDI is strongly influenced by the level of infrastructure capital.” The authors obtain estimates of rates of return to investment in infrastructure capital and human capital, which are much greater than the rates of return to investment in physical capital within firms. Finally, Young (2000) finds empirical evidence that trade among Chinese provinces has become more restricted in the post-reform era, which may have contributed to significant regional divergence. A related issue that has been increasingly discussed in the literature on the effects of FDI (and openness to trade) and growth in China is the growing regional inequality (Coughlin and Segev, 1999; Yang, 1999; Zhang, 2001; Baliamoune and He, 2002; Lu, 2002; and Yang, 2002). For example, Lu (2002) uses provincial data and shows that “rural-urban consumption disparity has, on average, increased during the 1990s, but the increase in disparity slowed in the second half of the 1990s.” The author also finds that provinces with higher per-capita income tend to have less inequality. This is consistent with Kuznets’ (1955) prediction that inequality will first rise then fall as countries move to a higher level of development. Baliamoune and He (2002) find empirical evidence suggesting that as FDI and growth increased so did regional inequality. In some provinces, higher wages and low literacy rates (poor levels of human capital) hinder FDI while coastal location, the size of the economy, and labor productivity (usually associated with higher literacy rates) tend to promote inward FDI (Coughlin and Segev 1999). Rural-urban income disparities in China are significant and may have a negative effect on China’s development. Yang (1999) concludes, based on results from inequality decomposition on data from Sichuan and Jiangsu provinces, that rural-urban income disparities constitute a significant portion of total inequality. Regional inequalities may have resulted from the deliberate policy to promote international trade and foreign investment in specific regions. Eckaus (2006) uses ordinary- least-square and random effects panel estimations on Chinese provincial data and finds that

101 the subsidies of state-owned enterprises (SOEs) had an important positive effect on the exports of SOEs in the provinces with significant exports. However, Pedroni and Yao (2006) show that divergence between provinces cannot be explained by differences in the degree of preferential open-door policies.

Table 2: Correlations (Regional Data, 2004)

Exports FDI Income per capita (log) (% GDP) (% GDP) Income per capita (log) 1.0000 Exports (% GDP) 0.7551 1.0000 FDI (% GDP) 0.7487 0.7193 1.0000

2. Empirical analysis:

We use data from 30 Chinese provinces and OLS estimations and examine the relationship among FDI (lagged one period) and exports, and per-capital income (in log). Table 2 displays correlation coefficients. As expected, there is strong positive correlation between exports and FDI, exports and income, and income and FDI. Overall, the results from OLS estimations reported in Table 3 suggest that there is a strong positive relationship between FDI, exports, and per-capita income. We use data from Chinese provinces (excluding Tibet) and FDI (in 2003) as a percent of GDP, exports (in 2004) as percent of GDP, and per-capita income (in 2004 Yuan) in its natural log transformation. All data are from the China Statistical Yearbook, 2005. We report the coefficients on the regressors and their statistical significance (p-value), the adjusted R square, and the F statistic. We start with a simple equation (column 1) where income is regressed on FDI, exports, and a constant. The results indicate that both exports and FDI have a statistically significant (at the 5-percent level) relationship with income. Next, following our previous discussion of the regional disparities in China (see Table A2), we add dummy variables for the Coastal provinces (Beijing, Fujian, Guangdong, Hainan, Hebei, Jiangsu, Shandong, Shanghai, Tianjin, and Zhejiang) and Northeast provinces (Heilongjiang, Jilin, Liaoning).1 The results (in column 2) indicate that the coefficients on these dummy variables are statistically significant (at the 5-percent level in the case of the Coastal region and the 10-perecent level in the case of the Northeast) and are, as expected, positive. However, once we account for this regional effect the statistical significance of FDI disappears. This, of course, could be due to high multicollinearity given that FDI is strongly correlated with exports and with the dummy variables for regions. Yet, the results suggest that we are not able to find additional effects on income from FDI beyond the indirect effect through its impact on exports. To explore this issue further we include an interaction term between FDI and exports. This would enable us to assess whether exports enhance the effectiveness of FDI in promoting higher income. We find a statistically significant (though the level of significance varies from 1 percent to 10 percent) but negative coefficient on this interaction term (columns 3-6). We also include interaction terms between the dummy variables for regions and FDI and report the results in columns

1 Following most studies on China, we group the provinces into four regions. The other two regions are Interior (Anhui, Chongqing , Guangxi, Guizhou, Henan, Hubei, Hunan, Shanxi, Inner Mangolia, Jiangxi, Shaanxi, Sichuan, and Yunnan) and Far West (Gansu, Ningxia, Qinghai, and Xinjiang).

102 4-6. The estimates suggest that, on average, FDI flows to provinces in the Coastal region may have been more effective in enhancing income. This may be due to higher levels of human capital and to spillover effects from dynamic (export oriented) firms in this region. In all six equations, the relationship between exports and income is positive and robustly significant (at the 5-percent level or better). On the other hand, the relationship between FDI and income is significant but not robust. The coefficient on FDI is statistically significant at the 5-percent level in 3 out of six estimations. Indeed, once we control for regional differences, the effect of FDI is no longer statistically significant. The negative and statistically significant coefficient on the interaction between exports and FDI seems to be inconsistent with empirical findings that export-biased FDI enhances growth (see for example, Baliamoune-Lutz 2003 and 2004). This result could reflect saturation effects, or it may reflect specification problems related to the endogeneity of both exports and FDI. Higher income provinces may be able to attract more FDI and export more. Instrumental variable estimation (such as two-stage least square estimation) would allow us to take this into consideration. We have not been able to find suitable instruments to perform this estimation but we plan to explore this further in future research. In addition, institutions are usually included in income equations. By focusing on provinces from China we minimize the effect of differences in institutions and thus we can undertake the estimations without including institutional quality. There may still be some differences in incentives and regulation but they are captured to a large extent in the differences in export and FDI levels.

Table 3. Regression Results

Dependent Variable: Income Per Capita (log) (1) (2) (3) (4) (5) (6) Exports (% GDP) 1.47 1.15 2.62 3.05 3.16 2.56 [0.010] [0.034] [0.003] [0.001] [0.001] [0.005] FDI (% GDP) 12.76 5.63 12.89 8.12 6.89 13.14 [0.014] [0.310] [0.010] [0.117] [0.198] [0.011] Exports X FDI -0.019 -0.041 -0.042 -0.019 [0.080] [0.009] [0.009] [0.095] Coastal 0.49 [0.033] Northeast 0.41 [0.053] FDI x Coastal 0.011 0.0112 [0.049] [0.042] FDI x Northeast 0.0117 [0.328] FDI x Far West 0.0002 [0.972] Constant 8.97 8.94 8.95 8.97 8.97 8.95 [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] F-stat 25.94 17.24 19.89 17.89 14.20 14.35 [0.000] [0.000] [0.000] [0.000] [0.000] [0.000] Adj R-squared 0.63 0.69 0.70 0.70 0.69 0.65 Number of observations = 30. p-values are in [ ].

103

3. Concluding Comments:

In this paper, we examined the relationship between income, FDI, and exports – after controlling for regional effects – in 30 Chinese provinces. The empirical results provide convincing evidence on the role of exports in promoting income. We also find support for a significant positive relationship between FDI and income in higher income provinces (coastal region). Our results are consistent with the findings in Wang and Gao (2003) who find positive effects of FDI and openness to trade on income in Chinese provinces. An interesting extension of this work would be to explore the contribution to the Chinese economy of specific foreign funded industries. Table A3 displays data from the China Statistical Yearbook (2004) on the main economic benefits of selected foreign funded industrial sectors (in 2003). We note that while many industries have economic benefits that exceed the national average, several industries have below-average economic benefits. China’s impressive growth in the last 15 years or so has relied to a large extent on inward FDI and exports. Assuming China’s reliance on these two factors continues, then the question of sustainability of its twin surpluses arises. China has been running a current account surplus and a large capital account surplus for over a decade now and this may exacerbate global imbalances. Even if manufacturing exports fall, China may soon start exporting products with advanced technology and scientific content. China is increasingly enhancing its position as a leading nation in scientific discovery. Zhou and Leydesdorff (2006) claim that China is currently the fifth leading nation in scientific publications and is in second position (after the US) in critical technologies such as nanotechnology. This implies that both inward FDI to China and its exports to the rest of the world may continue to grow and perhaps so will its twin surplus. This could have important implications for US-China relations given that the US runs a significant trade deficit vis-à-vis China and that many policymakers in the US consider the Yuan as undervalued and have been calling for more exchange rate flexibility on the part of China.

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106 Appendix A

Table A1. Selected Aggregate Indicators

Aggregate Data

Average Annual Growth Rate 1978 1989 2004 1979- 1990- 1998- 2004 2004 2004 (10 000 persons) Population at the Year-end 96259 112704 129988 1.2 1.0 0.7 Urban 17245 29540 54283 4.5 4.1 4.7 Rural 79014 83164 75705 Male 49567 58099 66976 1.2 1.0 0.8 Female 46692 54605 63012 1.2 1.0 0.6 (100 million yuan) Gross Domestic Product 3624.1 16909.2 136875.9 9.4 9.3 8.2 Primary Industry 1018.4 4228.0 20768.1 4.6 4.0 3.3 Secondary Industry 1745.2 7278.0 72387.2 11.3 12.0 9.8 Tertiary Industry 860.5 5403.2 43720.6 10.0 8.4 8.2 Net Export of Good and Service -11.4 -185.5 4079.2 Foreign Trade (USD 100 million) Total Value of Exports and Imports 206.4 1116.8 11545.5 16.7 16.9 19.8 Exports 97.5 525.4 5933.2 17.1 17.5 18.3 Imports 108.9 591.4 5612.3 16.4 16.2 21.6 Utilization of Foreign Capital (USD 100 million) Foreign Direct Investments 33.9 606.3 21.2 4.3 Other Foreign Investments 3.8 34.4 15.8 Source: China Statistical Yearbook, 2005

Table A2. Income, exports and FDI (averages by region, 2004)

Region Per capita income FDI (% GDP) Exports (% (current Yuan) GDP) Coastal 24478 4.02 24.64 Northeast 13709 1.48 5.05 Interior 8394 1.01 0.95 Far West 8414 0.24 0.70 Source: China Statistical Yearbook, 2005

107 Table A3. Main Indicators on Economic Benefits of Selected Foreign Funded Industrial Enterprises by Industrial Sector (2003) Ratio of Ratio of Overall Value Total Assets- Ratio of Labor Added to Assets to Liability Profits to Productivity Sector Gross Industrial Ratio Industrial (RMB/ Industrial Output (%) Cost (%) person- Output Value year) Value (%) (%) National Total 26.15 11.46 55.43 6.83 92158 Processing of Food from Agricultural 23.35 7.34 65.19 2.98 110189 Products Manufacture of Foods 31.24 12.21 53.72 6.64 97949 Manufacture of Beverages 36.16 13.03 54.66 7.58 152879 Manufacture of Tobacco 56.90 32.21 44.74 20.02 191153 Manufacture of Textile 25.22 6.04 53.95 3.61 49352 Manufacture of Textile Wearing Apparel, 27.16 9.74 54.86 4.10 29813 footwear, and Caps Manufacture of Leather, Fur, Feather and 25.85 7.84 58.12 2.86 29398 Related Products Processing of Timber, Manufacture of Wood, 26.44 5.58 58.64 2.63 51216 Bamboo, Rattan, Palm and Straw Products Manufacture of Furniture 24.78 7.37 55.62 4.46 41019 Manufacture of Paper and Paper Products 27.20 9.02 59.04 6.85 103885 Printing, Reproduction of Recording Media 31.16 10.79 47.61 10.20 72349 Manufacture of Articles for Culture, 26.31 6.27 51.97 3.80 23527 Education and Sport Activity Processing of Petroleum, Coking, Processing 23.70 15.66 47.27 5.88 401843 of Nuclear Fuel Manufacture of Raw Chemical Mat. and 28.40 15.42 51.60 10.32 206847 Chemical Products Manufacture of Medicines 38.47 15.86 52.06 13.55 144631 Manufacture of Chemical Fibers 23.25 8.73 49.66 6.38 143445 Manufacture of Rubber 29.01 8.78 58.93 5.93 73564 Manufacture of Plastics 25.70 7.20 49.50 4.99 57221 Manufacture of Non-metallic Mineral 30.86 7.75 51.99 6.90 71087 Products Manufacture of Metal Products 24.26 8.63 55.52 5.42 70646 Manufacture of General Purpose Machinery 30.53 11.64 53.18 9.84 120235 Manufacture of Special Purpose Machinery 27.54 11.74 54.40 9.30 103460 Manufacture of Transport Equipment 28.46 23.74 49.26 13.67 255996 Manufacture of Electrical Machinery and 25.58 10.14 54.50 6.59 78936 Equipment Manufacture of Communication Equipment, 19.86 8.07 64.47 3.69 136547 Computers and Other Electronic Equipment Production and Distribution of Electric Power 55.33 15.24 49.39 28.18 568891 and Heat Power Production and Distribution of Water 35.65 6.23 41.88 24.45 114224

Source: China Statistical Yearbook (2004).

108 THE DEMAND FOR HEALTH CARE IN CHINA

Chung-Ping A. Loh Department of Economics and Geography University of North Florida

John S. Akin Department of Economics University of North Carolina at Chapel Hill

William H. Dow University of California at Berkeley

Peter M. Lance Measure Projects, Carolina Population Center Chapel Hill, North Carolina

Abstract

The transition into market oriented economy in China in the past several decades has altered its health care system tremendously. Changes in access to health services include rising prices, declining insurance coverage, improving health care quality, and these changes mostly fall unevenly across regions and subpopulation groups. Meanwhile, the successful economic reform has caused income to rise faster than ever. The net effects of these on the health care utilization behavior are largely unknown. This study examines demand in terms of the binary decision to visit alternative types of facilities, using data from a unique and rich longitudinal survey that includes respondents from both urban and rural communities. Our results show that travel time, waiting time, and quality of care play only a small role in the demand for health care. Meanwhile, individuals with higher income seem to make better health choices over time and thus are less prone to visit health facilities in the long-run.

Introduction:

The health care system in China underwent several major changes during the post-1979 period, when Chinese government moved from a centrally planned economy to a market-oriented one. One change is that user fees have been increasingly relied upon as a result of a substantial decline in the government budget for health services. In addition, as the rural cooperative medical system and its insurance program have gradually deteriorated, many rural residents have been left with poor or no insurance coverage and inadequate access to health services. These changes may have contributed to the non-random reductions in health care utilization found in many studies. At the same time, the successful economic reform also led China to its fastest economic growth in history. The GDP per capita rose considerably from RMB 417 in 1979 to RMB 7,086 in 2000. However, as the reform placed different emphasis on different areas, the increase in income also fell unevenly across regions, economic sectors, and different social groups. The rising income and widening income gap likely created diverse patterns in health care utilization within China.

109 The demand for health care has attracted considerable research attention, with the majority of work examining the role of health care provider characteristics in shaping the demand for care. However, only a few studies consider the demand for health care in China, and even these possess limitations. Perhaps most importantly, since they use cross- sectional data sets, opportunities (and hence attempts) to control for the possible endogeneity of key explanatory variables (e.g., income or provider characteristics) have been relatively rare. In this paper we provide a first step toward addressing this shortcoming. Specifically, we estimate a health care demand model using several panels of a unique and rich ongoing longitudinal survey of households drawn from rural and urban communities in eight provinces of China. Although we conduct a traditional demand analysis, emphasizing the role of provider characteristics such as price of, travel time/distance to, and quality of local health care facilities, we are also particularly concerned with the role of income. Our study’s longitudinal nature allows us to offer the sort of endogeneity controls (particularly for income) generally absent from the literature thus far. The organization of this paper is as follows. The next section provides a brief review of the literature, emphasizing gaps relevant to this study. We then introduce the survey that this paper employs as well as our final sample’s features. In the final section we draw our conclusions.

1. Previous Literature:

A vast body of work examines the demand for medical care in poorer nations.1 Despite this extensive body of work, certain limitations recur. The reliance of most studies on cross sectional data sets has had several consequences. First, few papers have been able to rely on potential time series variation in provider characteristics that might have strengthened identification. More importantly, the lack of longitudinal variation leaves insufficient scope for controlling the possible endogeneity in provider characteristics. The concern could be the potential for program endogeneity (Angeles et al., 1998, Pitt el. al., 1993, Rosenzweig and Wolpin, 1986) with respect to the characteristics of any publicly owned, managed, or subsidized providers. These characteristics might be subject to some sort of systematic policy rule that relies on community characteristics that play a role in the distribution of demand but are unobserved by the researcher. At the same time, the usual endogeneity problems associated with variables like price present themselves, even when private players dominate the market (Deaton, 1997). Unfortunately, in the absence of within variation (of the sort that longitudinal data potentially provides), to control for such endogeneity one would be forced to rely on some variant of instrumental variables estimation. A classic instrument would need to have its effect felt only through the endogenous variable and be uncorrelated with demand residuals. Further, it would have to be statistically powerful in the sense that it delivers strong explanatory power. However, current demand relies on largely unobserved health, itself an implicit function of past health

1 Ainsworth et al., 1993 (Kenya), Akin et al.,1991 (Ogun State, Nigeria), Akin et al.,1985 (Phillapines), Akin et al.,1986 (Bicol Region, Phillappines), Akin et al.,1998 (Sri Lanka), Akin et al.,1995 (Ogun State, Nigeria), Birdsall et al. 1986 (mali), Bolduc et al.,1996 (Benin), Chawley and Ellis,2000 (Niger), Chernichovsky and Meesok,1986 (Indonesia), Deolalikar,1995 (Indonesia), Dor and van der Gaag,1988 (Cote d’Ivoire), Dow,1995, 1999 (Cote d’Ivoire), Ellis et al.,1994 (Cairo, Egypt), Ellis and Mwabu,1993 (Kenya), Gertler and van der Gaag,1990 (Cote d’Ivoire and Peru), Gertler et al.,1987 (Peru), Gertler and Sturm,1997 (Jamaica), Heller,1976 (West Malaysia), Heller,1982 (Peninsular Malaysia), Hutchinson,2000 (Uganda), Lavy and Quigley,1993 (Ghana), Mocan et al. 2001 (China) and Mwabu et al.,1993 (Kenya) represent only a small portion of this literature.

110 (see Grossman,1972). But past health relies, via health input demand, in reduced form on the identifying instruments’ past values. Thus instruments must satisfy all of the classical conditions but also be essentially uncorrelated over time – a difficult set of standards to satisfy. The only study of health care demand in China of which we are aware is Mocan et al. (2001). They consider the demand for care in urban China using a cross-sectional sample collected in 1989. In contrast with most of the remaining literature concerned with multi-nomial choice among alternative providers or binary demand, these authors model total expenditures on health care demand over a one year interval. They find that household characteristics and work conditions impact demand for medical care. Expenditures are price inelastic, though less so for the poorest respondents, while the income elasticity of demand is found to be around 0.3. Other studies attempt to examine the determinants of health care utilization in China (e.g., Henderson et al., 1998 and Liu et al. 2003), but none focuses on demand’s economic determinants.) Liu et al. (2003) finds that income has no significant effect on health care utilization.

2. Methods:

In this study, we categorize facilities into two strata: one for clinics and the other for hospitals. Clinics and hospitals generally differ in sizes, service scopes, and resources availability, so this categorization provides basic control for these differences. We separately model the individual’s choice of each facility type when seeking care as a function of health care provider characteristics (including price, travel time to and waiting time at the facility, type of physicians seeing patients, etc.) and a set of individual characteristics and household demographics (including per capita income). Year indicators are included to capture the time trend in care utilization. While demands for clinics and hospitals are separately estimated, the choices of these alternative facility types are actually mutually exclusive. To preserve the essence of such multinomial choices, we allow cross effects in the model. That is, we allow the demand for one type of facility to be affected by the characteristics of the other type of facility. Our preferred binary choice model is the linear probability model (LPM). One of the LPM’s major advantages is ease in interpreting estimated coefficients. Another important advantage of this paper is that the LPM does not suffer from incidental parameter biases that might occur under other, more nonlinear, discrete choice models such as the logit or probit. We will be introducing controls for household level fixed effects to fix the potential problem of endogenous program placement. Due to CHNS’s cluster-based sampling approach, we report the robust Huber-type standard errors. Most of the previous studies on demand for health care exclude healthy individuals (i.e., those failing to report illness) from the sample. Several researchers have suggested that using endogenous information such as the existence of any illness to truncate the sample can introduce selection bias (Shultz and Tansel, 1992; Akin et al., 1998; Dow, 1995). In addition, self-reported health measures are often misleading, because people’s definitions of illness and well-being differ (Schultz and Tansel, 1992; Dow, 1995). One consequence of not truncating by health state is that our demand elasticities can be interpreted as long-run in the sense of Dow (1995). In other words, our elasticity results embody not only immediate (i.e., short run or health-constant) effects but also the longer run dynamic feedback effects as changes in covariates influence health levels (which in turn affect demand). Specifically, by truncating to a sample of the self-reported ill, the traditional literature effectively conditions upon health (H), itself a function of previous input demand and hence the covariates X that influence demand:

D = D(X|H(X))

111 where D is demand. The traditional literature considers only the short-run effect of changes in x ∈ X. Taking logs and the derivative, we have the elasticity:

∂E(D) x ∂E(D(X | H (X ))) x ⋅ = ⋅ ∂x E(D) ∂x E(D(X | H (X )))

Our approach does not condition upon health so that, implicitly, we have

E(D)= E(D(X|H(X)))·E(H(X)) and our elasticities can be interpreted (following Dow 1995) as long run:

∂E(D) x ∂E(D(X | H(X ))) x ∂H (X ) x ⋅ = ⋅ + ⋅ ∂x E(D) ∂x E(D(X | H (X ))) ∂x H(X )

Specifically, as the effect of a change in X after dynamic feedback through health has occurred. In this study we estimate health care demand unconditional on illness.

3. Data and Variables:

We draw our data from the 1989, 1991, 1993, and 1997 panels of the China Health and Nutrition Survey (CHNS), an ongoing longitudinal survey of Chinese households and the communities in which they reside. This collaborative project involves the Carolina Population Center of the University of North Carolina at Chapel Hill and the Chinese Center for Disease Control and Prevention. All the variables required for this study, including health facility characteristics, are extracted from the household survey. Although the CHNS includes a separate health facility component in its community survey that provides detailed information on the facilities sampled from each community, facility coverage is too limited with the result that many of the provider strata visited by individuals in a given community weren’t represented. Thus we turn to the household survey as an alternative. As part of this survey, respondents were asked to list health facilities that household members might visit in the event of illness, injury, or some other health concern. For each facility mentioned, respondents were asked to provide information on the type of facility, travel time to reach it, average waiting time to be seen by a health professional, type of doctor that they expected to see, the general availability of medicine, and the approximate cost to a self-pay patient for treatment of cold or flu. Since almost eighty percent of the health facilities actually visited can be matched to one of those described in the health facility module of the household survey, it provides a source of information about the supply-side of the relevant local health care market. On the other hand, this approach might undermine the degree to which our measures of local health facility characteristics are truly representative of local market conditions. However, the households also mentioned many facilities never utilized by respondents, allaying these concerns. We categorize all the facilities into one of two general provider strata, clinic and hospital. In our definition, the clinic stratum includes village, neighborhood, mother and child health, work unit, and private clinics. The hospital stratum is comprised of township, county, street (community), work unit, municipal or district, university affiliated, provincial, specialty, and private hospitals. To operationalize our indicators for provider

112 characteristics (time and money costs, quality of care), we take averages at the community level. Thus, for instance, to obtain a price for clinic visits in community j at any given wave t, we average the reported self-pay costs for cold or flu treatment for clinics as reported by the local households surveyed in that wave. This community-level approach avoids difficulties associated with the existence of households that fail to report facilities within a particular provider stratum in any specific wave. Nonetheless, this strategy of averaging at the community/panel level still leaves some missing values. To address this problem, we pursue the following imputation strategies. We replace missing values on care price and facility quality measures with urban-rural level averages in each province in the same wave. The underlying assumption is that within a province price and quality can be adequately predicted or proxied by the average for communities of similar urbanicity within that province. This assumption naturally appeals to the existence of similar cost-influencing characteristics, such as transport costs, wages, competitive pressures, etc. To address missing travel time, we follow a two-step imputation strategy. First, we attempt to replace any missing values for a community in a particular panel by the value provided in other panels, theorizing here that facilities probably do not move around much over time. If an observation is still missing, we then replace the remaining missing value for travel time with the pooled averages at urban-rural level in each province, assuming that these measures do not vary greatly over time. This second step relies upon the implicit assumption that factors such as population density, geography, infrastructure, etc., are likely to be highly similar across communities of a similar degree of urbanicity within a province. Our sample has a total of 24,124 person-year observations, generated by interviews with 10,731 individuals over the four waves under consideration. The number of person-year observations falls short of 42,924 (10,731*4) because many people are, in the face of significant sample attrition and replenishment, interviewed for only a subset of the panels. Table 1 provides a description of the variables this paper uses. The sample splits relatively evenly along gender lines. Farmers, fisherman, hunters and loggers make up 49% of the sample, white highly skilled workers (including senior professionals, technical workers, administrators, managers, executives, and government officials) comprise only 5%, and non-workers about 6%. State enterprises employ approximately 20% of the respondents. Geographically, 55% of the sample resides in rural areas, 20% in urban communities. Thus, our sample, as with the CHNS itself, involves an over- sampling of urban residents and those employed in occupations more prevalent in cities, relative to contemporary conditions in China. In a variety of respects, visits to hospitals cost more than those to clinics: RMB 3.68 for routine services like treatment of flu at a clinic, as opposed to the RMB 6.84 average charge at a hospital; 6 minutes average travel time to clinics against 18 minutes for hospitals; 7 minute waiting times in a clinic compared to 23 in a hospital. Meanwhile, quality appears higher in hospitals, where patients are more likely to be seen by western or Chinese doctors. Hospitals are also more likely to be stocked with needed medicines.

Table 1: Summary Statistics and Variable Description

Variable Mean s.d. Description Facility type 0.073 0.357 type of health facility chosen Price for a flu shot (community average for Price_C 3.683 2.789 clinics) Travel time to facility (community average Travel time_C 6.291 5.981 for clinics)

113 Table 1: Summary Statistics and Variable Description (continued)

Variable Mean s.d. Description Waiting time at facility (community average Waiting time_C 7.009 8.822 for clinics) Probability of being seen by doctor practicing western medicine (community Western doctor_C 0.506 0.353 average for clinics) Probability of being seen by doctor practicing traditional medicine (community Traditional doctor_C 0.046 0.149 average for clinics) Health Probability of being seen by health worker worker/Midwife_C 0.018 0.085 or midwife (community average for clinics) Probability of necessary medicine being Drug availability_C 0.844 0.245 available (community average for clinics) Price for a flu shot (community average for Price_H 6.841 5.187 hospitals) Travel time to facility (community average Travel time_H 17.562 14.426 for hospitals) Waiting time at facility (community average Waiting time_H 22.595 17.551 for hospitals) Probability of being seen by doctor practicing western medicine (community Western doctor_H 0.745 0.232 average for hospitals) Probability of being seen by doctor practicing traditional medicine (community Traditional doctor_H 0.080 0.111 average for hospitals) Probability of being seen by health worker Health or midwife (community average for worker/Midwife_H 0.002 0.017 hospitals) Probability of necessary medicine being Drug availability_H 0.966 0.083 available (community average for hospitals) Age 31.858 7.504 Age Gender 0.499 0.500 0 if male; 1 if female Education 7.719 3.735 Number of years of schoolings Cadre 0.035 0.184 1 if individual is a cadre; 0 otherwise Married 0.786 0.410 1 if married; 0 otherwise Household head 0.315 0.465 1 if head of household; 0 otherwise

114 Table 1: Summary Statistics and Variable Description (continued)

Variable Mean s.d. Description Occupation: Senior 0.051 0.220 1 if if senior professional/technical professional personnel (doctor, professor, lawyer, architect, engineer, etc.) or if administrator/executive/manager, factory manager, gov't official, section chief, director, administrative cadre (1) 0.158 0.364 1 if low professional/technical personnel (midwife, nurse, teacher, editor, photographer, etc.) or if office staff (secretary, office helper, etc.) or technical, Occupation: Low skilled worker (foreman, craftsman, etc.); 0 professional otherwise (2) 1 if farmer, fisherman, hunter, logger, etc.; Occupation: Farming 0.485 0.500 0 otherwise (5) Occupation: Non-skilled 0.123 0.329 1 if non-technical, nonskilled worker; 0 worker otherwise (7) Occupation: Service 0.077 0.267 1 if driver or service worker (housekeeper, worker cook, waiter, doorkeeper, barber/beautician, counter sales, launderer, childcare, etc.); 0 otherwise (10) 1 if other (excluding non-worker); 0 Occupation: Other 0.042 0.202 otherwise (17) 1 if employee of a state enterprise; 0 State employee 0.204 0.403 otherwise Cadre Household 0.083 0.275 1 if household has a cadre; 0 otherwise Household size 4.518 1.478 Number of people in the household Wealth 2nd quartile 0.251 0.434 1 if wealth is in 2nd 25%; 0 otherwise Wealth 3rd quartile 0.260 0.438 1 if wealth is in 3nd 25%; 0 otherwise Wealth top quartile 0.268 0.443 1 if wealth is in top 25%; 0 otherwise Stratum: Town 0.111 0.314 1 if community type is town; 0 otherwise 1 if community type is suburban; 0 Stratum: Suburban 0.137 0.344 otherwise Stratum: Urban 0.202 0.402 1 if community type is urban; 0 otherwise Province: Liaoning 0.093 0.291 1 if in Liaoning province; 0 otherwise (1) 1 if in Heilongjiang province; 0 otherwise Province: Heilongjiang 0.030 0.170 (2) Province: Jiangsu 0.121 0.326 1 if in Jiangsu; 0 otherwise (3) Province: Shandong 0.113 0.317 1 if in Shandong province; 0 otherwise (4) Province: Henan 0.129 0.335 1 if in Henan province; 0 otherwise (5) Province: Hubei 0.127 0.333 1 if in Hubei province; 0 otherwise (6) Province: Hunan 0.122 0.327 1 if in Hunan province; 0 otherwise (7) Province: Guangxi 0.137 0.344 1 if in Guangxi province; 0 otherwise (8)

115 Table 1: Summary Statistics and Variable Description (continued)

Variable Mean s.d. Description Province: Guizhou 0.129 0.335 1 if in Guizhou province; 0 otherwise (9) Year: 1991 0.255 0.436 1 if in 1991 wave; 0 otherwise Year: 1993 0.237 0.425 1 if in 1993 wave; 0 otherwise Year 1997 0.244 0.429 1 if in 1997 wave; 0 otherwise Wage: child care 3.672 10.612 Wage/day for child care worker (nanny) Wage: construction 13.253 15.688 Wage/day for construction worker 376.10 Wage: driver 361.759 3 Wage/month for driver Asset: tricycle 0.066 0.249 1 if household owns a tricycle; 0 otherwise Asset: bicycle 0.838 0.369 1 if household owns bicycle; 0 otherwise Asset: number of Number of bicycles owned by household; 0 bicycles 1.602 1.219 otherwise Asset: motorbike 0.063 0.243 1 if household owns motorbike; 0 otherwise Asset: car 0.018 0.131 1 if household owns car; 0 otherwise Asset: radio 0.483 0.500 1 if household owns radio; 0 otherwise Asset: VCR 0.052 0.222 1 if household owns vcr; 0 otherwise Asset: black & white tv 0.527 0.499 1 if household owns bw tv; 0 otherwise Asset: color tv 0.331 0.471 1 if household owns color tv; 0 otherwise 1 if household owns washing machine ; 0 Asset: washing machine 0.416 0.493 otherwise Asset: fridge 0.208 0.406 1 if household owns fridge; 0 otherwise Asset: air condition 0.017 0.131 1 if household has air condition; 0 otherwise 1 if household has sewing machine ; 0 Asset: sewing machine 0.558 0.497 otherwise Asset: fan 0.676 0.468 1 if household owns fan; 0 otherwise Asset: camera 0.083 0.275 1 if household owns camera; 0 otherwise 1 if household water in home tap; 0 Asset: tap water in home 0.402 0.490 otherwise Asset: tap water out of home 0.178 0.382 1 if tap water out of home; 0 otherwise Asset: well water 0.255 0.436 1 if well for water; 0 otherwise Asset: other water source 0.165 0.371 1 if other water source; 0 otherwise Asset: in-house flush toilet 0.170 0.376 1 if in house flush toilet; 0 otherwise Asset: no flush toilet 0.050 0.218 1 if inside no flush toilet; 0 otherwise Asset: outside flush toilet 0.039 0.195 1 if outside/public flush toile; 0 otherwise Asset: other toilet type 0.740 0.439 1 if other toilet type; 0 otherwise

116 Table 1: Summary Statistics and Variable Description (continued) Variable Mean s.d. Description Asset: electric light 0.959 0.199 1 if electric light in home; 0 otherwise

Asset: coal for cooking 0.405 0.491 1 if coal for cooking; 0 otherwise 1 if use liquid or natural propane t; 0 Asset: gas for cooking 0.129 0.335 otherwise Asset: wood for cooking 0.283 0.451 1 if wood for cooking; 0 otherwise Asset: other cooking fuel 0.183 0.386 1 if other cooking fuel; 0 otherwise Asset: number of rooms 3.135 2.687 Number of rooms excluding bath/toilet Asset: brick/concrete wall 0.547 0.498 1 if walls brick/concrete; 0 otherwise Asset: other wall 0.453 0.498 1 if wall earth/wood/other; 0 otherwise

Number of Observations: 24,124

4. Results:

Table 2 reports the results for our linear probability model without controlling for possible endogeneity. The own price coefficients (Price_C for clinic and Price_H for hospital) are negative and fairly small. A one percent increase in own price reduces the probability of clinic visit by 0.0004 (or 0.0331 percent); a similar own price increase reduces the probability of hospital visit by 0.0012 (or 0.041 percent). Neither of these own price effects is significant at 10 percent confidence levels. Travel time to either type of facility exerts the intuitively anticipated negative effect on binary demand, although only in the case of clinics is that impact significant. Time spent waiting before being seen by a doctor in a hospital has a strongly significant positive effect on the probability of a hospital visit. Several possible reasons for this counterintuitive result present themselves, each involving the possibility of omitted variable bias. To begin with, facilities with longer waiting times may offer higher quality care. In other words, the providers’ high quality makes them more popular, and hence they have greater waiting lines; or the facility managers may feel that they can get away with longer waiting time, given the quality of care that they deliver. This explanation seems particularly reasonable given that we are able to offer only a very limited degree of control for quality. The other possibility, in terms of omitted variable bias, is the more general type (discussed in Deaton, 1997) and emphasized in this literature by Ainsworth et al., 1993). For instance, unobserved local health conditions, such as an outbreak of acute illness at the time of the survey, could largely drive health care demand so that longer waiting times effectively proxy for these more general unobserved factors. Lacking any a priori expectation regarding the direction of cross effects, we will touch only briefly upon them. Among cross effects of price, time, and quality, travel time has proved a strong, positive predictor in both types of visit. In any case, all of these results could be tainted by potential program endogeneity. Turning to individual and household characteristics, per capita income has a negative sign in both regressions. It is significant for clinic but not hospital visits. A one percent increase in income reduces the probability of clinic visit by 0.0002 (0.0176 percent) and of hospital visit by 0.0008 (0.0255 percent). These signs suggest that the wealthier are less likely to visit either provider stratum. Since our model does not condition on any health

117 or severity measure, one immediate explanation is that the wealthier may also be inherently healthier and thus in less need of health care. However, there is potentially any number of avenues by which income might be correlated with health care demand residuals. For example, if health shocks significantly affect earnings, then income could be correlated with demand residuals. A non-zero correlation clearly violates the standard orthogonality assumption and our estimates of income effects will, as a result, be inconsistent. To investigate this possibility, in the paragraphs that follow we introduce endogeneity tests and possible remedies. In terms of the remaining controls, we can summarize the demographic pattern as follows: older individuals, household heads, farmers, and members of small households are more likely to visit clinics. Older individuals, women, and Communist cadres are more likely to visit hospitals.

Table 2: Linear Probability Estimation Clinic Hospital Variable Estimate Robust s.e. Estimate Robust s.e. Price_C -0.0001 0.0003 -0.0006 0.0005 Travel time_C -0.0004 *** 0.0001 0.0005 ***0.0002 Waiting time_C -0.0001 0.0001 0.0002 0.0001 Western doctor_C -0.0034 0.0024 -0.0015 0.0036 Price_H -0.0006 *** 0.0002 -0.0002 0.0003 Travel time_H 0.0004 *** 0.0001 -0.0001 0.0001 Waiting time_H 0.0001 0.0000 0.0003 ***0.0001 Western doctor_H -0.0026 0.0035 -0.0090 * 0.0051 Age 0.0004 *** 0.0001 0.0013 ***0.0002 Gender 0.0031 0.0019 0.0078 ***0.0028 Education -0.0004 0.0002 0.0002 0.0004 Cadre 0.0040 0.0057 0.0248 ***0.0084 Married 0.0014 0.0022 0.0040 0.0033 Household head 0.0047 ** 0.0022 -0.0014 0.0033 Occupation: Senior professional -0.0029 0.0051 0.0047 0.0076 Occupation: Low professional -0.0035 0.0038 -0.0023 0.0057 Occupation: Farming 0.0057 * 0.0033 -0.0046 0.0048 Occupation: Non-skilled worker -0.0038 0.0038 0.0037 0.0056 Occupation: Service worker -0.0008 0.0041 -0.0038 0.0060 Occupation: Other 0.0015 0.0047 -0.0093 0.0069 State employee 0.0023 0.0024 0.0027 0.0036 Cadre Household -0.0015 0.0036 0.0049 0.0053 Household size -0.0012 ** 0.0006 -0.0013 0.0008 Year: 1991 -0.0012 0.0021 0.0004 0.0031 Year: 1993 -0.0046 ** 0.0022 -0.0240 ***0.0033 Year: 1997 -0.0013 0.0024 -0.0210 ***0.0036 Per capita income -4.27E-08 1.96E-07 -1.37E-07 2.88E-07 Constant 0.0069 0.0068 0.0016 0.0100 R-Square 0.0094 0.0142 Change by 1% increase in Price -0.0004 0.0012 -0.0012 0.0018 Income -0.0002 0.0011 -0.0008 0.0016

Elasticity: Price -0.0331 0.0873 -0.0410 0.0612 Income -0.0176 0.0807 -0.0255 0.0536

118 Table 3: Linear Probability with Fixed Effects Clinic Hospital Variable Estimate Robust s.e.Estimate Robust s.e. Price_C 0.0006 0.0005 -0.0012 0.0007 Travel time_C -0.0002 0.0002 0.0004 0.0003 Waiting time_C -4.42E-05 0.0001 0.0002 0.0002 Western doctor_C -0.0016 0.0033 -0.0006 0.0049 Price_H -0.0003 0.0003 0.0004 0.0004 Travel time_H 0.0001 0.0001 -4.19E-05 0.0001 Waiting time_H 2.18E-05 0.0001 0.0001 0.0001 Western doctor_H -0.0061 0.0045 -0.0031 0.0068 Age 0.0003 * 0.0002 0.0013 *** 0.0003 Gender 0.0016 0.0021 0.0066 ** 0.0032 Education -0.0005 0.0003 0.0000 0.0005 Cadre 0.0033 0.0063 0.0135 0.0095 Married 0.0037 0.0033 0.0046 0.0049 Household head 0.0031 0.0025 -0.0006 0.0037 Occupation: Senior professional -0.0061 0.0061 0.0004 0.0091 Occupation: Low professional -0.0066 0.0045 -0.0008 0.0068 Occupation: Farming 0.0001 0.0041 -0.0020 0.0061 Occupation: Non-skilled worker -0.0072 0.0045 0.0031 0.0067 Occupation: Service worker -0.0020 0.0048 0.0016 0.0072 Occupation: Other 0.0007 0.0053 -0.0061 0.0080 State employee 0.0019 0.0033 0.0003 0.0049 Cadre Household -0.0127 *** 0.0051 0.0046 0.0076 Household size -0.0011 0.0012 -0.0027 0.0018 Year: 1991 0.0001 0.0022 -0.0015 0.0032 Year: 1993 -0.0054 ** 0.0024 -0.0274 *** 0.0036 Year: 1997 -0.0054 * 0.0030 -0.0282 *** 0.0044 Per capita income -1.31E-07 2.64E-07 1.29E-07 3.94E-07 Constant 0.0176 * 0.0100 0.0066 0.0150

σμ 0.0674 0.0958 σε 0.1103 0.1647 ρ 0.2722 0.2527 R-Square: Within 0.0033 0.0095 Between 0.0070 0.0210 Overall 0.0057 0.0130 Change by 1% increase in Price 0.0023 0.0018 0.0029 0.0028 Income -0.0007 0.0015 0.0007 0.0022 Elasticity: Price 0.1707 0.1336 0.0984 0.0947 Income -0.0539 0.1087 0.0240 0.0733

To establish some control for potential endogeneity of income and provider characteristics, we also estimate LPMs with fixed effects at the household level. To understand the source of identification under this approach, consider income. Our measure

119 of income is gathered at the household level. Because we lack data regarding variation in income among household members at a particular time, to identity demand we turn to variation in household income levels across households and over time. Inclusion of fixed effects controls for household level unobservables that might be correlated with income. However, identification is now achieved by variation in income within a household over time. We estimate the effect of income on demand by considering the degree to which variation in changes in income across households explains variation in changes in demand. In terms of facility level variables such as price, which really are determined at the community level, we nonetheless resort to the same type of variation. Household fixed effects controls should be sufficient to control for the endogeneity of facility characteristics since the unobservables shaping endogeneity due to program p1acement or unobserved local market factors are generally thought to operate at the community level. Table 3 provides estimates for this household fixed effects model. After controlling for heterogeneity, all the own time and quality effects retain the same signs as before, while the sign of own-price for both strata is reversed. However, none of the facility variables is statistically significant. The own price elasticities remain quite small and are measured imprecisely. Income still exerts an insignificant negative effect on the probability of clinic visits. As for the probability of hospital visits, income has a positive but slight effect. As mentioned, per capita income endogeneity occurs in multiple forms, although identifying the particular mechanism for it is difficult. We can always diagnose whether any combination exists, however, since these generally share symptoms (i.e., income and the error term would be correlated). We therefore conduct endogeneity tests. First, we estimate a linear probability model of facility visit under random and fixed-effect specifications using the full sample. If income is not correlated with the error term, both random- and fixed-effect models should provide consistent estimates, but the random- effect specification should be equally or more efficient. If income is correlated with the error term, however, the fixed-effect specification will at least partially difference out the source of correlation in the error term, providing more consistent estimates. The random- effect model’s estimate, which provides no control for correlation between regressors and errors, would be inconsistent - the essence of Hausman’s classic endogeneity test (Hausman, 1978), results of which Table 4 provides. We reject the null of exogenous income for hospital visits at the 10% confidence level but fail to reject it for clinic visit.

Table 4: Endogeneity Test: Income Chi-Square Prob> Chi-Square Full Sample (89-97) Clinic Visit 0.9 0.3418 Hospital Visit 3.51 0.0609 First difference (89-91) Clinic Visit 0 1 Hospital Visit 0 1 (91-93) Clinic Visit 0 1 Hospital Visit 0 1 (93-97) Clinic Visit 0 1 Hospital Visit 0 1

120 To improve control for income’s potential endogeneity, we pursue two-stage least squares estimation with controls for household fixed-effects. We do so because of the uncertainty as to whether the household level fixed effect controls for all income endogeneity. The fixed effect addresses only endogeneity driven by cross-sectional variation in rather permanent unobserved household factors. However, unobserved demand determinants that influence income but change significantly over time – for example, the household’s environmental status – may also be present. A simple household-level fixed effect cannot remove the effect of such time-varying unobserved heterogeneity. Therefore, in addition to the fixed effect, we also instrument for income. To do this we require at least one variable correlated with per capita income but not with facility visits. Since local community wage rates offer one immediate possibility, we select the community’s average monthly wages for construction workers (wage c). Table 5 reports the results of first stage

Table 5: First Stage Results for 2SLS: Community Average Wage as Instrument

Variable Estimate Robust s.e. Price_C 28.1767 ** 13.1687 Travel time_C 23.4271 *** 4.8900 Waiting time_C -11.7354 *** 2.9774 Western doctor_C 426.7295 *** 89.0773 Price_H 13.1208 * 7.4735 Travel time_H 16.5885 *** 2.4539 Waiting time_H 3.6129 * 1.9636 Western doctor_H -804.4087 *** 122.8708 Age -8.1728 5.1243 Gender 118.2790 ** 56.9862 Education 19.2065 ** 9.2428 Cadre -39.1315 171.0182 Married -37.1259 88.5184 Household head -69.4496 67.1105 Occupation: Senior professional 1332.7800 *** 164.4867 Occupation: Low professional 1420.5220 *** 122.3952 Occupation: Farming 180.4708 109.7307 Occupation: Non-skilled worker 1427.7250 *** 120.6703 Occupation: Service worker 1928.9770 *** 128.9774 Occupation: Other 1062.8920 *** 144.0789 State employee -230.7616 *** 88.7582 Cadre Household 577.1277 *** 137.6357 Household size 711.4632 *** 32.0625 Year: 1991 619.9201 *** 58.7464 Year: 1993 1302.6940 *** 63.7748 Year: 1997 1868.4500 *** 82.0071 Wage: construction 8.0408 *** 1.6993 Constant 413.5639 271.2942 sigma_u 3027.0841 σµ 2979.0465 σε 0.5080 R-Square: within 0.1126 between 0.2185 Overall 0.1851

121 regressions. The community’s average construction worker’s wage, significant at 1% confidence level, is thus a statistically good instrument. The first stage R-square is .19, which has been found to be sufficient in other work (e.g., Bollen et al. 1995)

Table 6: 2SLS Estimation: Community Average Wage as Instrument Clinic Hospital Variable Estimate Robust s.e.Estimate Robust s.e. Price_C 0.0006 0.0005 -0.0004 0.0009 Travel time_C -0.0002 0.0003 0.0010 ** 0.0004 Waiting time_C -0.0001 0.0001 -0.0001 0.0002 Western doctor_C -0.0013 0.0046 0.0098 0.0076 Price_H 0.0003 0.0003 0.0007 0.0005 Travel time_H 0.0001 0.0002 0.0004 0.0003 Waiting time_H 2.38E-05 0.0001 0.0002 * 0.0001 Western doctor_H -0.0065 0.0075 -0.0227 * 0.0123 Age 0.0003 * 0.0002 0.0010 *** 0.0003 Gender 0.0017 0.0023 0.0096 ** 0.0038 Education -0.0005 0.0004 0.0005 0.0006 Cadre 0.0033 0.0063 0.0125 0.0104 Married 0.0037 0.0033 0.0037 0.0054 Household head 0.0031 0.0025 -0.0024 0.0042 Occupation: Senior professional -0.0053 0.0121 0.0348 * 0.0199 Occupation: Low professional -0.0057 0.0121 0.0360 * 0.0199 Occupation: Farming 0.0002 0.0043 0.0027 0.0071 Occupation: Non-skilled worker -0.0064 0.0121 0.0400 ** 0.0199 Occupation: Service worker -0.0009 0.0159 0.0516 ** 0.0263 Occupation: Other 0.0013 0.0099 0.0214 0.0163 State employee 0.0018 0.0038 -0.0057 0.0062 Cadre Household -0.0124 * 0.0068 0.0194 * 0.0112 Household size -0.0007 0.0057 0.0155 * 0.0093 Year: 1991 0.0004 0.0051 0.0137 0.0084 Year: 1993 -0.0047 0.0104 0.0060 0.0171 Year: 1997 -0.0043 0.0157 0.0225 0.0259 Per capita income -7.26E-07 7.82E-06 -2.56E-05 ** 1.29E-05 Constant 0.0179 * 0.0108 0.0195 0.0177

σμ 0.0675 0.1233 σε 0.1103 0.1817 ρ 0.2727 0.3154 R-Square: Within 0.0030 Between 0.0059 0.0001 Overall 0.0055 0.0003 Change by 1% increase in Price 0.0024 0.0020 0.0049 0.0033 Income -0.0040 0.0434 -0.1422 ** 0.0716 Elasticity: Price 0.1747 0.1468 0.1655 0.1099 Income -0.2991 3.2231 -4.7643 ** 2.4048

122 Even after replacing income with its predicted first stage value, it is negatively associated with the likelihood of visiting either provider type (see Table 6). 2SLS thus preserves the original clinic visit result, except that the income elasticity has slightly increased from 0.0539 to -0.299l but is still insignificant. Since Hausman’s test suggests no endogeneity of income with respect to clinic visits, this is unsurprising. Instrumenting for income in hospital visits produces remarkable changes. The income effect not only remains statistically significant, but its magnitude increases: a one percent increase in income reduces the probability of hospital visits by 4.76 percent. Other variables also significantly impact hospital visits: waiting time and western doctor indicator reveal that the own time and own quality effects remain important; travel time exerts an important cross effect. Meanwhile, older individuals, women, workers both skilled and unskilled, service employees, members of large households and of those with a cadre are more likely to use hospital care. Intuitively, economic variables should play a substantial role in the distribution of health care demand and, in certain instances; one might expect their effects to occur more forcefully in low-income countries. Yet we have thus far recovered only very small price effects. These estimates may partially suffer from attenuation bias: if an error occurs in measuring a right hand side variable (say, price or income), the true parameter’s least squares estimate will be biased toward zero and inconsistent. One possible solution is to use instrument variables to remove measurement error-related attenuation bias. Since the average cost of flu treatment for a community is not likely to fully represent the fee for all types of service nor to reflect any under-the-table payments made to the physicians – a common phenomenon in China – the price variable is obviously susceptible to measurement error. Unfortunately, we could not find any suitable instrument for prices. When we instrument per capita income with wages, we obtain a pronounced income effect for hospital care. Because local wages could provide a suitable instrument in the face of either behavioral endogeneity or measurement error, it is not clear what our instrumental variables strategy addressed. However, if measurement error were a significant concern, we would expect it to introduce endogeneity bias in both the clinic and hospital models. Since our endogeneity tests suggest the exogeneity of income in the clinic demand equation, at first pass it would seem that instrumental variables is not controlling primarily for measurement error. To assess the likelihood that the dramatic changes in the hospital results brought on by instrumenting for income reflect the presence of measurement error, we adopt alternative instruments that would be less suitable in the face of behavioral endogeneity but acceptable in the case of measurement error. Specifically, we employ a set of indicators for household asset ownership (whether the household possesses a tricycle, car, radio, television, refrigerator, etc.) and living conditions (the type of toilet, the heat source for cooking, wall material, etc.) to construct a proxy for income. Our strategy is to find a correlated substitute for income “free” of the original measurement error, one that would likely remain endogenous if the correlation between income and demand residuals is due to more behavior related factors. Next, we use this instrument to re-estimate the main equation. Table 7 presents our first stage results. Over half of the asset ownership and living condition indicators significantly predict per capita income; the regression also has a high overall R-square of 0.29. In terms of identification strength and the degree to which the variation is reproduced, this gives us a good instrument for income. The second stage results vary slightly from those in the wage-instrumented case (Table 8). For clinic care, the income effect is actually the smallest so far. For hospital care, income effect is greater than the estimate using LP with fixed effects (Table 3) but smaller than that using wage- instrumented 2SLS. Though this result suggests some measurement error, we nevertheless believe that behavioral endogeneity plays a larger role in introducing inconsistency in our

123 estimate of income’s effect on demand for hospital care. Controlling for measurement error improves the estimate some, but the largest gain comes from using an instrument that addresses behavioral endogeneity more directly. Table 7: First Stage Results for 2SLS: Assets as instruments

Variable Estimate Robust s.e. Price_C 25.5631 ** 13.0076 Travel time_C 25.1297 *** 4.8106 Waiting time_C -14.6240 *** 2.9429 Western doctor_C 321.0846 *** 87.6262 Price_H -0.7277 7.3934 Travel time_H 19.4436 *** 2.4309 Waiting time_H 5.9413 *** 1.9421 Western doctor_H -681.6814 *** 120.6685 Age -6.8728 5.0518 Gender 109.2230 * 55.8664 Education 13.4004 9.0678 Cadre -15.0692 167.6537 Married -125.8813 87.3419 Household head -48.1445 65.7836 Occupation: Senior professional 1245.3870 *** 161.3230 Occupation: Low professional 1383.9200 *** 120.1615 Occupation: Farming 267.7306 ** 107.7454 Occupation: Non-skilled worker 1432.4110 *** 118.5054 Occupation: Service worker 1778.8760 *** 126.7511 Occupation: Other 1002.8770 *** 141.4021 State employee -243.0658 *** 87.1652 Cadre Household 463.9053 *** 135.3172 Household size 620.9219 *** 32.7581 Year: 1991 359.6930 *** 62.1601 Year: 1993 1030.9570 *** 85.1935 Year: 1997 1337.1800 *** 102.9698 Asset: tricycle 133.9954 128.3449 Asset: bicycle -200.5568 * 106.8910 Asset: number of bicycles 71.4444 * 38.6729 Asset: motorbike 744.8960 *** 125.4333 Asset: car 2960.7670 *** 218.4232 Asset: radio 129.1249 ** 64.8763 Asset: VCR 1015.1830 *** 147.1649 Asset: black & white tv 184.3580 ** 74.9592 Asset: color tv 465.8992 *** 101.9328 Asset: washing machine 499.6359 *** 94.3701 Asset: fridge 518.2797 *** 106.2688 Asset: air condition 1923.4590 *** 216.3853 Asset: sewing machine 87.2680 78.7285 Asset: fan 90.0498 85.9335 Asset: camera 133.4178 128.8297 Asset: tap water in home -1427.3640 1740.1540 Asset: tap water out of home -1616.0290 1740.4190 Asset: well water -1800.5420 1738.4340 Asset: other water source -1563.4940 1740.9960

124 Table 7: First Stage Results for 2SLS: Assets as instruments

Variable Estimate Robust s.e. Asset: in-house flush toilet 342.4549 ** 159.3002 Asset: no flush toilet -288.4578 196.8558 Asset: outside flush toilet -61.6701 138.0232 Asset: electric light 4.0531 141.4431 Asset: coal for cooking 230.4046 ** 97.2530 Asset: gas for cooking 840.4744 *** 123.7585 Asset: other cooking fuel -73.1993 87.6046 Asset: number of rooms 116.4606 *** 11.9044 Asset: brick/concrete wall -172.8300 ** 73.0420 Constant 1453.0410 1774.6060

σµ 2735.8090 σε 2919.0138 ρ 0.4676 R-Square: within 0.1492 between 0.3521 overall 0.2913

Table 8: 2SLS Estimation: Community Average Wage as Instrument

Clinic Hospital Variable Estimate Robust s.e.Estimate Robust s.e. Price_C 0.0006 0.0005 -0.0010 0.0007 Travel time_C -0.0002 0.0002 0.0005 * 0.0003 Waiting time_C -4.40E-05 0.0001 0.0001 0.0002 Western doctor_C -0.0016 0.0033 0.0012 0.0050 Price_H -0.0003 0.0003 0.0005 0.0004 Travel time_H 0.0001 0.0001 3.52E-05 0.0001 Waiting time_H 2.18E-05 0.0001 0.0001 0.0001 Western doctor_H -0.0060 0.0046 -0.0066 0.0070 Age 0.0003 * 0.0002 0.0012 *** 0.0003 Gender 0.0016 0.0021 0.0071 ** 0.0032 Education -0.0005 0.0003 0.0001 0.0005 Cadre 0.0033 0.0063 0.0133 0.0095 Married 0.0037 0.0033 0.0045 0.0049 Household head 0.0031 0.0025 -0.0009 0.0037 Occupation: Senior professional -0.0061 0.0063 0.0065 0.0095 Occupation: Low professional -0.0066 0.0049 0.0058 0.0073 Occupation: Farming 0.0001 0.0041 -0.0012 0.0061 Occupation: Non-skilled worker -0.0072 0.0048 -0.0097 0.0072 Occupation: Service worker -0.0021 0.0054 0.0105 0.0081 Occupation: Other 0.0007 0.0055 0.0012 0.0083 State employee 0.0019 0.0033 0.0008 0.0049 Cadre Household -0.0127 ** 0.0051 0.0073 0.0077 Household size -0.0011 0.0015 0.0005 0.0022 Year: 1991 0.0001 0.0023 0.0012 0.0034

125 Table 8: 2SLS Estimation: Community Average Wage as Instrument

Clinic Hospital Variable Estimate Robust s.e.Estimate Robust s.e. Year: 1993 -0.0055 * 0.0029 -0.0214 *** 0.0043 Year: 1997 -0.0055 0.0039 -0.0192 *** 0.0058 Per capita income -1.13E-07 1.28E-06 -4.47E-06 ** 1.92E-06 Constant 0.0176 * 0.0100 0.0089 0.0150

σμ 0.0674 0.0967 σε 0.1103 0.1653 ρ 0.2722 0.2551 R-Square: Within 0.0033 0.0026 Between 0.0071 0.0103 Overall 0.0057 0.0068 Change by 1% increase in Price 0.0023 0.0018 0.0033 0.0028 Income -0.0006 0.0071 -0.0248 ** 0.0107 Elasticity: Price 0.1699 0.1339 0.1104 0.0952 Income -0.0464 0.5285 -0.8314 ** 0.3588

5. Conclusion:

In this study, we use a longitudinal dataset of China during a period of time when the country experienced substantial transition in its health care system as well as its economy to estimate the demand for health care in China. The considerable cross-section and over-time variations in health care utilization, health care access, and income provided in this dataset are expected to contribute to obtaining more precise estimates of price and income effects on health care demand. Our estimation of the unconditional demand for health care suggests that facility level characteristics, such as travel time, waiting time, and quality, play only a small role in the distribution of demand for health care. Possibly due to large measurement error, we cannot precisely estimate the price effect. But the small estimates are quite consistent with the existing body of work on health care demand in developing countries. After controlling for endogeneity and measurement error, we recover small and yet negative income effects. It suggests that the individuals with higher income may make better health choices over time and thus are less prone to visit health facilities, especially hospital-type, in the long-run.

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128 LOGISTICS IN CHINA: THE INDUSTRY IN 2006 AND THE NEAR FUTURE

Robert Frankel Yemisi Bolumole Department of Marketing and Logistics University of North Florida

Abstract

It is readily acknowledged that the rate of growth in China is incredibly rapid. In relation to this growth, the role of manufacturing to supply internal/domestic demand and rapidly expanding export markets is critical. But the development of such markets relies heavily on infrastructure, in particular logistics infrastructure. The carriers, transportation network, warehousing and distribution center support, and third-party providers that plan and execute this logistics activity will have an increasingly important role in China’s development. What is the current (and near future-term) state of the logistics industry in China? What obstacles do international logistics firms face in China today, and in the next 5-10 years? What improvements are necessary to address those obstacles, and how achievable are the solutions? This paper examines these three questions and offers a global assessment of such an overview.

1. China’s Economy:

Asking how the Chinese economy is progressing requires one to think in numbers of staggering proportions. As is well documented on a daily basis in the press, the Chinese economy is booming. China’s foreign direct investment is projected to reach $86.5 billion in 2006, an increase from $79.1 billion in 2005 (World Watch – Asia Pacific, 2006). Exports from China rose to a record $762 billion in 2005, with no significant slowdown in sight (Rehak, 2006), growing 28% in both 2004 and in 2005. China’s trade with the European Union and the United States, similar to most all regions of the world, is rapidly expanding. Specifically, trade with the United States is expanding at a phenomenal rate. In the coming year, China will originate over 48% of all import freight into the United States, much of it via the West Coast (Gordon, 2006). To grasp the scale of the imports, Wal-Mart alone imports $12-20 billion per year directly from China (approximately 10-15% of all United States imports from China), which is more than the country’s total exports to Russia or to the United Kingdom (Richards and Sanderson, 2005). There are many key factors integral to the growth in China’s export economy, such as low cost labor in manufacturing. However, one often ignored component critical to the above trade expansion is the logistics industry in China. Consistent with the economy’s growth in China, the logistics industry is also expanding quickly. Very fast (double digit) growth is projected in the next five years (Wang, 2006). Accompanying the growth in the economy and the logistics industry specifically, a significant number of issues and related concerns require consideration.

2. The Status of Logistics in China Today:

The basic components of logistics are transportation, warehousing, inventory management, order processing, and lot size quantity (Stock and Lambert, 2001). Logistics management, which is a very complex and difficult task, is generally defined as “that part of supply chain management that plans, implements, and controls the efficient, effective forward and reverse flow and storage of goods, services and related information between the point of origin and the point of consumption in order to meet customers’ requirements” (www.cscmp.org, 2005). In the context of global logistics, the concept becomes that much more difficult. Distances are longer, demand (and lead-time) are more uncertain, and demographics more complex. The concept of logistics as a management field is only 20 years old in China. Most logistics providers are still offering traditional services such as transportation and storage, and are in the process of transition to modern logistics thinking. The industry contains many local, regional and small-scale “logistics businesses” which do not provide quality services in a professional manner. For example, there are only 6,000- 7,000 logistics businesses in the U.S. but more than several hundred thousand in China (www.supplychain.cn, 2006). Logistics value-added in China in 2005 was RMB 1.2 trillion ($149 billion). As noted above, China’s rapidly increasing economic growth in export trade has been driven by its global manufacturing base. The country’s competitive advantage in global manufacturing due to low-cost labor will not last forever. Multiple factors, including increasing technological sophistication, workers’ skills, scientists, and entrepreneurs, suggest that there is appreciation coming in the Chinese Yuan (versus the dollar), and also real competition with other low-cost manufacturing centers around the world. In regard to the relationship between manufacturing and logistics, the logistics cycle is critical to the competitiveness of global firms. However, logistics costs and delays due to poor infrastructure may offset the cost savings generated by low-cost manufacturing in China. Thus the need for drastically improved logistics capability in China is not far off in the future, a situation that is well-known to the Chinese government and its officials (Wang, 2006). When discussing the general state of logistics in China, it is most helpful to consider the topic from a regional development perspective. According to Wang (2006), two basic levels of development are acknowledged: (1) areas where an existing logistics development plan is being implemented, such as in the Yangtze River Delta (YRD) and the Pearl River Delta (PRD) regions; and (2) areas where a plan is still being made and the logistics market is still in development, such as the central and western regions of the country. The three most logistically developed regions of China are the YRD (centered around Shanghai), the PRD (the most important part of Guangdong Province), and the Bohai Sea Rim (the coastal economic zone which includes Beijing, Tianjin, Dalian, Qīngdǎo and Yantai). Each of the three regions has its own unique capabilities and concerns. When analyzing Chinese logistics providers, third-party logistics providers (i.e., 3PLs) and traditional freight forwarders dominate the marketplace. State-owned logistics providers (i.e., COSCO Logistics, SinoTrans, China Shipping Logistics, China Postal Service, China Chengtong Group) are the major players; these firms have evolved from the traditional service offerings of a planned economy. Privately-owned logistics players have developed in the past 10-15 years (i.e., PGL, CJ Logistics, GSD Logistics). Whether state- owned or privately-owned, there is some evidence of logistics service beyond the basic offerings of transportation and storage, but it is not typical. For example, leading 3PLs are offering supply chain management services in the PRD and YRD, but this is a recent development (Wang, 2006). And some providers (in the PRD) are offering logistics and supply chain management services and have built national service networks. However, China’s 3PL sector represents just 2% of the country’s total logistics spending (Gordon, 2006). Many major players have entered China since 1990 in a variety of logistics activities: sea-borne (APL Logistics, Maersk Logistics, P&O Nedlloyd); air-borne (DHL,

130 FedEx, UPS); ground transport (Schneider, Ryder, C.H. Robinson); retailing (Wal-Mart, Carrefour, Metro) (Wang, 2006). Investment is increasing rapidly and Chinese logistics firms are facing severe challenges and competition. The majority of non-Chinese logistics firms are international companies with operations mainly outside of China (exhibiting a diverse spread of geographic coverage); few companies focus only on China. The dominant expansion strategy is “overall international networks” (Eye for Transport’s China Summit, 2005). It is only intra-China activity that is viewed as risky. In regard to the relationship between logistics and supply chain management, the latter is a new concept in China. It typically involves manufacturers (state owned enterprises and medium and small sized manufacturers) and 3PLs. The focus in SCM is shifting from government planning to manufacturer and/or 3PL planning. The shift is expected to increase efficiency and responsiveness, which is necessary because China’s supply chains are fragmented. Outsourcing (to 3PLs) is another efficiency and responsiveness tactic. However, in China only 21% of large corporations (including MNCs) outsource logistics to 3PLs; in the European Union and the United States, approximately 45% of corporations outsource (Richards and Sanderson, 2005). Across Chinese firms of all sizes, outsourcing to the 3PL sector accounts for only about 2% of all logistics spending compared to 10% in the USA and 25% in Europe (Gordon, 2006). This low level of outsourcing leads to massive duplication and underutilization of supply chain assets, such as ocean shipping containers. Containerization is a key component of finished goods manufacturing export strategy. The level of containerization in China is low, although the growth in containers is extraordinary. This fragmentation leads to heavy reliance on railway and trucking traffic, which now far exceeds the infrastructure capacity that was originally designed, which then leads to shortages of key commodities and increases in logistics costs. Infrastructure capacity issues are particularly acute with respect to the port situation; of the world’s ten largest container ports, two (Shanghai and Shenzen) are located in the Chinese mainland.

3. Critical Issues in International Logistics:

There are a considerable number of critical issues which China must resolve to increase its logistics capability, and all of the issues significantly impact the country’s ability to maintain or expand its role as a force in the global economy. Logistics costs as a percentage of GDP in China in 2005 were estimated at 18.5%, although most sources cite a figure of 21.5%. The figure in 2004 was estimated to be 18.8%. Thus logistics and related supply chain management in China is very inefficient, relative to logistics costs as a percentage of GDP in the European Union and especially to the United States figure of approximately 9% (Gordon, 2006). Infrastructure problems in addition to the aforementioned port capacity and containerization include traditional forms of transport, small and/or outdated warehouses, un-standardized vehicles, over-loaded vehicles, mostly poor roads, and highways. However, considerable risk exists with regard to overbuilding logistics capacity too quickly, especially with the availability of development funds. Most major cities in China now have some type of distribution center or logistics park, but according to the China Storage Association, 60% of them are empty (Byrne, 2006). Security issues are also problematic. Related to infrastructure are challenges regarding energy cost and instability of supply, which remains problematic across all industry in China. The environmental issues of logistics infrastructure expansion have also not been considered to any significant extent. Institutional cost is the largest component of doing business in China (Wang, 2006). The government in the planned economy still drives the process, and government agencies are still the center of all economic activity. The government controls the planning and operation of logistics infrastructure, energy and resources, market entry and

131 administrative regulation, taxation, and incentive policies. All government documents and regulations have the binding force of law. But legislation and its enforcement is necessary to support a market economy, and such enforcement is uneven, at best today. In addition to institutional cost, shared jurisdiction is a related and large concern. Overlapping functions at the central government and local government levels are problematic and costly. As many as sixteen administrative departments have the authority to directly interfere with logistics firms and the industry as a whole (www.supplychain.cn 2006). Companies still must acquire separate licenses from several governing bodies, and they often must obtain separate licenses for each province in which they operate (Byrne 2006). Regional protectionism is very problematic. Systems only seem to be operating nationally when in fact they are really segmented and controlled regionally (Byrne 2006). Legislation in China lags far behind economic practice, and this situation is perhaps most evident with respect to taxation. Redundant taxation on logistics outsourcing is a significant institutional problem. Different tax rates apply to outsourced logistics activities. There is a 3% rate on transportation, (un)loading, and lifting and a 5% rate on storage, distribution, and agency. The rates are considered to be too high, given that the gross margin in the industry is only 4-5% and net profit only 1-2% (Wang 2006). Reforms are being considered to unify the tax rate and to reduce redundancy. Both actions would significantly increase the efficiency and expansion of logistics outsourcing. Cultural issues are critical to doing business in China. The country has a long, proud history which firms must understand to be effective. Guanxi is vital. Government agencies deal with foreigners differently than native Chinese. Marketing is only effective on a one-to-one basis, which is time-consuming and requires great patience. Doing business in and with China requires the Western mind-set to adjust to enormous differences in expectations and practices. For example, it took 13 years of “closed-door” negotiation to achieve agreement with the WTO – in other words, the wheels of progress move slowly. Similarly, credibility such as due diligence investigations (for example, a 3PL investigating a manufacturer client) are lengthy. Delays in doing business exist in many forms. Terminal delays are common due to inspections, re-loading, and complex documentation. Customs are a major problem due to complicated formalities, inconsistent decision-making, and processing times. The advent of the United States Container Security Initiative has especially complicated these problems. Additionally, the concept of high quality service is not the norm in China. To the contrary, price (in the form of low cost) is the priority in outsourcing. Technology applications are still lacking. Many if not most all logistics firms are unable to collect, process, and manage information to track product, automate storage management, and speed up customs clearance. There are indications that some firms are improving rapidly in many respects from data input, electronic sealing of containers, trucks using global positioning systems (GPS), radio frequency identification devices (RFID), and third generation (3G)1 technologies, and the use of “green lanes” to connect logistics hubs and customs checkpoints (Richards and Sanderson 2005). The Chinese government is closely watching the adoption of RFID by overseas companies to understand potential customer requirements and to learn best practices. From a human resource perspective, there is an urgent need for talented logistics people. Experience at the senior level is particularly problematic. Logistics education and training is a recent phenomenon in China, and the scale of the system is small. Academic programs have not caught up with changes in the marketplace. Logistics is a network

1 The Container Security Initiative (“CSI”) is designed to “expand the borders” by focusing on preventing terrorist access to containers at foreign ports rather than relying on discovery of contraband after containers arrive at United States ports.

132 business, and when it is fragmented and weak the entire business suffers (www.supplychain.cn, 2006). The 3PL market in and of itself is a challenge to understand and perform well in, given all of the above considerations. The 3PL market is expected to grow at a rate of 33% annually by the end of the decade – from RMB 40 billion ($5 billion) in 2004 to RMB 230 billion ($28 billion) in 2010 (Wang, 2006). Currently, the 3PL services provided are primarily basic functions such as transportation, warehousing and distribution; packing, processing, IT, MIS, and comprehensive service offerings are far less prevalent. 3PL expertise in the current marketplace varies widely by competitive segment. State owned enterprises are strong in infrastructure, policy connections with government, and national service network coverage; they are weak by virtue of their bureaucracy and having been developed from the foundation of a planned economy. The MNCs are strong with regard to capital, technology, and international service networks; but weaknesses are evident concerning high service charges, and the lack of a local resource base. The strengths of private firms are focused on flexibility, efficiency, and low service charges; however, their weaknesses include their small scale and size. Interestingly, a recent survey (Eye for Transport’s China Summit, 2005) revealed that the key logistics issues in China today are not viewed as demonstrably different from those which are expected to be key challenges in five years: government regulation, quality of service, infrastructure (especially rail), data tracking, local knowledge and expertise, and port capacity. This perspective indicates that the improvement in logistics capability and capacity is a large problem that will be improved and eventually solved only via patience and long-term solutions of investment.

4. Recent Trends and Responding Policy Changes:

What trends and changes are recognizable with respect to contemporary and future logistics in China? The Chinese government is moving state assets out of transportation. For example, export growth is leading numerous government owned ports to privatize, selling stakes to companies, and listing publicly in order to put the proceeds to work on expansion and improvements to meet the growing demand (Rehak, 2006). The expansion of port facilities is increasing. Since demand is strong, container handling charges have increased. For example, the port of Shanghai has raised handling charges by 10% in 2005 and in 2006 as well (Rehak, 2006). The government has recognized the value of integration with other countries with respect to economic development, and logistics in particular. It formed (with 26 other countries) the Boao Forum for Asia, a non-profit, non-government group focused on creating dialogue and making progress on issues concerning global trade, logistics and the environment. A specific focus is centered on furthering Asia’s efforts to improve logistics and supply chain management. For example, there has been some reduction in redundant taxation, which went into place earlier in March of 2006. A group logistics company can now declare income tax solely from their headquarters location. Similarly, improvements in the customs process are being made. Customs regional unification systems are being implemented in the PRD, YRD, and Bo Hai Sea Rim, and the use of bonded zones (type B) is being encouraged (Wang, 2006). In some areas, the government will become more involved rather than less involved. For example, a projected rapid rise in the adoption of RFID in China is anticipated, as the government looks to leverage the technology to benefit the country’s overall logistics infrastructure and support key customers. Rather than an industry-driven initiative common in the USA and Europe, the path in China will be guided by the government as the over-riding force as it attempts to improve the country’s overall efforts to improve supply chain management. Such guidance is expected to take the form of

133 promoting industry standards and the launch of pilot programs (Richards and Sanderson, 2005).

5. What to Do: Decisions to Consider for Logistics Success in China:

How to invest in China from a logistics perspective is critically important. Firms may invest in network construction with associated high up-front costs that are beneficial to long-term development, as COSCO Logistics has done. Another option is to form alliances or cooperate and share network resources; this allows a firm to dedicate internal resources to strategic initiatives while relying on qualified third parties to develop and operate distribution networks. For example, a firm may reinforce the capabilities of domestic distributors to improve distribution efficiency. This approach may also make training a priority, especially due to the aforementioned workforce shortage of qualified personnel. The risk is that a core competence must still be developed or one runs the risk of being controlled by others. In either approach to expansion, investing, or outsourcing, it will be necessary to pay attention to local and regional rules and relationships. Thinking “end-to-end” is very important. China is one of the world’s most dynamic markets, so aligning supply with demand (forecast) is particularly critical. The related key requirement here is to leverage technology to maximize data visibility. Such vision enables a firm to make global decisions quickly and correctly, to track demand in real time, and to maintain a flexible supply chain (Byrne, 2006). A related task is to assist in, or at least encourage, the removal of unnecessary levels of bureaucracy. Finally, a comprehensive risk assessment methodology is also important. Managing risk factors and their relationship to a firm’s baseline cost structures and ultimately net landed cost, as well as to the drivers of integrated fulfillment are absolutely necessary. In conclusion, the potential in China for logistics is enormous – and the challenges are too.

References:

Byrne, P. M. (2006, July 1). Supply chain mastery: One key to success in China. Logistics Management. Retrieved from http://www.logisticsmgmt.com/article/CA6352891.html.

Council of Supply Chain Management Professionals. (2005). Retrieved from www.cscmp.org

EyeforTransport’s China summit. (2005). 3PLs’ views on the logistics landscape in China. Retrieved from http://www.eyefortransport.com.

Four elements restrict development of China logistics industry. Retrieved September 4, 2006 from www.supplychain.cn

Gordon, B. (2006, March). Asian emergence – The brave new world of logistics. LogisticsQuarterly.com, 19-20.

Rehak, J. (2006, March 25-26). Every port in a storm - China is the center of a global boom in an increasingly strategic sector. International Herald Tribune, p. 16.

Richards, J. & Sanderson, J. (2005). Understanding RFID adoption in China. Retrieved February 7, 2005 from http://www.rfidjournal.com/article/articlereview/1391/1/128.

134 Stock, J.R. & Lambert, D.M. (2001). Strategic logistics management, 4th edition. NY: McGraw-Hill Irwin.

Wang, C. G. (2006). China, CSCMP global perspectives. Oak Brook, IL: Council of Supply Chain Management Perspectives.

World Watch – Asia/Pacific – Reports find the pace of China’s overhauls lure foreign investors. (2006, September 7). The Wall Street Journal, p. A12.

135 136 MACRO ANTECEDENTS, MICRO OUTCOMES: A FRAME OF REFERENCE FOR UNDERSTANDING MARKETING TO, IN, AND OUT OF CHINA

Adel I. El-Ansary David R. Whitsett Department of Marketing and Logistics University of North Florida

Introduction

After years of being a command-driven economy, China partially opened its doors to a global market economy in 1978 with the reforms spearheaded by Deng Xiaopeng. Prior to 1978, China was a centrally-planned economy that was mostly closed to international trade, but in the last quarter century it has become a rising economic power and a major force in the global economy. China’s rapid ascent is in many ways unique and is due to a variety of factors that have not previously existed, either by themselves or in combination, at any other time in world history. Because of these growth factors and China’s sheer size, the impact of China’s meteoric rise on the world economy demands scrutiny and analysis by all parties interested in trade relations with China. The purpose of this paper is to present an organizing frame of reference of the antecedents, processes, and outcomes of economic developments in China. This frame of reference will be deployed to clarify the implications of the macro antecedents to engaging in outsourcing operations to China, to identify the micro outcomes and their impact on marketing processes to Chinese consumers, and finally, to present a summary assessment of the impact of the macro antecedents, marketing processes, and micro outcomes on trade relations (import to/export from) with China. Although this paper is conceptual, based on a review of academic literature, news articles, and reference texts, it presents check points and landmarks to guide those engaged in marketing to, in, and out of China.

1. Macro Antecedents

1.1 Chinese Historical and Cultural Influences

According to Shenkar (2005), there are three distinct periods that stand out on the timeline: (1) the Imperial period, which lasted on an off for more than 2,000 years, (2) the “foreign humiliation” period of the 19th and early 20th centuries, and (3) the three decades of Communist rule from 1949 up to the beginning of reforms at the end of 1978, including some of the first years of the reforms that followed. Each period contributed unique factors to China’s current conduct in the milieu of the world’s political economy. One of the strongest influences to come out of the Imperial period is the teachings of Confucius (circa 551-479 BC). Confucius considered “people as a part of the social network”; for this reason Confucianism, an ancient philosophy that stressed that hierarchical obedience to family and government was for the greater good and a stable society, includes the concept that “the whole society is just a huge network in which a person plays different roles” (Yongqiang & Zhilong, 2006). This concept influences contemporary Chinese consumer behavior to this day. Whereas in the West, consumers see themselves as individuals, in Chinese society collectiveness is a strong tradition and it impacts shopping patterns (Melewar, Meadows, Zheng, & Rickards, 2004). According to Lu and Lee, “People in Chinese emphasize ‘we’ more than ‘I’” (Lu & Lee, 2005). Since refusing people’s requests is indicative of losing “face,” the Chinese tend to use “I will consider it” or “maybe next time” instead of “No” to maintain personal relationships. The younger generation of Chinese, however, because of more prevalent Western influences, is shifting to more individualism. Confucius held scholarship to be the premier human activity, surpassed only by bureaucratic service, which allowed the scholar to use his knowledge to benefit others (Shenkar, 2005). Other elements of Confucianism included discipline, stability, and the prestige of officialdom. The bureaucratic principles that Confucius espoused were then combined with the philosophy of Legalism, which “prescribed a modified and ruthlessly enforced system of rules and obligations (rather than rights)” (Shenkar, 2005). Confucianism and Legalism formed the basis for the Imperial bureaucracy which lasted for hundreds of years. Another concept often mentioned along with Confucianism is guanxi, which Hutchings and Weir define as “a relationship between two people expected, more or less, to give as good as they get” (Hutchings & Weir, 2006). Under guanxi, a Chinese person with a problem turns to his or her guanxiwang, or “relationship network” for assistance (Hutchings & Weir, 2006). These spheres of influence are relevant to any discussion of business networking in China because, as Melewar et al. (2004) commented, “the market is best understood from the inside – that is, after staying in the market for a period.” China’s period of foreign humiliation included “unequal treaties and foreign powers obtaining extraterrestrial rights on Chinese soil. . . .” and ran from around 1911 to 1949, the beginning of the Communist period (Shenkar, 2005). This period of humiliation taught the Chinese to be distrustful of the motives and intentions of foreign nations, to not become dependent on others (especially for technology), and to not let foreign technology influence or corrupt traditional Chinese values. China also realized during this period that “technology was a key ingredient of independence” and that there was a close bond between technology and national security (Shenkar, 2005). According to Manev, Yan, and Manolova (2005), the rise of Communism in China “supplanted the supremacy of the law by party decrees and plans.” Because the legal system in China was already less substantial than that of some Western civilizations, the advent of Communist rule led to illegal behavior such as corruption and counterfeiting, which helped entrepreneurs mitigate their risk under the new system (Manev et al., 2005).

1.2 Chinese Governmental/Political Influences

China’s single-party system is very different from the multiple party political systems of the West. There are no political campaigns or campaign contributions to influence political action and politicians. According to Yongqiang and Zhilong (2006), “discussion on how to deal with the government is always a taboo or at least a secret that is not talked about publicly, even though firms often engage the government in its business dealings.” The Congress in China (the National People’s Congress or NPC) is also different from the West in that the Chinese Congressmen are part-time public servants. Congressmen in China are very often business people and participate in decisions that could potentially impact their own enterprises or those of contacts within their guanxiwang (relationship network). China’s political and economic reforms of the last few years have essentially moved the country from a state-owned command economy to more of a market-based exchange system. China is moving from state ownership of property and the means of production to private ownership of property and the means of production. China’s remaining state-owned enterprises will have to become competitive or they will cease to exist in a market economy. During the transition to a market economy, the Chinese government will eventually remove or reduce subsidies to these state enterprises and will

138 cease to “condition foreign direct investment with requirements for local content, technology transfer, and exports” (Koehn, 2005). These steps to overcoming local protectionism will impact how foreign companies operate in China and how privately- owned businesses and state-owned enterprises will compete for business in China.

i. The Chinese Legal System

According to Manev et al. (2005), China has never had a “legal-rational system of rulership, which served as the foundation of contemporary Western capitalism of pluralistic democracy and the rule of law.” Before Communist rule came to China, friendship and kinship relations took the place of law, contractual relations, and private enterprise within the business world (Manev et al., 2005). The political and economic reforms that are now in process in China have left the legal system in a state of flux as well, with inconsistent and often conflicting laws and haphazard enforcement. Regulations can be different at the local, national, and provincial levels. In the absence of strong laws and enforcement, illegal activities have flourished. Corruption, piracy of intellectual property, and counterfeiting are rampant. Strong protection of intellectual property rights (IPR) in developed economies has led to the pursuit of technological and knowledge innovations. When consumers substitute a cheaper imitation product for the real thing, it has a substantial cost to IPR owners who have invested in development and marketing initiatives. According to Shenkar (2005), “ABC News recently estimated the losses suffered in China by foreign firms at $20 billion annually.”

1.3 Chinese Economy

China’s economy is large by any standard and growing rapidly. This has to do with the size of the population (approximately 1.3 billion with a labor force estimated at 791.4 million in 2005) and the attractiveness of China as a target for foreign investment. In terms of a purchasing power parity basis, in 2005 China was the second-largest holder of U.S. Treasury debt after Japan (April 28, 2006). There has been a more than tenfold increase in China’s GDP since 1978 when current-era reforms began. Inflation in China is currently around 1%. In terms of foreign investment, net foreign demand has quickly grown in China because of the low price of Chinese labor relative to capital. China’s labor force is gradually making the shift from agriculture into industry or services, but China currently has excess labor within agriculture (Holz, 2006). According to the Journal of Commerce, economic development has been faster along the Chinese coast than in the interior of the country (around 80% of China’s population lives in the eastern part of the country) and there are large differences in per capita income between regions (April 17, 2006). The Journal of Commerce also states that the Chinese government has struggled to sustain job growth for workers laid off from state-owned enterprises, people moving from the interior to the coast, and for new entrants to the work force (2006). According to Holz (2006), the Chinese labor force is likely to start declining around 2014 because of the shrinking and aging of the population. Currently, China is at a stage where cheap labor is its chief competitive advantage.

i. Industry

In the labor-intensive manufacturing sector, China is a world leader in many products. According to Shenkar, “China-based factories make 70% of the world’s toys, 60% of its bicycles, half its shoes, and one third of its luggage” (2005). China is also a leading manufacturer of furniture, apparel, appliances, electronics, transportation equipment, and consumer products. In addition, China has strong mining and ore

139 processing industries and is involved in machine-building, armaments, petroleum, cement, chemicals, fertilizers, and telecommunications equipment. There are numerous multinational corporations operating manufacturing facilities in China, many of which are joint ventures with Chinese firms.

ii. Banking

China is making moves towards reform of its banking system along with the rest of its economic system. According to the Journal of Commerce, in July of 2005 the central bank of China revalued its currency by 2.1% against the U.S. dollar and changed to an exchange rate system that references a basket of currencies (April 17, 2006). In April of 2006, China’s central bank increased bank lending rates for the first time since 2004 in an effort to cool off an overheated economy (Wall Street Journal, April 28, 2006). Chinese authorities are concerned about out-of-control bank lending and in the past have sought to control lending through administrative measures, but are now focusing on more market- based remedies. According to the Wall Street Journal, “Authorities focused first on fixing the debt-laden banks, which have been restructured with the help of billions of dollars from the likes of Bank of America Corp., Merrill Lynch & Co., and HSBC Holdings PLC” (April 28, 2006). If China allows the RMB to strengthen versus the dollar, it could slow demand for Chinese exports and slow foreign investment inflows.

iii. Logistics and Distribution Systems

China has approximately 1.1 million miles of roadways, of which about 875,000 miles are paved. There are approximately 76,000 miles of navigable inland waterways. There are ports and harbors in Dalian, Guangzhou, Nanjing, Ningbo, Qingdao, Qinhuangdao, Shanghai, Tianjin, and Xiamen. China has a merchant marine fleet comprised of approximately 1,649 ships. Firm location within China is a critical success factor. Areas that have experienced the greatest levels of reform and investment provide the best infrastructure for supporting a business. There is also a shortage of logistics professionals in China. According to Industry Week, there are only 18,000 licensed logistics professionals in China compared to over 500,000 in the United States (April, 2005). Chinese technical infrastructure can also be a limiting factor in that updates on product movements or inventories can take days to obtain because relatively few Chinese companies can provide the information electronically. Logistics personnel in China also have to deal with confusing and sometimes overlapping rules from the World Trade Organization, the U.S. and Chinese governments, and local principalities. Because of the time it takes to establish guanxi, building a reliable supply chain can be a long term task.

iv. Technology and Innovation

Historically, China has been a source of many great inventions, including paper, gunpowder, the compass, and the abacus. According to Shenkar, “The Chinese were the first to develop printing and iron casting, the first to use paper money, and the first to launch fireworks and fly kites” (2005). However, China never developed a formal approach to science and technology and lacked the “ideological, administrative, or economic infrastructure to support technical innovation or to disseminate the new knowledge to economic or military activities” (Shenkar, 2005). The result was that Chinese innovation and technology lagged behind the West. China is trying to rapidly make up ground in this regard on several fronts. China has increased spending on research and development (R&D) and has encouraged foreign

140 companies to establish R&D centers on Chinese soil. Data from the National Science Foundation shows that by 2000 China was the eleventh largest site for overseas R&D expenditure by U.S. firms, up from thirtieth in 1994 (Shenkar, 2005). China gives priority to technology-centered foreign ventures, giving them tax breaks, access to more favorable locations, and accelerated processing through regulatory red tape. The Chinese are also training a larger number of scientists and engineers relative to the West and their high schools and universities are rapidly improving. According to Holz, “the number of annual graduates with a bachelor’s or associate degree in China since 2004 exceeds the number in the U.S., and by approximately 2008 it will be twice the number in the U.S.” (2006). China’s growth trend for master’s and doctorate degrees is similar. Moreover, China sends a great number of graduate level students overseas – in the U.S. alone, there were over 65,000 Chinese students in the 2002-2003 academic year, with 36,000 more from Taiwan and Hong Kong (Shenkar, 2005).

1.4 Globalization and the World Economy

i. China and the WTO

China joined the World Trade Organization (WTO) in December 2001, after 15 long years of negotiation. According to Agarwal and Wu, “The WTO framework includes the three basic principles concerning the trade administration system; uniformity, transparency and judicial reviewability” (2004). This framework will lead to a reduction of market imperfections in China and a reform of government policies dealing with trade and investment. China’s membership in the WTO will also lead to a rapid liberalization of import and export policies, will attract more foreign direct investment, and will open up previously closed sectors of the Chinese economy. In addition, it is widely believed that there will be an increase in China’s GDP and a general increase in China’s overall economic welfare as a result of WTO membership.

(a) The rise of the multinational corporations. According to Thomas Friedman (2006), “Companies have never had more freedom, and less friction, in the ways of assigning research, low-end manufacturing, and high-end manufacturing anywhere in the world.” Friedman uses the example of Lenovo, a Chinese computer company. In 2004, Lenovo bought IBM’s personal computing division and IBM bought an 18.9% equity stake in Lenovo. The combined company would be headquartered in New York with factories in Raleigh, North Carolina, and Beijing, China; it would have a Chinese chairman and an American CEO; and it would be listed on the Hong Kong stock exchange. Who is to say what nationality this new entity represents? Accelerated foreign investment in China has resulted in many different types of joint ventures that are hard to classify. These new entities are examples of corporate strategies creating structures and organizations to best take advantage of market conditions. A summary of the implications of the macro antecedents in China on global company outsourcing operation in China is presented in Table 1. Outsourcing is viewed as a multi-stage process of marketing to China. The implications of the macro antecedents are presented for each stage.

141 Table 1 Marketing to China: Macro Antecedents Impacting Outsourcing Processes, Part 1 Outsourcing Processes Identification: Negotiation: Contracting: Delivery: Macro Impact/ Impact/ Impact/ Impact/ Antecedent Implications Implications Implications Implications History & Impact. Building a Impact. Chinese Culture – relationship with negotiation style is Collectivist suppliers can take a different than the society rather long time. Western style. than Implications. Implications. individualistic. Tapping into existing Negotiators must Guanxi networks guanxi networks is not put Chinese are very vital. Using Chinese parties in a place important and nationals within the where they will can take time to organization or lose “face” or talks establish or tap Chinese business will sour. into. partners is important. Government – Impact. Businesses Impact. Lack of Impact. IPR Impact. WTO Large central don’t participate enforcement and protection is a regulations could government with with government changing laws has problem because affect export enormous through campaign led to massive of weak laws and pricing for foreign bureaucracy and contributions. corruption. enforcement. companies provincialism. Implications. Implications. There Counterfeiting is shipping products Legal system is Businesses must use is a possibility that rampant. from China and changing quickly other means such as bribes will be Implications. domestic pricing due to reforms. guanxi-based necessary to Strong agreements for imports based Single party lobbying, trade achieve business and incentives on fair system, no organizations, or objectives. Hire have to be put in competition. political parties commonwealth outside help to place to protect Implications. or campaigns. contributions to navigate continuous IPR. Hire outside Lowering of Congress is part- influence changes in Chinese professionals to tariffs could lead time and government policy. legal code. translate Chinese to more foreign composed of law – there are companies many many ambiguities. targeting the businesspeople. Chinese market. China’s WTO membership is also bringing about changes.

142 Table 1 Marketing to China: Macro Antecedents Impacting Outsourcing Processes, Part 2 Outsourcing Processes Identification: Negotiation: Contracting: Delivery: Continuity: Macro Impact/ Impact/ Impact/ Impact/ Impact/ Antecedent Implications Implications Implications Implications Implications Logistics & Impact. Impact. Info on Distribution Foreign shipments may be Structure – companies difficult to get Transportation and must verify from Chinese communications their supply partners. infrastructure are chain partners’ Implications. weaker than the capabilities Foreign West. There is a early in the companies may shortage of cycle. have to build their logistics Implications. A own personnel. mistake in communications verifying network for capabilities can shipping info. lead to higher costs and long delivery times. Technology – Impact. Impact. Anemic China has been Chinese services more of a follower companies are infrastructure and than an innovator. very anxious to strong E-commerce is establish government heavily controlled partnerships control may slow by the for technology down growth of government. and knowledge e-commerce in exchange. the near term. Implications. This could Foreign hamper delivery/ companies shipping info willing to exchange. transfer Implications. knowledge can Growth in e- receive commerce trade – favorable in different stages treatment from of the value chain Chinese will happen over partners and time the Chinese government.

143 Table 1 Marketing to China: Macro Antecedents Impacting Outsourcing Processes, Parts 2 and 3 Outsourcing Processes Identification: Negotiation: Contracting: Delivery: Continuity: Macro Impact/ Impact/ Impact/ Impact/ Impact Antecedent Implications Implications Implications Implications /Implications Economy – GDP is Impact. The growing, inflation government is only about 1%, encourages banks are slowing labor-intensive down lending, and and capital- Yuan is being intensive strengthened industries. relative to the U.S. Implications. dollar. There is Foreign some surplus companies labor. would do well to consider these industries for Chinese ventures. Industry Impact. In Structure – addition to the Large strong manufacturing manufacturing base of Chinese base, the and foreign Chinese origin. The government is service sector looking for and companies that communications can help infrastructure advance their are not as strong strategic as the West. objectives. Labor costs are Implications. very low. For example, companies that help with resource exploitation will be welcomed.

2. Micro Outcomes – China and Strategic Marketing Planning Processes

2.1 Chinese Strategy Formulation

i. Environmental and Situational Factors

Until Deng cracked open the door to a market economy in 1978, the media in China had been firmly under the heel of the Communist Party. When Deng launched economic reforms at the end of 1978, China had only 186 newspapers and 32 television

144 stations, all government-owned. Most media content emanated from the Xinhua “news agency,” which distributed government announcements, filtered and refocused all international news, and, most importantly, disseminated a steady barrage of government propaganda (McGregor, 2005). But the rapid transformation of China’s socialist command economy into a market economy created the need for an informed citizenry. In the wake of Deng’s reforms, many Chinese journalists and progressive government officials began using China’s newspapers and magazines to focus and refine China’s emergence from the grinding poverty, political chaos, and inhumane cruelty that had gripped the country during most of the 1960s and 1970s. The press was even given a short leash to act as a watchdog on government corruption, all under the guidance, of course, of the Propaganda Department, which allowed reporters to unveil the details of corruption cases that the government wanted to use as examples to frighten others into behaving. While the idealists saw the press as a way to push for reform and government accountability, the Communist Party officials who served as the country’s newspaper editors and television station directors realized they were sitting on a gold mine. Advertising had disappeared under Mao when the government funded the media. Within weeks of Deng’s pronouncement of economic reforms, Shanghai’s Wenhuibao newspaper carried the headline, “Restore the Good Name of Advertising.” Two weeks later, Shanghai TV ran an advertisement for medicinal wine, and two months later Wenhuibao and Shanghai TV carried the first foreign advertisements with ads for Rado Swiss watches. Advertisers knew a good thing when they saw it. Chinese consumers were a blank slate. Virtually no Chinese brand names had survived the decades of communism. Suddenly everyone from Japanese appliance makers to American baby food producers opened their wallets to introduce their products to the Chinese consumer. Television programming was a boring procession of Chinese operas interspersed with patriotic variety shows. But the commercials, now that was entertainment! Surveys showed that viewers eagerly watched well-produced commercials. As people became more affluent, advertising taught them how to groom and dress, what to eat, and which electronics or automobiles to purchase to show their sophistication and prosperity. A Gallup poll in the mid-1990s showed that of the 10 best-known brands in China, six were Japanese (Hitachi, National, Toshiba, Toyota, Suzuki, and Honda), three were American (Coke, Mickey Mouse, and Marlboro), and one was Chinese (Tsingtao Beer). More than any other consumers in the world, the Chinese equated the quality of a given brand with the quantity of the advertising for it. The reason was simple: when they purchased the products that were advertised, the products turned out to be good. To catch this wave, hundreds of enterprising bureaucrats and businesspeople opened newspapers, magazines, and television stations. By the early 1990s, China had more than 2,000 newspapers, 7,000 periodicals, and some 750 local television stations that either produced their own programming or acted as relays for CCTV (Chinese Central Television Agency). Major cities were wired for cable television. By 1993, Shanghai Cable had 700,000 household subscribers who received 12 channels for the equivalent of one dollar a month. The little old ladies who, in less-affluent times, served as Communist Party watchdogs in their neighborhoods now became effective saleswomen for the government cable operator. Sprawling Soviet-style factories wired their huge compounds to VCRs to build their own entertainment stations. At the end of 1993, Chinese consumers were purchasing 20 million televisions per year and 97% of urban families had at least one television. Foreign-owned advertising enterprises were made legal in 2005; direct marketing, illegal since 1998, in 2006. In fact, in February 2006, China gave Avon Products, Inc., the “green light” to resume direct sales to homes across China after an eight- year ban.

145 ii. Psychological and Demographic Factors

Despite being open to the West, China is still a country ruled by the Chinese Communist Party. Chinese communism, while based on Marxism, also includes a number of precepts and theologies from Confucianism. “Confucianism was very anti-capitalistic,” says George Haley, Director of the Center for International Industry Competitiveness at the University of New Haven and author of “The Chinese Tao of Business.” Merchants were persecuted in the 19th century and those in Canton died bankrupt due to Chinese bureaucracy. The idea that business is to be mistrusted has been in place, philosophically speaking, for thousands of years. It is one of the inherent challenges all businesses – domestic and foreign – have to overcome in order to be successful in China. Following the advent of Maoism and the Chinese Communism party’s ascent to power, advertising and marketing were virtually non-existent for three decades. “Advertising was the essence of the capitalistic culture and highly suspect,” states Steve Marshall, President, The New Group, an agency specializing in overseas marketing and interactive media services. However, change has been rapid since the start of Deng Xiaoping’s “Open Door” business policy in 1979 and China’s profound societal transformation from one of laborers to one of consumers. With the “Open Door” policy came relaxed regulations. In 1979, there were only 12 advertising agencies in all of China; today there are approximately 80,000. But the rapid growth alarmed the party. The media was getting out of control. In October 1993, Li Peng signed State Council Proclamation 129 banning the purchase or possession of satellite dishes by ordinary Chinese citizens. Editors and television station directors were told that their main goal was not to make money but to “educate the people about patriotism,” “promptly defuse sensitive issues,” “guide public opinion correctly,” and “not speak in a middle position” (which actually means to not be objective). Information is a tool that serves the interest of those in power in China. The truth is always shaded to preserve privilege and maintain harmony. For most party officials, life is guided by the proverb Zhi Lu Wei Ma, which means “point at a deer and call it a horse.” Saying one thing and doing another is a way of life because the party believes that to do anything else would risk destabilizing the system. The party today operates much like a corporation in the way it makes decisions and deals with people. Bright young officials are selected for ideological indoctrination and management training and are moved through increasingly responsible positions. Like a corporation, there is some democracy at the top of the party and almost none at the bottom. Global trade, foreign investment, and the commercialization of China’s economy have brought in an extensive body of laws and a constantly improving legal system. But the core philosophy is rule by law, not the rule of law. China today is a strange hybrid. It has a continental-size domestic market that sets businesspeople worldwide salivating, a population of ambitious, risk-taking entrepreneurs who can use the country’s massive domestic markets to build world-class products and businesses, and, by virtue of its size and stature, can force others to deal with it on terms it dictates. But, unlike the United States and almost all other nations that have become successful global commercial powers, China has an authoritarian and often paranoid political system that crushes dissent, controls information, and injects itself into every facet of business. There is constant experimenting with new political slogans, but the country really has no leading ideology other than enriching itself. Several decades of averaging 9% average annual growth has transformed China in terms of material goods. It has created a society of haves and have-nots, with significant poverty remaining in many rural areas with rust-belt cities and tremendous wealth evident in cities large and small across China. The vast majority of the population is much better

146 off. Government social programs are weak, but fast economic growth and the country’s strong family system have so far provided a safety net. In poor villages, most people have televisions and other conveniences because they have children who have gone off to the cities to work in factories or on construction projects and send much of their income home. Figure 1 (below) illustrates the implications of micro outcomes for the behavior of Chinese consumers. Understanding consumer behavior is a prerequisite to sound marketing planning in China. Such planning requires the development of a marketing strategy involving precise segmentation, targeting, differentiation and positioning schema and marketing tactics involving product, pricing, promotion, and distribution decisions explained in the remainder of this section.

iii. Chinese Consumer Behavior

Western companies, in particular, have tended to view China as a potent production powerhouse, a multinational marketer’s dream come true, or an increasingly capable competitor in branded goods marketing. Another common notion is that China is a consumer giant keen to slake its thirst with products of all kinds – the fantasy of getting 1.3 billion consumers to buy previously unavailable foreign goods ranging from shampoo to luxury automobiles. In the absence of solid data about China and its people, myth and conjecture have prevailed. To fill this void, the Gallup Organization undertook an ambitious 10-year, nationwide survey of the Chinese people, beginning in 1994 and ending in 2004. Unlike other surveys this one looked at the habits, hopes, and plans of all Chinese adults, from rural farmers to city dwellers. The data suggest that many of the perceptions held by companies outside – and even inside – China are inaccurate. Self-satisfaction is now the number one motivator in the big cities of Beijing, Guangzhou, and Shanghai; it is the principal objective among the young, edging out “work hard and get rich” among 18- to 24-year-olds. It has also become the predominant aspiration among the most affluent. Certainly, the endless drumbeat in the media about China’s increasing prosperity supports the image of a growing high-potential market. However, a market is not about size alone. Consumers must not only want to buy products but also have the money to do so. While Chinese buyers are many, and incomes are rising, most citizens remain too poor to purchase what they want. Despite the overall increase in household income – the average income rose 30% from 1997 to 2004 (Gallup, 2004) – China’s average household income in 2004 was still less than $1,800. The 10-year research (1994-2004) shows that a “Made in China” label does not guarantee protection against newer, more exciting, and perhaps more relevant foreign competitors. Chinese consumers are increasingly concerned about the quality of domestic products. Consumers’ preference for domestic goods has dropped from 78% to 67% in the last five years (Gallup, 2004). Chinese consumers want more than just function. This is one reason why Nokia, which has emphasized fashion over function, has seen its cell phone sales in China rocket past those of Motorola and Ericsson. If a company wants to sell vacuums or washing machines in China, it had better pay attention to emotional needs as well as physical ones. And if it is selling microwave ovens, air conditioners, and televisions, it should be sure those products are as fashionable as they are reliable. In some product categories, where consumers live appears to be a more important predictor of spending than affluence. This may reflect the needs of urban dwellers for products such as air conditioners or the availability of technology support for items such as computers. In other categories, like automobiles, affluence is the largest predictor of ownership.

147 Figure 1. Consumer Behavior Framework for Marketing in China

Factors Framework for Marketing In China

Economy: Social: Second Largest China’s Ancient economy / Reform Culture Financial System Technology: Environmental Largest Potential Internet Market / and Political: No Innovation Legal: Situational Communism / Protection of Intellectual Factors Control of Information Property

PERCEPTIONS (desired): Luxury – High Quality – Prestige – Pride of Ownership

Sex: Women / Men Attitude: Age: Belief in equity of brand, Motivation: Individual Young People belief that high quality = Achievement, Security Demographic high price Income: Social Acceptance, and Upper / Lower Reward, Status Psychological Occupation: Factors Well Educated / No Education Personality: Learning: Attention to social Brand Loyalty, Trial, Education: comparison information, Reinforcements of the College / need for power benefits/rewards Master / Ph

Post-Purchase Dissonance: Mitigated by established brand strength & continued consumer marketing (reinforcement) post- purchase

BUY NOT BUY Decisions and Outcomes

Satisfaction: Dissatisfaction: Brand Loyalty, Word of Diminished Brand Strength, Mouth Selling to peers Negative Word of Mouth, within target market, Lost Increase Profits Sales

148 Overall, the Chinese appetite continues to be strong for certain must-have items, including televisions and mobile phones, hard goods such as refrigerators and air conditioners, and “fun” products such as stereos and digital cameras. The Chinese consumer is indeed clamoring for a great many goods and services. But this hunger does not necessarily mirror that seen in other countries. What sells in Turkey or Chile or Thailand may not be what sells in China. China is in many ways unlike any other developing market. The Chinese consumer is neither complacent nor compliant, and rapid change is now the norm. We can conclude that most Chinese citizens are more interested in expressing their individuality than in getting rich. Chinese workers are not as engaged by their jobs as the world might think. Only the affluent have extra money to spend and the average Chinese consumer is more interested in buying luxury and entertainment items than in purchasing basic household goods.

iv. Corporate Strategy

The starting point for the marketing plan and the context, within which it is set, is the corporate plan. In most marketing-oriented organizations, the contents of the corporate plan will closely match those of the marketing plan itself, but it will also include the plans for the disposition of the other internal resources of the organization. Thus, the corporate plan is likely to contain three main components: (1) where the organization is now, (2) where the organization intends to go in the future, and (3) how the organization will organize its resources to get there. The overall objectives of commercial organizations are conventionally supposed to be financial, such as maximizing revenue, maximizing profit, maximizing return on investment, or minimizing cost. However, other aims are also possible. Many companies chose long-term growth (which may be quite different from revenue maximization in the short term). Behind the corporate objectives, which offer the main context for the marketing plan, lies the corporate mission, which in turn provides the context for these corporate objectives. The corporate mission is a definition of what the organization is and what it does. The definition should cover three dimensions: customer groups to be served, customer needs to be served, and technologies to be utilized. Perhaps the most important factor in successful marketing is the corporate vision. Surprisingly, this concept is largely neglected by marketing textbooks, although not by the popular exponents of corporate strategy. Nothing drives progress like a strong vision. If the organization in general and its chief executive in particular have a strong vision of where its future lies, then the organization has a good chance to achieve a strong position in its market and to attain that future. In a country where the traditional greeting for Chinese New Year, the equivalent of saying “Merry Christmas,” is Gongzi facai, or “Congratulations on getting rich,” it should not be surprising that most of the companies are set to accomplish the main objective of commercial organizations: maximizing revenue or maximizing profit. Given the distrust of the political system resulting from the Cultural Revolution and the corruption and constant change of the reform era, many Chinese place their complete trust only in money. Money is what really drives most companies in China. The challenge confronting the Chinese today is learning to manage the large, complex organizations that will be necessary if the country is going to continue its ambitious climb to the top of the world’s economic ladder. The country was built on two models. Before Mao’s Communist revolution, business in China was traditionally a family affair that took advantage of the complex network of rights and obligations – and trust – within the family. The other model is the Soviet-style state-owned enterprise, the basis for

149 China’s rapid industrialization in the 1950s. That model failed, allowing Deng to unleash the capitalist hounds in 1978. As China now searches for a third way – global businesses with professional management and a mix of private and state ownership – managers in China face an overriding problem: learning how to create and manage companies where strategy formulations and strategy implementations drive the revenues and other markers of company success; and learning how to compete with the growing foreign companies that every year are entering the Chinese market, looking for a larger piece.

v. Growth, Functional Areas and Competitive Strategies

Marketing strategy is not a stand alone endeavor. Marketing strategy is an integral component of functional area strategies of the firm (for example, marketing, finance, and human resources) designed and implemented in unison with other strategies of the firm, including those involving corporate, growth, competitive, global, and e-business strategies (El-Ansary, 2006). These strategies are translated into competitive strategies designed to win battles in market places and spaces. Firms that achieve sustainable competitive advantage capitalize on other weapons in the strategy arsenal including strategic synergy between marketing and other functional areas and organizational strategies. The thesis here is that additional productivity gains can be harvested from synergies between: (a) marketing and production (outsourcing), (b) marketing and human resource management (internal marketing), (c) marketing and finance (marketing-financial engineering of margin and asset management), and (d) marketing and organizational strategy (lease or buy, strategic alliances and partnerships involving co-marketing and/or co-branding). In order to reach the next step in its economic evolution, China must find ways to go beyond some of the lingering cultural, social, and psychological barriers that will soon impede its progress. The struggle now is to discover the management principles and techniques that will harness and focus the immense energy and intelligence of the Chinese to build efficient, innovative, and responsive companies capable of competing on their own with the best in the world. That means training managers to operate within organizations that are not dictatorships, to treat others as equals, to accept responsibilities for mistakes, and to share information, all behaviors that have historically been almost absent in China. The Chinese government and Chinese companies often are not really interested in forging genuine partnerships. They simply want a vehicle to gain access to foreign technology, capital, and know-how while retaining Chinese control of the venture. This is why Chinese law requires joint ventures in key sectors like finance, insurance, auto production, telecommunications, and marketing. Multinational advertising agencies, eager to extend their reach into China’s booming market, are buying up Chinese companies that specialize in direct marketing, sales promotions, event planning, and other nontraditional ad services. Companies are drawn by the enormous growth of advertising in China, which many executives think will overtake Japan as the world’s second-largest advertising market, behind the U.S., by 2010. China represents a huge growth opportunity for the ad industry. According to Nielsen Media Research estimates from published ad-rate cards, Chinese advertisers already spend about $37 billion on space in traditional media. That doesn’t include marketing services that offer publicity with methods beyond the expertise of many ad agencies. In China, as elsewhere, those methods are attracting advertisers eager for new ways to insert their message and products into people’s lives. By offering low cost and wide reach, China’s marketing services shops have lured business away from the big multinational ad firms. Chinese agencies that focus on traditional media are less attractive to Western ad firms looking to expand through acquisition, because of low profit margins. “If you’re a multinational, what do you buy: local agencies which do what you do at a lower price? Or do you find an

150 implementation agency to take your advertising to a broader market?” asks Greg Paull, the principal of Asian marketing-consulting firm, R3. Newly acquired Chinese agencies are likely to help the multinationals as they push beyond China’s wealthy coastal cities into its interior, increasingly an important commercial battlefield. China has more than 100 cities with a population exceeding one million, so this is about scale, in order to extend into every corner of the country.

vi. Marketing Strategy

Goals or objectives state what is to be achieved and when results are to be accomplished, but they do not state how the results are to be achieved. That is where marketing strategies enter the picture. A marketing strategy is essentially a pattern or plan that integrates an organization’s major goals, policies, and action sequences into a cohesive whole. Marketing strategies are generally concerned with the 4 P’s: • Product • Price • Promotion • Place These strategies describe how the objectives will be achieved. The 4 P’s are a useful framework for deciding how the company’s resources will be manipulated to achieve the objectives. However, they are not the only framework. The interface between the consumer and the supplier is the market. The position the supplier chooses in that market for the product or service – relative to the consumer needs – defines all the marketing actions. Markets often contain groups of customers with different needs and wants, each of which represents a different segment. Target marketing occurs when the supplier carefully targets a specific group of customers. In one sense, segmentation is a strategy firms use to concentrate, and thus optimize, their resources within an overall market. There can be some confusion between segmentation and positioning, and indeed the two processes often overlap. The key difference is that the former applies to the customers (occasionally to products) that are clustered into the natural segments that occur in a particular market. The latter relates specifically to the product or service and to what the supplier can do to best position its offering against these segments. Another technique, which is more normally considered under marketing strategy, is product differentiation, and it is used to give products unique identities to distinguish them from their competitors. The epitome of this process is branding. The product is given a character, an image, almost like a personality. This is based first of all on the name, but then almost as much on the other factors affecting image: the packaging and advertising. While more than 400 million Chinese live on less than $2 a day, others are buying Prada (handbags with $1,000-plus price tags), Armani, Gucci, BMW, and Bentley merchandise. Such an unedifying wealth gap may be undesirable in itself, but it provides fertile ground for the growth of luxury goods suppliers, who are making their mark now in the hope and expectation that an increasing number of people will find themselves with disposable income as their country’s economy booms. Those who are already trying to make a sale with China’s nouveau riche need to know who holds the purse strings. Unlike Japan, where the key luxury customers are single women in their 20s and 30s, in the Chinese market, analysts estimate, middle-aged men account for at least 60% of consumer spending. That gives a lift to male-oriented brands like Zenga and Hugo Boss. But it does not seem to have hindered sales of women’s fashions: boutique managers report brisk sales to men lavishing presents on their mistresses. The majority of foreign consumer goods companies are targeting their products at China’s “top end” – an approach which involves building a premium brand aimed at the

151 wealthiest 5 to 10% of consumers who are mainly in the biggest and most sophisticated markets such as Beijing and Shanghai. Serious growth, however, will depend on tapping into the much larger middle- and lower-income segments, which make up 90% (by volume) of China’s entire consumer goods market. How to do this without cannibalizing sales of premium brands is a challenge facing marketers. Offering a product with different specifications to reflect the different income groups will ensure a company that it is not limiting its sales to just one section, but there is the dual risk of diminishing the product’s status in the eyes of those who can afford the more expensive one, and of winding up with sales of the less-expensive product taking away sales from the higher-income customers. Targeting customer segments in the middle and lower price levels might depress grow-margin ratios, but it could also enable foreign consumer goods companies to scale up their business in China more rapidly and to increase their total revenues and profits dramatically. Companies that go down this road must not only give careful thought to the design and marketing of their product but also cut their manufacturing costs to levels approaching those of the local competition.

2.2 Chinese Strategy Implementation – Marketing Practices

i. Corporate Structure

The Chinese constitute the world’s largest racial, linguistic and cultural group. They are spread across a vast geographical area and live in a variety of states, from the still- communist People’s Republic of China to overseas Chinese settlements in Southeast Asia to industrial democracies like the United States, Canada and Great Britain. Despite this variation in political environment, it is nonetheless possible to speak of a relatively homogenous Chinese economic culture (Fukuyama, 1995). The hallmark of this Chinese economic culture is “small scale enterprises” and the cause is the “very great difficulty Chinese family businesses seem to have in making the transition from family to professional management” (Fukuyama, 1995). The State-led industrialization in China skipped the historical stage that each capitalist economy went through in its own way – the transition from family businesses to managerial businesses. What is called the “managerial revolution” in business histories of capitalism (Chandler, 1977) was simply a byproduct of this process. This is not only true of China or of post-Communist economies, but also of capitalist economies where public enterprises have played a lead role in industrialization. Starting in 1952, when the socialist command economy officially began, China spawned a huge economic bureaucracy, which is not fundamentally different from bureaucracies found in large enterprises in market economies. As pointed out by Wilson (1989), “business firms are also bureaucracies and McDonalds is a bureaucracy that regulates virtually every detail of its employees’ behavior by a complex and all encompassing set of rules.” The principal problem in China is not one of transitioning from family management, as it still is in Korean chaebols, but of reorienting the enterprise management from just organizing production to seeking higher returns on assets and investments. The structure of the large Chinese enterprises and corporate groups, and their pattern of specialization, bears the deep imprint of both the division of the government into territorial jurisdictions, each jealously controlling a group of enterprises, and the division of economic administration of industrial lines. The latter is becoming blurred because of the reorganization of the government. But, given China’s geographical expanse and regional diversity, the territorial division of the government, and the hierarchy and rivalry that go with it, the government will continue to play a central role in shaping China’s industrial structure. The large Chinese enterprises and corporate groups do not fit one format but are

152 diverse in their genealogies and structures. Some date back to the planning period while others are post-1979 developments. Compared to those in Japan and Korea, the large Chinese enterprises and corporate groups tend to be less diversified and vertically integrated. Most are focused on one industry, and there are no Chinese counterparts of multi-industry conglomerates such as Mitsubishi, Samsung or Hyundai.

ii. Marketing Management

Once customer needs or wants are determined, the marketer has to satisfy them. The first aspect of this implementation is the product itself, which must match customer needs as closely as possible. Another aspect is the delivery system: the producer must get the product within reach of the consumer in a timely manner. The product must be priced right, and the producer needs to persuade the customer to purchase the product. Marketing to the Chinese is nothing like marketing in the U.S. or other Western countries. Because the various provinces are so different and because marketing depends on what type of product or service is being sold, it is difficult to give concrete marketing tactics. For example, it is a complete waste of money to send out direct mail, and email that requires people to make purchases online will bomb because access to credit cards is still a very new development. (a) Advertising. Chinese have their own unique creative approach. Print, billboard, and television advertising should be emotion-inspired and filled with bold, colorful photographs and imagery and employ heavy use of animation. The Chinese like to see passion in their advertising rather than specifications. Images from the West also work very well. Every city and province has television, radio, newspapers, and magazines. According to figures provided by the ORO Group (2005), the Chinese media landscape includes 200 television stations (CCTV claims an audience of one billion), 1,000 radio stations with 700 million listeners, 2,000+ newspapers, 9,000 magazines, and 568 publishing houses. When developing ads for local markets and specific provinces, marketers must have their advertising copy translated by Chinese locals or a national living stateside. These people can properly translate the sense and meaning of the copy and spot any serious cultural error. For example, when Kaiser Permanente opened a Chinese language call center in the San Francisco Bay Area some years ago, they could not figure out why no one was using it. The reason was that their prefix, 446, included the number 4, which signifies bad luck in China. Marketers must also be aware that important symbols in the U.S. may have no corresponding value in China. (b) Public relations. All media in China has government oversight, which gives journalists less freedom over the stories they write, particularly when it is with regard to government news or policies. And, unlike their Western counterparts, Chinese journalists are not as motivated to develop individual story angles and are not as inquisitive and investigative. (This is slowly changing, however, particularly in the Guangdong region of China.) Forget about blasting press releases to local media. Media roundtables are one of the major tactics for “pushing” news. It helps to deliver the CEO or other top executives to briefings, and then let country managers and local experts conduct the follow-up. Most companies must pay a “media transportation fee” of RMB 200 ($26) to journalists in order to get them to attend its conferences or interviews. This is because Chinese journalists are not reimbursed for their travel expenses; the fee covers their transportation costs and meal fare. Westerners may see this as pay-for-play, but that the fee does not guarantee coverage.

153 Marketers must align their company’s messages with key government initiatives in order to get more press; for example, the Olympics, China’s “Go West” campaign, rising standard of living, trade, etc. (c) Collateral and web content. At first glance it seems pretty easy to take existing sales and marketing collateral and/or Web content and simply translate it into Chinese. Clara Ng, a marketing specialist for Waters China Ltd. (Waters is a life science company based in the U.S.) and Bondi both advise against this. Says Ng, “In China, we want to know how a company does business worldwide. We are swayed by emotion, and we want to know that you understand how we think.” With regard to the Web, the Chinese prefer Web pages that are busy and packed with information, which can cause problems with U.S. designers who believe in minimal text and lots of white space or corporate communication departments’ formatting rules and standards. Although millions of people are online, marketers should not assume that Chinese counterparts understand Web design or other “backend” technical issues. As with marketing in general, the Chinese know where they want to go but do not have the technical expertise on how to get there (yet). Ng also points out that few business people are ordering consumables or other products online. Until recently, the Chinese did not use credit cards. A prospect will go online to research a company and/or products, but transactions always take place face-to- face. (d) Road shows, public promotions, tradeshows. Marketers should consider increasing their normal road show budget substantially as a percentage of overall marketing spent for China. The best way to get to know prospects and customers, meet distributors and suppliers, and promote one’s company is by way of large events such as road shows, public promotions, and tradeshows. Both consumer and B2B companies use these events to promote everything from products to the CEO. (e) Branding. Protecting and building one’s brand in China can be tough. Brand experts can use the same tactics they would use anywhere else but with the following caveats: • Never underestimate the power of local competition. Local marketing, branding capabilities and resources are challenging business issues. • Effective distribution and sales networks are crucial for success but very difficult to build and maintain. All procedures in China take time, patience and money. Keep integrity and build guanxi. • If one chooses the wrong partner and the deal is heading south fast, it is better to abandon ship rather than try to make it work. Business is tough everywhere and even more so in a dynamic country like China. To be successful any company needs to get local help, be patient, respect the Chinese and their way of doing business, and keep an open mind.

3. Summary and Conclusions – What Is It To Trade With China?

3.1 Challenges/Issues for Exporters to China

Doing business in China is not easy. From building relationships (once again, do not even consider email) to understanding the cultural differences between Shanghai and Beijing, marketers need to do extensive research before developing a plan of action.

154 i. Understanding the Markets Within China

The biggest mistake companies make is approaching China as a single, huge market when, in fact, China is a series of markets that vary widely by geographic location and population characteristics. According to Piset Wattanavitukul, Managing Director, P.W. Consultants, a Chinese firm specializing in investment, management, and trade in China, foreigners have a very hard time grasping the vast differences between urban and farming populations; each one, he says, makes up two distinctly different markets (Wattanavitukul, 2002). Businesses must not be fooled by the hype concerning the economic wealth and infrastructure found in urban centers. Rural China is comprised of 750 million people whose per capita cash income in 2005 was RMB 967 ($117) versus the per capita disposable income of urban residents of RMB 2,938 ($355) (Ernst & Young, 2005). In the major cities there is a high demand for the latest in electronic gadgetry and brand name products like Louis Vuitton bags. In the rural areas one may find people who are considering buying their first washing machine or television. China is made up of 100 dialects and dozens of disparate cultures and market segments – making it particularly challenging for B2B. Each region or province has its own preferences and business needs; any company that ignores this will fail. Generally, the urban centers are on the coast while rural areas are inland. Examples include Beijing (population: 14.3 million), Shanghai (16.3 million), Chongqing (31.1 million) and Guangzhou (9.9 million). (By comparison, the entire population of the U.S. numbered 281.4 million in 2000.) It pays to know the market because each province is different. Shanghai is fashion-forward, Beijing more cultured and the center of activity, while Guangzhou has close ties with highly efficient Hong Kong, making this industrial region very business savvy.

ii. Building Personal and Business Networks (Guanxi)

Most of the experts emphasized the importance of “Guanxi” or the building of personal relationships/networks. In the West, we know networking is important and most of us do it to a greater or lesser extent (i.e., we network when we are looking for a job). In China, however, Guanxi is essential if one wants to be successful, whether one is a marketing vice president closing deals or a manager trying to get Web content and collateral translated into Chinese. Building a network of personal connections in China is complex, because one has to build relationships with the central, municipal and provincial governments, suppliers and distributors and the influential people who have these connections. If one is in marketing and public relations, one will also need to build relationships with people who have connections to the media. Why are connections with the government important? First, the Chinese Central Government owns much of the land and it regulates many industries, such as media and banking. Second, Chinese laws and regulations, especially in the provinces, are difficult to understand and often are not written down. One will need a trustworthy local advisor and interpreter who can speak the dialect, explain the rules and customs, and ensure the government’s support. And, this point cannot be overemphasized, one will need to build networks with people who have government contacts and who in turn can introduce one to the local ministry and other authority figures. The Chinese style of communication is indirect and non-confrontational. In the U.S., for example, if you ask the local government, “Can I build here?” one will be told “yes” or “no.” In China, however, one will be told “no” indirectly: “How about if you put your building here instead?” Establishing the requisite networks takes time, a lot of time. Every company needs to do extensive research before establishing a connection with someone. In China,

155 reputation is very important. To choose a person who is not viewed as upright or honest is to take on that person’s negative reputation and hence jeopardize one’s own reputation and future network building opportunities. Martin Roll, CEO of VentureRepublic, a firm specializing in Asian Branding, and author of the book, Asian Brand Strategy, adds that Western companies mistakenly think they can market a product “quick and dirty” in Beijing or Shanghai. He states: If you’re serious about marketing to China, you have to be in it for the long haul. The Chinese value commitment; you have to gain their trust and build Guanxi with face-to-face meetings. Guanxi does not happen remotely through email and you cannot sit around waiting for someone to call you. It won’t happen.

iii. Developing Infrastructure

Urban centers in China have gone from crawling to running and have bypassed hardwiring altogether. Mobile phones and other wireless devices are huge with young urbanites. Phone stores in China may have 20 salespeople in a department when stores in the U.S. may have only two or three. This is because the affluent urban Chinese are buying everything electronic. Since they may be buying it for the first time, however, they do not know how to use the devices. Hence, the salespeople are there to educate them. While China may boast 100 million Internet users and 300 million using wireless, its developing network has not extended to the rural provinces. Those in manufacturing who need to worry about supply chain logistics must ensure that the right warehouses, trucks, railcars, etc., are available (or even exist) and that government regulations permit the transport of materials. (In other words, foreign businesses must not assume anything.) The rugged terrain in many parts of China that bogged down the imperial armies remains a significant challenge for foreign companies who think they can open markets in the rural provinces. Martin Roll advises companies to look at a map and plan accordingly.

iv. Finding the Right Partner and/or Distributors

Finding the right partner or distributor and employing prudent payment practices are particularly critical in china, where the judicial process is slow, expensive and plagued by corruption. The Commercial Service emphasizes companies ensure “partners are reliable, have the right motivation, can perform everything specified in the contract, and are allowed by law to fulfill the promises in the contract” by checking the reliability of partners via independent third-party sources. “Finding the right local partner is key,” confirms Kris Bondi, Principal of CNW Worldwide, and a marketing consultant who travels to China frequently. Bondi has aligned herself with a Chinese National who has become her local representative. “I definitely have better relationships due to his contacts and network,” she states. Her partner, for example, helped her find a former journalist who had a solid media network. “Because of this person, I was able to get interviewed for several publications which in turn have lead to discussions with the government concerning joint cultural work.” Trustworthy local partners are also invaluable when it comes to obtaining access to distribution networks. The U.S. Commercial Service recommends locating distributors and sales agents through trade shows, business connections and via the U.S. Department of Commerce’s Gold Key Service.

156 v. Protecting Your Brand

Brand piracy, counterfeit products and the black market are major concerns for foreign and domestic companies, whether they do business in China or not. Toshiba, for example, reached a 10% market share in China for its laptop batteries. The funny thing is, at the time Toshiba did not make batteries for China; the 10% market share was for Toshiba knockoffs. And then there is the case of Microsoft, who is fighting the widespread use of pirated versions of its software with little apparent success. Counterfeiting is 4-6% worldwide and estimated at about $450 billion dollars, with 80% of counterfeit goods coming from China. The Chinese have no respect for intellectual property or trademarks at this time. This is a real problem, not just for Western companies, but for Chinese companies, too. As Chinese brands themselves are now getting counterfeited, the pressure is on Chinese authorities to do something serious about the problem. Protecting one’s brand is difficult. Companies have learned – the hard way – that all molds, drawings, etc., have to be destroyed once they are no longer needed. Why? Because these items are routinely stolen from the trash and then sold on the black market to Chinese companies who then reproduce realistic knockoffs of lower quality. The Chinese government is cracking down, and municipal governments like Beijing have issued regulations stating that government offices must use licensed software. However, IP and brand stealing remain a huge issue for many companies.

3.2 Challenges/Issues for Chinese Exporters to the World

A growing number of Chinese companies are seeking to expand overseas to bolster their technological know-how and management skills and to escape intense domestic competition that is gnawing at profit margins. But poor management and product design could hamper their ambitions to go global. A study, conducted by International Business Machine Corporation’s Institute for Business Value, China, and Fudan University’s School of Management in Shanghai, surveyed 40 state-run and private Chinese companies mostly in the manufacturing sector. It said Chinese companies are considering strategies from mergers and acquisitions to strategic partnerships to construction of factories abroad to strengthen their international presence. The increasing overseas focus of Chinese companies is occurring against a backdrop of rising protectionist sentiment in the U.S. and other Western countries, where fears are growing over China’s rise as a global economic power and its role as a trade juggernaut powered by cheap exports. Some efforts by Chinese companies to expand overseas have run into resistance, such as Cnooc Ltd.’s failed bid to take over the U.S.’s Unocal Corporation, which sparked protect from the U.S. Congress. The study compared the current situation in China with similar transitions in Japan in the 1980s and South Korea in the 1990s, when companies in those countries were seeking to transform themselves to producers of higher value-added goods and services from low-cost manufacturers. The survey identified some 60 companies that could succeed internationally over the next decade. Several already have some international presence, including electrical-appliance makers Qingdao Haier Company in northeastern China and Galanz Group Ltd. of the southern province of Guangdong, which makes one third of the world’s microwave ovens under 80 foreign brands. Others include auto-parts make Wanxiang Group, which has sales offices in the U.S. and has expressed interest in buying U.S. parts maker Delphi Corporation, and motorcycle maker Chongqing Lifan Industry Group Company, which has a strong presence in emerging markets. In heavy industry, state-owned steel giant Shanghai Baosteel Group

157 Corporation could grab a larger global market share, the survey said. Telecom equipment manufacturer Huawei Technologies Company, which enjoys strong sales in a number of developing countries, could also continue to grow. Many more companies are lining up, especially as the government moves to ease currency controls and other restrictions. China’s Ministry of Commerce has predicted that outward investment by Chinese companies could grow an average 22% each year over the next five years, to reach $60 billion by 2010. Researchers are surprised by the number of manufacturers who wanted to go abroad, but very few had a well thought-out plan. That lack of a plan is among the broader challenges facing Chinese companies trying to globalize their operations. Chief among the Chinese companies’ complaints was a shortage of employees with the management and marketing skills to break into the international market. That could offer an opportunity for foreign players to partner up with Chinese companies overseas, in exchange for foreign companies getting better access back in China. Even if China’s investments overseas were to surge over the next few years, the total is likely to continue to be dwarfed by the amount of foreign investment coming into China – which totaled some $500 billion over the past decade. More than half of China’s exports are produced by foreign-invested companies.

4. Strings Attached – Case Studies in the Chinese Market

4.1 The Dum Birds Fly First – KFC Got Five Years Lead In China

The old Chinese adage, “Ben Niao Xian Fei,” is usually translated to mean that those with less intelligence and simpler minds tend to take for the sky before the smarter ones. Yet it can also be interpreted to refer to the willingness of some to accept the risks by taking action while others are still waiting for more complete information on the situation. Kentucky Fried Chicken – known throughout Asia as KFC – had more than 510 outlets in China as of October 2001, compared to less than 400 outlets for McDonalds. What is more important is that market surveys by A.C. Nielsen consistently confirm Chinese consumers’ general preference for KFC outlets and products over McDonalds’. One KFC outlet in Shanghai even claimed the highest one-day sales volume ever of any KFC outlet in the world. KFC opened their first outlet in Beijing on November 12, 1987, as a joint venture – a full five years ahead of McDonalds’ enter into China. Subsequently, it opened a wholly-owned outlet in Shanghai in 1989. Responding to a question in a television interview, McDonalds China’s president emphasized McDonalds’ command of the China market in the medium and long term. He will certainly have a lot of catching up to do. After all, long before KFC and McDonalds came on the scene, chicken has had a greater appeal to Chinese consumers than beef as chicken is usually more expensive and is served only on festive or special occasions in Chinese homes.

i. Other Leading “Dum Birds”

Kang-si-fu is a small flour supplier from Taiwan who became the market leader for instant noodles in China early on. Despite more than 10 years of playing catch up, the Taiwanese Top Food Conglomerate, President Food still finds the road to catching up to Kang-si-fu in China too rugged. With more than 70 high speed production lines in China, Kang-si-fu still maintains a big lead in the market despite being chased by President Food, Nissin, and other smaller local brands. Kang-si-fu took its winning money from China to Taiwan two years ago to buy up the controlling shares in the third largest food company in Taiwan. The C.P. Group from Thailand entered one of the first joint ventures in the reformed China when establishing a feed mill in Shenzhen in 1979. It proceeded to invest in

158 more than 100 feed mills in China, claiming more than 5% of China’s animal feed market of 30 million tons a year. The investment in animal feed in China has placed C.P. Group among the world’s top five animal feed manufacturers. From their traditional Chinese market stronghold in animal feed, the group proceeded to invest in motorcycle production, retailing, and real estate development. It will open one of China’s largest shopping malls in Shanghai Pudong (east bank of Shanghai) during July of 2007.

ii. Old Faithful Friends Rewarded: How VW Came to Dominate the Chinese Car Market

Volkswagen entered a joint venture with Shanghai Automobile Company in October 1984 to produce 30,000 cars each year. It surpassed 100,000 cars in 1993. It also entered another joint venture with the First Automobile Company in 1987 to produce the more luxurious Audi. Nearly 100% of automobiles used by Chinese central and local governments are manufactured by Volkswagen. The two joint ventures between Volkswagen and these Chinese firms today account for more than 50% of the market share for cars and automobiles in China. In comparison, the 1980s U.S. market was an era of revival for Chrysler and Lee Iacocca, who did not pay much attention to this sleeping dragon market. Toyota and Mercedes Benz literally laughed off the invitation for them to invest in China in the late 1970s. It should come as no surprise that establishing their presence in China now will not be easy. Honda took advantage of the managerial and investment disappointment of Peugeot to grab a 50,000 vehicle-a-year plant in Guangzhou. The latest entry into the Chinese automobile market was General Motors in 1997 with the first Buick rolling out of the production line 23 months later. Quite tactfully, Buick’s CEO declared the Shanghai General Motor Company to be a Chinese company – not an American company in China. To catch up with the market, GM has been actively acquiring shares in other automobile firms such as Isuzu’s joint venture in Jiangxi and Sichuan, Daewoo’s joint venture in Shandong, Daihatsu’s joint venture in minivan manufacturing in Chongqing, and a few more local automobile manufacturers. Already, Shanghai General Motors shows a profit of RMB 600 million in its first year of Buick sales.

iii. The Chinese Cola War

Coca-Cola presented the governments of Beijing and Guangzhou with complete bottling production lines as free gifts in 1981. The string attached was that the machinery must be used for the production of Coke’s brand of soft drinks only. As of the end of 2001, Coca-Cola operated 30 bottling plants in China with a total investment of 1.1 billion U.S. dollars. Sales in 2000 was slightly over RMB 20 billion ($2.5 billion) – a long way ahead of its arch rival, Pepsi-Cola, which entered China two years later and was operating only 15 bottling plants in China as of 2000. Wahaha grew from a school-operated factory producing milk into the number one Chinese beverage company in an explosive manner. It was easily the biggest marketers of bottled drinking water in China in addition to being the biggest manufacturer of yogurt. Since the end of 1999, it started challenging the cola giants with its own brand of local cola called, “Fei Chang Cola.” Advertising which appealed for support to the local heritage industry featured traditional Chinese folk themes. Little noticed by outsiders was that the “Chinese Cola” manufacturer Wahaha is 92% owned by the French food giant Danone.

iv. The Daring Danone

Relatively quietly, Danone began buying its way into China’s food and beverage market by acquiring established and well-managed Chinese firms since 1991. By 2000, it

159 owned majority shares in the top two Chinese bottled drinking water companies as well as two top yogurt companies. It has also made inroads into the packaged milk market in China with the acquisition of a small share of Shanghai Guang Ming Milk Company, the largest packaged milk company in China. Unlike other foreign investors which drove hard bargains before their joint venture or acquisition of shares in Chinese firms, Danone has been known to be willing to pay much higher prices, eschewing price bargaining. More than once, Danone grabbed the “prey” that was already in front of the mounts of other MNCs such as Nestlé. It also accepted tough conditions set forth by the local side with relative ease and grace. These “attached strings” included retention of the entire existing local management team and employees, complete responsibility for the welfare of retirees of the acquired company, and retention of the local firm’s existing brand. Since Danone typically opted to acquire relatively well-managed firms, there was less need for Danone to increase costs by importing herds of expatriate executives. Thus far, Danone’s localized management strategies appear to have paid off as the acquired firms continue to thrive and reinforce market appeals with a local color.

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162 CULTURAL INFLUENCES ON MANAGEMENT ACCOUNTING IN THE PEOPLE’S REPUBLIC OF CHINA

John B. MacArthur Ziming (Madeleine) Rao Department of Accounting and Finance University of North Florida

Abstract

The paper identifies management accounting models that are popular in the People’s Republic of China such as target costing and those that are less popular such as activity-based costing. Possible cultural reasons for the various degrees of popularity of these two management accounting models are explored. The literature on Chinese management accounting concepts and practices, published in both English and Chinese, is discussed in the paper.

Introduction:

From the formation of the People’s Republic of China (hereafter, China) in 1949 until 1978, the Chinese communist government administered a planned economy in which most business organizations were state-owned enterprises (SOEs) that served only to fulfill the planned targets set by the central government. In this planned economic environment, SOEs used fund accounting to record and report the use of funds obtained mainly from the state and bank loans, with any profits remitted to the state (Chow, Chau, & Gray, 1995; Tang & Lau, 2000). During this period, many management accounting practices used in the Western hemisphere were largely unknown in China (Bromwich & Wang, 1991). Since 1978, China has been moving to a more market-based economy, and, as a result, management accounting models have become more important to SOEs and to those private enterprises newly founded since the Chinese government’s open door policy announced in 1978 (Bromwich & Wang, 1991). In 1984, the Chinese State Council issued a regulation entitled Regulation on Cost Management of State Owned Enterprises that clearly defined “cost elements, costing methods, and responsibility of cost management” (Chow et al., 1995, p. 33). It is interesting to note that this regulation was ahead of its time in using the more contemporary and active term of cost management instead of the more traditional and passive term of management accounting. In the 21st Century, China is increasingly providing manufactured goods in the global marketplace. The resultant increases in manufacturing complexity, product volume variations, product diversity, and manufacturing indirect costs, coupled with China’s entry into the World Trade Organization in December 2001, has led to the need for improved cost management systems for planning and controlling organizational activities to replace obsolete traditional costing systems (Wang, Jin, & Lin, 2005). In September 2006, it was reported that China needs to have more world-class competitive enterprises in place of SOEs and more efficient banks in order to sustain its economic growth pattern (Reyes, 2006). If the private sector continues to increase in China, the demand for world-class management accounting systems is likely to grow too. It has been observed in the literature that some traditional (e.g., budgeting) and newer (e.g., target costing) management accounting models are more popular than other traditional (e.g., standard cost variances) and newer (e.g., activity-based costing [ABC]) management accounting models. Literature on the development of Chinese management accounting concepts and practices, published in both English and Chinese sources, is discussed next before the cultural dimensions behind management accounting preferences in China are explored.

1. Management Accounting in China:

Since 1949, management accounting has experienced the following three stages of development: cost management under a planned economy using the USSR’s cost measurement model (1949-1993), cost management within a market economy (1993-2000), and the introduction of contemporary cost management models, such as target costing (after 2000) (Bohao, 2005; see Appendix 2, Example 1, for further details of the historical development of Chinese management accounting1). A recent review of the literature on management accounting practices in four Asian countries (Sulaiman, Ahmad, & Alwi, 2004) discussed the findings reported in a paper on Chinese management accounting published in 1991 (Bromwich & Wang, 1991; largely based on two 1981 questionnaire surveys) and a paper on China published in 1996 (Firth, 1996; largely based on a 1993 questionnaire survey), which are now rather out-of-date given the rapid pace of changes in China since the survey data were collected. In respect of the two surveys conducted in 1981, over 50 percent of the respondents perceived practical usefulness for traditional cost- volume-profit (CVP) analysis (79%) and responsibility accounting (54.3%),but less than 50 percent believed standard costing (38.3%), capital budgeting (29.6%), and operational budgeting (only 3%) had practical value (Bromwich & Wang, 1991, p. 55). As regards the later 1993 survey, the questionnaire findings reported about traditional accounting models use in China were: • For budgets, widespread use of production budgets by all surveyed Chinese organizations but less than 50 percent of the Chinese partner firms (CPFs) and matched state owned enterprises (SOEs) in the same industry, used cash/working capital and other types of budgets versus high usage of all types of budgets by foreign partnered joint-ventures (JVs) and the divisions of the foreign partner companies (FPCs) operating in China. Also, higher middle management participation was found in JVs and FPCs than the Chinese run CPFs and SOEs (Firth, 1996, p. 637). • For standard costing and variance analysis, high usage of standard costing for budgeting (planning) and control, with standard cost variances calculated, by JVs and FPCs, both with foreign company involvement, but high usage for budgeting (planning) purposes only by the Chinese run CPFs and SOEs (Firth, 1996, p. 636). The influence of foreign company involvement in JVs and FPCs was evident in the reported differences in their higher adoption of traditional management accounting practices typically used in the West, compared with the Chinese run CPFs and SOEs. The 1993 questionnaire survey results on selected contemporary management accounting tools showed a similar pattern to the traditional management accounting results (Firth, 1996, p. 637): • Small but higher adoption of ABC by FPCs (15%) and JVs (10%) compared with CPFs (2%) and SOEs (1%). • Small but higher adoption of throughput accounting by FPCs (5%) and JVs (4%) compared with CPFs (1%) and SOEs (1%).

1 The Chinese in this and all other referenced documents were translated into English by co- author, Ziming Rao.

164 • Small but higher adoption of backflush accounting by FPCs (4%) and JVs (5%) compared with CPFs (1%) and SOEs (0%). As with traditional management accounting, the influence of foreign company involvement in FPCs and JVs was clearly evident in the reported differences in their uniformly higher adoption of contemporary management accounting practices compared with the Chinese run CPFs and SOEs. A more recent study, published in Chinese on the Internet in 2003, was based on data collected from 1985-1999 (Yimin, 2003). The study tracked activity based management (ABM) and ABC usage from 531 Chinese enterprises. These 531 enterprises are scattered in at least 27 Chinese provinces and more than ten different industries. The usable sample consisted of 397 companies. Table 1 indicates that the study results showed very low usage of ABC among the usable sample of companies, which is consistent with the findings of other studies, although there is a separate report of at least early benefits from the implementation of ABC in one SOE (Wang et al., 2005). However, the study results translated in English and reproduced in Table 1 show at least a moderately high degree of popularity for target costing (40.6%) among the usable sample of respondent Chinese companies. The popularity of target costing is also shown in the results of another Chinese study that is translated into English and reproduced in Table 2 and Table 3, a study based on survey results from 2000 (Xiongsheng, 2001). These interesting survey results will be considered later in the context of Chinese cultural characteristics.

Table 1: The Formulation and Development of ABC and ABM in Chinaa

ABC Target Life PDCA Quality Costd Otherse None Usable Costing Cycle Cycleb Costsc Sample Costing Number of 6 161 0 2 2 10 8 208 397 Companies

Percentage 1.5% 40.6% 0.0% 0.5% 0.5% 2.5% 2.0% 52.4% 100% of Usable Sample

Notes: a. Table 1 was adapted from Yimin (2003). b. The “PDCA Cycle” is the plan-do-check-act cycle, or the Deming Wheel, that is a TQM problem solving tool devised by Dr. W. Edwards Deming (e.g., see Garrison & Noreen, 2003, pp. 18-19). c. “Quality costs” are prevention costs, appraisal costs, internal failure costs, and external failure costs. d. The meaning of “Cost” was not discussed in the Chinese text of the online publication, but it presumably means traditional costing. e. Examples of “Others” were not given in the Chinese text of the online publication.

165 Table 2: Usage of Cost Management Tools in China (Comparing Industries)a,b

Standard Costing Budgets Target Costing Othersc

Classification by Number of % of Number of % of Number of % of Number of % of industry (Total # enterprises Total enterprises Total enterprises Total enterprises Total of Enterprises):

Total (72) 13 18.1 28 38.9 37 51.4 3 4.2

Textile (4) 0 0.0 1 25.0 2 50.0 1 25.0

Chemical 0 0.0 3 23.1 9 69.2 1 7.7 industry (13)

Oil (3) 1 33.3 0 0.0 3 100.0 0 0.0

Mechanics (18) 4 22.2 13 72.2 6 33.3 0 0.0

Construction (5) 0 0.0 1 20.0 4 80.0 0 0.0

Other industries 3 23.1 6 46.2 5 38.5 1 7.7 (13)

Agriculture (7) 2 28.6 0 0.0 5 71.4 0 0.0

Commerce (5) 2 40.0 0 0.0 3 60.0 0 0.0

Others (4) 1 25.0 4 100.0 0 0.0 0 0.0

Notes: a. Table 2 is adapted from Xiongsheng (2001); see Appendix 2, Example 4, for the narrative (translated into English) accompanying the data in Table 2 and 3. b. The percentages in each row do not all add up to 100% as enterprises can have more than one cost management model. c. Examples of “Others” were not given in the Chinese text of the online publication but, based on the narrative (see Appendix 2, Example 4), ABC implementation is probably included in this column.

166 Table 3: Usage of Cost Management Tools in China (Comparing Regions)a,b

Standard costing Budgets Target costing Othersc

Classification Number of % of Number of % of Number of % of Number of % of by Regions enterprises Total enterprises Total enterprises Total enterprises Total (Total # of Enterprises): East China (48) 7 14.6 16 33.3 28 58.3 3 6.3

Central and 3 21.4 8 57.1 4 28.6 0 0.0 West China (14) Old Basement 3 30.0 4 40.0 5 50.0 0 0.0 Industriesd in Northeast China (10)

Notes: a. Table 3 is adapted from Xiongsheng (2001); see Appendix 2, Example 4, for the narrative (translated into English) accompanying the data in Table 2 and 3. b. The percentages in each row do not add up to 100% as enterprises can have more than one cost management model. c. Examples of “Others” were not given in the Chinese text of the online publication but, based on the narrative (see Appendix 2, Example 4), ABC implementation is probably included in this column. d. “Old Basement Industries” also could be translated as “old industry areas,” which is where the Chinese “industry revolution” started. After the founding of the People’s Republic of China in 1949, during the 1950s and 1960s, the central government decided to focus investment to develop industrial factories in the northeast areas of China, which are called the old industry or old basement areas (see Chinese Internet site http://www.lntv.com.cn/lntv/dxzt/ln-industry/ssdh/2.htm).

2. The Impact of Cultural Factors on Accounting in China:

There has been some accounting research on the impact of cultural factors on management accounting (e.g., MacArthur, 2006), but most accounting studies have focused on comparative studies of financial reporting in different countries. The impact of cultural factors on the financial reporting changes enacted in China during the 1980s and early 1990s and the prospects for continued movement towards Anglo-American model were explored by Chow et al. (1995) using Hofstede’s cultural (e.g., Hofstede, 1980) and Gray’s accounting sub-cultural (Gray, 1988) frameworks, which were also used in other similar cultural studies (e.g., MacArthur, 1996, 1999). A later paper explored three other environmental factors (i.e., economic reform, capital market development, and significant foreign investment in China) behind the Chinese financial reporting changes that stem largely from the accounting reforms in 1993 (Tang & Lau, 2000). The results of a study of Taiwanese managers with a common Chinese ethnicity, using Hofstede’s cultural model, showed that national culture influenced manager preferences for and the design of management control systems (Chow, Shield, & Wu, 1999).

167 The updated version of Hofstede’s seminal book, Culture’s Consequences, contains numerous details of Chinese culture taken from various writings and studies that include his work; selected examples of these details are summarized in Table 4 (Hofstede, 2001). Hofstede’s famous IBM study did not include any survey data from China but did for Hong Kong, Singapore, and Taiwan, countries with mainly Chinese people (e.g., Hofstede, 2001, p. 250). However, Hofstede does report the results of studies that include data from China (e.g., Hofstede, 2001, p. 352). For the benefit of readers not familiar with this line of cultural research, Hofstede’s cultural and Gray’s accounting subcultural dimensions are briefly explained in Appendix 1. In Table 4, the content summary of cultural research clearly identifies China as a collectivist nation, and yet this may not be universally true for all aspects of Chinese life. It was reported by Lin (2005) that the CEO of a global Chinese company, Haier Group, made the following observations from everyday life and from the work environment in China, which seem to be consistent with the cultural characteristics expected of people from an individualistic country: If you observe Chinese people’s behaviors at the traffic lights, when the red light is on, people simply ignore it and cross the street anyway. At the workplace, Chinese people also tend to ignore rules and do not pay enough attention to details. We need a tough management system with fair rewards and penalty features to help our workers get things done properly. (p. 1) Hofstede (2001, p. 236) identifies “More conformity behavior” and “Harmony: confrontations to be avoided” as typical personality and behavior traits of low individualistic (i.e., collectivist) societies that would suggest instinctive obedience to laws (e.g., red lights) and work rules. These collectivist personality and behavior traits are clearly opposite to the CEO’s observations. Also, the CEO’s observations indicate the need for fair rewards and penalties, not allegiance to a collective group, to motivate employees. Moreover, Haier’s worker incentives are individual rewards and penalties and not group based (Lin, 2005, pp. 7, 11). The high masculinity and low/neutral uncertainty avoidance of the Chinese culture tend to favor performance-based rewards, but there is evidence that individualism/collectivism is the most dominant national culture dimension (Chow et al., 1999). In any case, the CEO’s observation of individualistic personality and behavior characteristics of Chinese people is consistent with the experience of one of the co-authors, born in mainland China. Since 1949, collectivism in China is clearly evident in the socialist-market economic structure imposed top-down by the political leadership for many years. Interestingly, from a bottom-up perspective, there are many small, family-owned (or partnership of friends), one-time manufacturers who make single products (often of low quality) for sale in open markets with no intention of a continuing business. For example, such entrepreneurs may decide to buy computer chips and put together a cheap flash-drive for sale for a relatively short time period before dissolving the partnership or family venture. These temporary enterprises seem to be opposite to the long-term orientation expected in Chinese culture (see Table 4). Perhaps it is the larger SOEs and independent multinational corporations that tend to have a long-term strategic viewpoint.2 However, Hofstede reported a laboratory experiment with management trainees from southern China versus a matched group from the USA in which the Chinese trainees exhibited behavior consistent with a collectivist society (Hofstede, 1991, pp.64-65). Subsequent, more refined comparative research studies obtained similar findings (Hofstede, 2001, p. 238). Hofstede made the important point that individual behaviors can deviate significantly from societal norms in collectivist and individualistic societies as

2 Except for the first sentence, the paragraph is mainly based on the personal experience of Ziming Rao, co-author.

168

Table 4: Summary of Selected Chinese Culture Material from Various Writings and Studies Contained in Hofstede (2001)

Cultural Dimensions Content Summary Relating to Chinese Culture (Page Numbers) High and Low Power High acceptance level in China of unequal power distribution (101). Distance Since about 500 BC, believed a stable society needs unequal relationships (114). Typically, hands-on management by owner and family to coordinate work of Chinese organizations (376-377).a Strong and Weak Uncertainty Uncertainty avoidance not identified in Chinese culture using the Chinese Avoidance developed “Chinese Value Survey” study (71 and 362).b Chinese heritage nations showed low uncertainty avoidance in Hofstede’s IBM study (151 & 181). Historically, Chinese society has a relatively high tolerance for uncertainty (181). Individualism and Collectivism dominates Chinese culture because it is believed that the Collectivism (Low individual is better off if the group is well looked after (210-211). Individualism) Adoption of new technologies prevalent in collectivist China and Japan because of appropriate political and organizational design (213). Chinese individual exists to support the family not vice versa (226-227). China is a strongly collectivist nation (234). Masculinity and Femininity High masculinity in China influenced by Confucian requirement to continue the family line on the male side (331). Long-Term and Short-Term Surprisingly longevity of ideas and cultural values in China and India (34). Orientation (Confucian A “long-term orientation” dimension found in Chinese culture (71). Dynamism) This cultural dimension was identified in the Chinese constructed “Chinese Value Survey” but not in Western developed cultural surveys (354 and 362). China is the most long-term orientated nation per surveys (352-356). Long-term personal relationships should not be sacrificed for short-term gains (362). Focus on future-oriented virtues including education, frugality, and perseverance (363). Chinese virtuous thinking produces superior synthesizing skills to coordinate the implementation of the new ideas from the more analytical thinking typically inbred in Western nations (364). Tradition and modernity surprisingly coexist in China (368). Notes: a. This Chinese cultural characteristic mentioned in Chapter 8 of Hofstede’s book, entitled “Culture in Organizations,” and in connection with a discussion of both power distance and uncertainty avoidance. b. Hofstede (2001, pp. 353-354) speculates that uncertainty avoidance is not of great importance in the Chinese culture.

demonstrated by the varying organizational cultures found within nations (Hofstede, 1991, p. 65). In fact, the Haier Group has an organizational culture that appears to be a blend of collectivist and individualistic values. For example, the following main features of the Haier Enterprise culture reported in Lin (2005, p.2) –“We work diligently to serve the country,”3 “The top 10% of performers ought to help the bottom 10% performers to

3 Hofstede (2001, p. 353) reports that “Patriotism” and “serve your country” are hallmarks of collectivist societies.

169 improve the firm’s competitive advantage,” and “Hair should be like the sea and make contributions to mankind “sincerely for ever,” – mirror collectivist cultural values, whereas, “Every employee is talented with an open bid for a vacant position” and “Excellent employees produce high-quality products” are more individualistic value statements. Of course, the extensive international scope of Haier’s business activities may be a major reason for its collectivist/individualistic blended corporate culture. The findings of another research study suggested that employee behavior in knowledge-sharing is a complicated mixture of knowledge type, national culture, employee relationships, and workplace culture (Chow, Deng, & Ho, 2000).

3. The Impact of Cultural Factors on Management Accounting Practices in China:

Several authors have recognized the potential impact of cultural factors on management accounting development in China, and some have called for studies on the possible influence of cultural and other factors on firms that, based on their findings, do not adopt the newer management accounting models (e.g., Bromwich & Wang, 1991; Sulaiman et al., 2004; Islam & Kantor, 2005). The Chinese-based studies reported earlier in Tables 1, 2, and 3 confirm that ABC is not a popular model with Chinese enterprises but indicate that target costing is quite prevalent among the respondent organizations. Reasons for the varying degrees of popularity of traditional costing, target costing, ABC, and other cost management models in China are published on the Internet in Chinese. Examples of these Chinese publications were translated into English and are listed in Appendix 2 of this paper.4 The possible cultural reasons for the varying degrees of popularity of ABC and target costing in China are considered next.

4. The Impact of Cultural Factors on ABC and Target Costing Adoption in China:

Based on the cultural research reported in Table 4, China is a high power distance, weak or neutral uncertainty avoidance, high collectivist, masculine, and long-term oriented nation. The long-term orientation and low/neutral uncertainty avoidance of Chinese culture would both support the adoption of a strategic, long-term cost management models such as ABC/ABM and target costing. Clearly, there is more uncertainty about target costing which determines estimated costs that are 100 percent in the future, versus ABC, which assigns historical and current period activity costs to cost objects. However, based on the discussion in Appendix 2, Example 4, it is not clear that target costing in China is being used in the usual way for future products but rather is focused on current products.

4.1 ABC

The collectivist cultural characteristic of Chinese nationals suggests that ABC/ABM models would be popular in China as teamwork is critical in the development and implementation of ABC systems in enterprises. However, ABC teams are usually developed by cross-functional, interdisciplinary groups with members from various parts of an enterprise, such as engineering, manufacturing, marketing, management accounting, and design. A research study found that Chinese knowledge-sharing was much greater within members of an in-group than with those outside an in-group (Chow et al., 2000). It was

4 Modifications to the Chinese translation into English were made to make the English text more understandable, while trying to preserve the meaning of the original Chinese writing.

170 found that the U.S. counterparts in the research study were much more willing to share knowledge with out-of-group members than the Chinese study participants, whereas the opposite was true in the case of sharing knowledge within the in-group. The results of this study showed that prior relationships and established trust generally were very important prerequisites to knowledge sharing for Chinese participants in the study. Members of ABC interdisciplinary teams from different areas of a Chinese enterprise might be viewed as out- of-group members by individual team members, and this might be a cultural factor impeding the adoption of ABC in China. Also, ABC was first developed in the USA in a Western culture, which might slow its adoption by enterprises in the Eastern country of China. Typically, ABC is significantly different from, and much more complex than, traditional costing and might not be too readily accepted in the Chinese culture that values tradition.

4.2 Target Costing.

Similar to ABC, target costing involves cross-functional, interdisciplinary teams (e.g., Horngren, Datar, & Foster, 2006, pp. 425-432). However, target costing teams are used to value-engineer front-line processes and products to achieve target costs and not to design a supportive costing system, such as ABC. The target costing cross-functional, interdisciplinary teams are likely to be more stable in-groups, in comparison with the ad hoc teams likely to be developing and periodically modifying ABC systems. Target costing is a contemporary extension to the traditional production budgeting and standard costing for budgeting purposes, which are also popular in Chinese enterprises according to the studies discussed earlier. Also, target costing was developed in the Eastern hemisphere in Japan by Toyota, which might have facilitated its acceptance and adoption in Chinese enterprises. The discussion in Appendix 2, Example 4, indicates that target costing is better known than ABC in Chinese enterprise in 2000.

5. Summary:

This paper has identified management accounting models that are popular in China, such as target costing, and those that are less popular, such as ABC. This paper has presented possible cultural reasons for the various degrees of popularity of these two management accounting models. The literature on Chinese management accounting concepts and practices, published in both English and Chinese, is presented and discussed. National culture is one of the factors affecting the costs and benefits of different management accounting designs for China and other nations (Chow et al., 1999, p. 457; MacArthur, 2006, p. 16). Other factors affecting Chinese management accounting preferences include market competition (Firth, 1996), ethical culture (Islam & Gowing, 2003), and the other factors discussed in the Chinese literature summarized in Appendix 2.

171 Appendix 1:

What do the Cultural and Accounting Subcultural Values Mean?

Cultural Values in the Workplace:5

Individualism and collectivism: Employed persons in an individualist culture are expected to act according to their own interest, and work should be organized in such a way that this self-interest and the employer’s interest coincide…. In a collectivist culture an employer never hires just an individual, but a person who belongs to an ingroup. The employee will act according to the interest of this ingroup, which may not always coincide with his or her individual interest: self-effacement in the interest of the ingroup belongs to the normal expectations in such a society. (Pages 63-64.)

Large and Small Power Distance: In the large power distance situation superiors and subordinates consider each other existentially unequal; the hierarchical system is felt to be based on this existential inequality. Organizations centralize power as much as possible in a few hands. Subordinates are expected to be told what to do. (Page 35.) In the small power distance situation subordinates and superiors consider each other as existentially equal; the hierarchical system is just an inequality of roles, established for convenience; and roles may change, so that someone who today is my subordinate may tomorrow be my boss. Organizations are fairly decentralized, with flat hierarchical pyramids and limited numbers of supervisory personnel. (Page 36.)

Strong and Weak Uncertainty Avoidance: Uncertainty avoiding cultures shun ambiguous situations. People in such cultures look for a structure in their organizations… which make events clearly interpretable and predictable. (Page 116.) In uncertainty avoiding societies there are many formal laws and/or informal rules controlling the rights and duties of employers and employees. There are also many internal rules and regulations controlling the work process, although in this case the power distance level plays a role too. (Page 120.) The emotional need for rules in strong uncertainty avoidance societies can be turned into a talent for precision and punctuality. (Page 122.) In countries with very weak uncertainty avoidance there seems to be an emotional horror of formal rules. Rules are only established in case of absolute necessity, such as to determine whether traffic should keep left or right. (Page 121.)

Masculinity and Femininity: The masculine manager is, of course, assertive, decisive, and ‘aggressive’ (only in masculine societies does this word carry a positive connotation). The manager in a feminine culture is less visible, intuitive rather than decisive, and accustomed to seeking consensus. (Page 94.)…Although one might expect it, there is no relationship between the masculinity or femininity of a society’s culture and the distribution of employment over men and women (page 95).

Long-Term and Short-Term Orientation: For example, a short-term orientation is associated with an expectation of fast returns and a high regard for traditions, whereas a long-term orientation is associated with patiently waiting for slow returns and adapting traditions to meet current needs (page 173).

5 Taken and adapted from Hofstede (1991, page numbers are shown in parentheses). Except for long-term and short-term orientation, the cultural characteristics are discussed by Hofstede in various contexts such as in the family and at school, but in the workplace seem more pertinent for this article.

172

Accounting Subcultural Values:6

Professionalism versus Statutory Control — a preference for the exercise of individual professional judgment and the maintenance of professional self-regulation as opposed to compliance with prescriptive legal requirements and statutory control.

Uniformity versus Flexibility — a preference for the enforcement of uniform accounting practices between companies and for the consistent use of such practices over time as opposed to flexibility in accordance with the perceived circumstances of individual companies.

Conservatism versus Optimism — a preference for a cautious approach to measurement so as to cope with the uncertainty of future events as opposed to a more optimistic, laissez faire, risk-taking approach.

Secrecy versus Transparency — a preference for confidentiality and the restriction of disclosure of information about the business only to those who are closely involved with the management and financing as opposed to a more transparent, open and publicly accountable approach.

6 Taken from Gray (1988, p. 8).

173

Appendix 2:

Examples of Chinese Internet Postings translated into English with Reasons for the Varying Degrees of Popularity of Traditional Costing, Target Costing, ABC, and Other Cost Management Models in China

Example 1:

Changes in Chinese Cost Management (Bohao, 2005) 中国成本管理思维的变迁

The three phases of cost management in China (see the graphic), are as follows:

• 1949-1993: cost management under planned economy • 1993-2000: cost management under market economy • 2000-present: contemporary cost management

After 2000, all kinds of advanced cost management tools are introduced to Chinese enterprises. Interpretation of the graphic:

1949-1993: Adopted USSR’s cost measurement system based on positions, budget, and analysis model 1993-2000: Adopted international regulations of cost measurement. 2000-present: Cost management models are introduced. ABC is introduced from the USA and other advanced strategic cost management tools and ideas are introduced. Cost management has been transformed from conservative methods (i.e., control after cost takes

174 place) to contemporary methods (i.e., control before cost takes place, control processes, and strategic cost management). Generally speaking, due to the imbalance of Chinese regional economic development, only a small number of enterprises are actually using those new methods, such as standard costing, target costing, ABC, and the balanced scorecard. In summary, Chinese cost management is far behind that of developed countries.

Pitfalls of Chinese Cost Management

1. When considering cost, many managers only focus on product cost rather than activity cost. Managers don’t understand the production process, so they can only know the cost of products after production has taken place. In this way management can never control cost before it takes place. 2. Many enterprises don’t consider cost management a comprehensive and whole system. For example, when procurement cost is high, they focus only on procurement cost; when production cost is high, they focus only on production cost. While they decrease cost of A, they increase cost of B. 3. Most of Chinese enterprises depend only on finance department to reduce costs. Employees in other department are not held responsible for costs at all. Cost control, however, should be inter-departmental. 4. In many Chinese enterprises, once the cost has been reduced, management no longer monitors it. In consequence, the cost usually goes up again soon after it has been reduced.

Example 2:

ABC: a new cost management tool—part of ABCM (Guangyu & Ming, n.d.) 中国第三方物流网

The vision of future of ABC in China

1. ABC must be accepted and adopted by high-level management. This is not easy for Chinese enterprises because management is not familiar with ABC and because China has been under the influence of a planned economy.

2. Make sure to identify who is responsible for the ABC system. ABC systems require work from all the internal departments of the enterprise. However, inside Chinese enterprises in manufacturing industries, there is no management accounting department. This function is dispersed in the finance department or procurement department. If there is no special management accounting department to oversee accounting matters, it is hard to implement a complex costing system such as ABC.

3. Software design. There is not enough technical support for ABC in China. In developed countries, mature software has been developed but it does not fit Chinese enterprises. Chinese enterprises must develop software adapted to their own business environments.

175 Example 3:

Accounting blog: ABC: theory and practice (Weiming, 2005)

Discussion: Why it is so difficult for Chinese enterprises to implement ABC?

1. It is hard to coordinate employees from different departments. Usually, the finance department is supposed to take charge of ABC implementation, but actually it is the manufacturing department which has the best employees to design the ABC system, because they know better than employees in finance what the cost drivers of manufacturing activities are. Then it is the sales department that uses the cost information. Finally, the staff of the front offices will put ABC into practice. Additionally, it requires IT support. Thus, ABC will affect every facet of the organization, and the failure of one link of the chain will jeopardize the whole ABC system.

2. It is hard to control the levels of computing costs: if the calculation system is too detailed, it will be impractical; if it is too general; there is no benefit to implementing ABC. It is difficult to determine how detailed the cost calculation should be. For example, customers expect the logistics cost to be specified per order (by the number of storage days). It requires detailed data from each department involved in manufacturing as well as systematic support from the organization as a whole. Such detailed work is difficult to implement and thus likely to be aborted at some point.

3. Lack of implementation software. If enterprises use ERP, the whole ERP system will have to be renewed. It is expensive. Additionally, enterprises are not familiar with related software. If enterprises use Microsoft Excel, it is too complicated for them. Intensive training will be required. Lack of IT support would be another critical reason why ABC is not popular in China.

4. Chinese enterprises are bound by traditional cost management methods. This has been considered one of the biggest impediments of ABC implementation. Currently, cost management is mainly used for the purpose of financial accounting. Managers are so used to the rules of financial accounting that it is difficult for some of them to understand why logistics costs should be traced to each customer instead of just considering it as overhead cost.

5. It is hard to persuade management to accept the new idea of ABC and to explain why it is important to implement ABC. It is difficult to reach agreement about ABC among management.

6. It takes a long time to even design an ABC system. Also, it will take a long time to see the potential benefits of ABC, which would cause a lot of doubts about the new management tool and management will lose their enthusiasm to continue.

7. In Chinese enterprises, there are usually very poor internal control systems, and costs often increase because of corruption. Such cost increases could not be resolved by using ABC. For example, the external analysts (e.g., auditor) cannot tell the real market value of raw materials.

176 Example 4:

“Survey of cost management tools used by Chinese enterprises and their effects” (Xiongsheng, 2001)

Standard Costing:

Not many enterprises use standard costing because the processing of standard costs requires precision and sometimes requires technical support. It is hard to combine technical measures with an accounting tool. Moreover, the cost of implementation and maintenance of a standard cost system is high. For each unit of labor and material, enterprises must make price standards and quantity standards and improve these as time goes by. It is difficult for Chinese enterprises to implement standard costing. Compared with target costing and budgeting, the cost of standard costing is higher. Advances in technology will require the change of cost standards. But employees prefer to keep old cost standards and are unwilling to implement new standards. Additionally, management lack experience in updating cost standards.

Target Costing:

Target costing is popular in Chinese enterprises because the target cost is directly related to profit. Although target costing is already popular throughout China, it needs refinement. More than half of the enterprises in the survey use target costing. Enterprises use product sales price and deduct established target profit in order to calculate target cost. Then enterprises establish some performance indicators according to the target cost so that they can recognize the departments who have the best outcomes. Enterprises expect to gain cost advantages by doing so. Currently, target costing is only used for management of current products because enterprises are only reacting to market competition instead of being proactive. In fact, target costing is more successful when applied to products at the R&D stage.

Budgets:

Budgeting is another popular method used by Chinese enterprises in the survey, especially in the mechanics industry. Because Chinese enterprises are used to regulations under the planned economy system, they are familiar with the budgeting method. Nevertheless, the mechanics industry started to pay attention to the target costing method. Such a switch indicates that Chinese enterprises are more and more influenced by the market economy. From the aspect of regions, enterprises in central and western areas mainly use budgeting. The reason may be that most of the enterprises in these regions are state-owned and greatly susceptible to the planned economy. Under the planned economy, “budget” was the mainstream concept and was impressed in people’s minds. Standard costing is the least used method regardless of regional differences. This is because the Chinese government propagandized that “standard” is a capitalist concept and “budget”/”quota” is a socialist concept.

ABC:

ABC usage in China is low although it has been paid some attention in the past 10 years. While target costing is widely used in China, enterprises are not familiar with ABC. Nevertheless, ABC will have a bright future in China.

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179 180 THE FOREIGN CORRUPT PRACTICES ACT, SARBANES-OXLEY, AND THE IMPLICATIONS FOR AMERICAN BUSINESS IN CHINA

Christina Shea Jeffrey E. Michelman Department of Accounting and Finance University of North Florida

Abstract

To facilitate their rapid economic development China has begun to combine aspects of capitalism with communism. This combination has created a unique business atmosphere that poses many challenges and opportunities for U.S. corporations. U.S. companies operating in China come under many international laws and regulations, yet two important U.S. federal laws – the Foreign Corrupt Practices Act and the Sarbanes-Oxley Act – still apply to those companies that are listed on the U.S. stock exchanges. This paper outlines various ways for American businesses to achieve success, with respect to the Foreign Corrupt Practices Act and the Sarbanes-Oxley Act, as they expand into the Chinese marketplace.

Introduction:

In the past three decades, China has quickly risen to become one of the world’s largest superpowers. China’s vast population of over 1.3 billion people dazzles the global investment and business world with seemingly endless opportunities (Johnson, 2005). A current survey of United States businesses revealed that 60% of companies currently have a wholly foreign-owned enterprise in China, and this trend is expected to continue to rise in the future as more U.S. businesses begin competing in the Chinese market (Cronin, 2006). In recent years, China has begun to combine aspects of capitalism with its longstanding tradition of socialism, which has created a unique business atmosphere that poses many challenges and opportunities for foreign businesses and investors (Johnson, 2005). Although U.S. businesses operating in China are often regulated by international laws and regulations, there are two important U.S. federal laws – the Foreign Corrupt Practices Act and the Sarbanes-Oxley Act – that still apply to those companies that are listed on the U.S. stock exchange. Therefore, it is important for American businesses operating in China to fully understand these laws and the business implications that result from implementing their regulations within an organization. This paper attempts to outline various ways for American businesses to achieve success, in regards to the Foreign Corrupt Practices Act and the Sarbanes-Oxley Act, as they venture into the global marketplace of China. The paper begins by describing U.S. business relations with China and then details both of these U.S. federal regulations. Chinese history and culture is next discussed as a backdrop for the business environment in China. The paper then discusses the Foreign Corrupt Practices Act and its implications for U.S. businesses operating in China. The paper concludes with a discussion of corporate governance policies that U.S. companies should use to avoid violations of either the Foreign Corrupt Practices Act or the Sarbanes-Oxley Act when conducting business in China.

1. China and United States Business Relations:

China’s current business relationship with the United States began only a few decades ago. After World War II, numerous political reasons caused China’s tenuous relationship with the United States to collapse, sanctions were imposed in the U.S. against doing business with China. Relations between China and the United States remained extremely tense for decades. In 1972, President Richard Nixon took the groundbreaking “first step” as the first U.S. president to visit China, tour the country, and enter into discussions with top officials, including Mao Zedong, who still had absolute power over China and the Chinese people. President Nixon’s trip shook the world, and despite his embarrassing resignation in 1974, he will be remembered as a foreign policy genius who laid the foundation for the future of United States commerce in Asia. Nixon created the dawn of a new era with his peace talks in China and altered the course of history for both countries (Schurmann, 2005). In 1979, the United States established formal diplomatic relations with China and agreed that while the two countries were not quite allies, they were also no longer enemies. The United States also agreed to recognize that Taiwan was part of China and that the People’s Republic of China was the sole legal government of the entire country. However, it should be noted that Taiwan and its people consider themselves to be a separate country from China and continue to claim independence as a distinct state to this day. While this issue remains a source of contention worldwide, most countries, including the United States, do not officially recognize Taiwan as independent of China (U.S. Department of State, 2006). Over the years, the U.S. has encouraged China to abandon former policies which kept them isolated from the rest of the world and has helped them to become an important part of the international and global business environment. While significant breakthroughs have occurred between China and U.S. relations, relations between the two countries are complex and evolving (U.S. Department of State, 2006). Events such as the Tiananmen Massacre in 1989 and the accidental U.S. bombing of the Chinese embassy in Belgrade in 1999 have continued to strain this often contentious relationship. More recently, China has become an international superpower much too powerful for the U.S. to try to manage or contain. Therefore, the United States must strive to maintain and strengthen a mutually beneficial relationship with China in order to maintain global competitiveness in the market and peaceful relations with the East (McGregor, 2005).

2. Foreign Corrupt Practices Act:

The Foreign Corrupt Practices Act of 1977 (FCPA) is a United States federal law that requires public companies to maintain accurate books and records as well as a sufficient system of internal controls in order to achieve the goal of prohibiting bribery of foreign officials by all U.S. citizens and business entities, all companies listed on the U.S. stock exchange, and foreign persons acting within the U.S. To this end the FCPA makes it illegal for U.S. companies to give, offer, or authorize payments to foreign officials either directly or indirectly (Calhoun, 2001). United States companies are prohibited from “giving anything of value to a foreign or international official, with corrupt intent, for the purpose of obtaining or retaining business or gaining an improper advantage” (Martin, 2004, p. 5). However, the FCPA does allow U.S. businesses to make “facilitation payments” to speed up routine governmental transactions, as long as these payments do not involve efforts to gain new business or gather business favors. Facilitation payments are not seen as bribes but are considered to be part of the routine customs and traditions of doing business in a particular country. The distinction between bribes and facilitation payments is often a fine

182 line, and U.S. businesses should take extra precautions to ensure that they do not “cross the line” and commit bribery (Bailes, 2005). During the 1970s, the Office of the Special Prosecutor investigated numerous illegal acts of bribery by U.S. companies in foreign countries. These investigations led Congress to enact the Foreign Corrupt Practices Act to help restore public confidence in the integrity of the United States business system (Calhoun, 2001). The FCPA was the first and only regulation of its kind against corruption and bribery by U.S. citizens and companies doing business in foreign countries. When Congress enacted the FCPA in 1977, the U.S. was the only country in the world that had an enforceable set of laws against bribery in foreign business dealings. Since the inception of the FCPA, there has been much debate surrounding the issue of whether or not it has hurt U.S. businesses by leaving them at a competitive disadvantage against international companies that are allowed to continue business practices that are illegal for U.S. companies. There are good arguments on both sides of the issue; not surprisingly, it is still not clear if the FCPA has had the damaging effects that some U.S. businesses claim it has imposed upon them (Carr, Kaikati, Sullivan, J. Virgo, K. Virgo, 2000). In a 1988 amendment to the FCPA, the President negotiated an international agreement with the member countries of the Organization for Economic Cooperation and Development (OECD) to curtail international bribery of foreign officials. However, this policy has had little effect on the OECD member countries, and corruption remains commonplace in international business practices. In 1997, the United States signed an agreement with members of the OECD as well as with five non-OECD members that for the first time will force countries to prosecute companies for bribery of foreign officials. Member countries are expected to monitor themselves and one another for compliance with the treaty, and it remains to be seen if this policy has had a major effect on preventing corrupt actions and bribery involving international businesses and foreign officials (Carr, Kaikati, Sullivan, J. Virgo, K. Virgo, 2000).

3. Sarbanes-Oxley Act:

During 2001 and 2002, the international business world was shocked with wave after wave of various accounting scandals at major U.S. companies, such as Enron, WorldCom, and Tyco. These scandals shook public and investor confidence in the U.S. capital markets and threatened the overall stability of the global marketplace. In order to restore public faith and investor confidence in America’s corporate sector, Congress enacted a new United States federal law in 2002 known as the Sarbanes-Oxley Act (SOX). Sarbanes-Oxley applies to all public companies listed on the U.S. stock exchanges, and goals of the SOX regulations include cracking down on corporate corruption and helping to prevent future accounting scandals. Because SOX has been in effect in the U.S. for a short time only, it is difficult to determine the full impact that these regulations will have on public companies (Selling, 2004). Sarbanes-Oxley greatly enhances corporate governance standards and auditing procedures with its new regulations. SOX created a new entity called the Public Company Accounting Oversight Board (PCAOB) to maintain and regulate the auditing profession. In an effort to increase transparency, SOX requires companies to provide many additional financial reporting disclosures in its annual statements (AICPA, 2006). In addition, SOX requires all audit committee members to be members of the company Board of Directors. Another requirement of SOX is that all audit committee members must maintain strict independence from the company. In order to help maintain independence, SOX requires that the lead auditor for the company be rotated every five years and does not allow the auditing firm to perform non-audit services for the company. Under the SOX provisions, a company must disclose whether or not it has a “financial expert” on its Board. A “financial

183 expert” is defined as one who has an extensive background and knowledge of accounting. In order to minimize the threat of corporate corruption, SOX does not allow directors or executives to receive loans from the company and requires the CEO and CFO of each public company to certify that the financial statements are accurately and fairly presented. Another important provision of Sarbanes-Oxley is that it makes it illegal for companies to punish corporate whistle blowers in any way (Boardsource and Independent Sector, 2006). One of the most important provisions of Sarbanes-Oxley is regulatory section 404, “Management Assessment of Internal Controls.” This section is aimed at improving corporate governance by increasing the effectiveness of internal control systems at public companies (AICPA, 2006). Sarbanes-Oxley requires companies to assess its internal control system in relation to a suitable framework, such as the Committee of Sponsoring Organizations Enterprise Risk Management Integrated Framework (COSO ERM). The COSO ERM Framework is designed to help companies identify and manage risk across the enterprise. By putting an effective risk management system in place, companies also increase the effectiveness of internal control systems (D’Arcangelo and Matyjewicz, 2004). SOX 404 requires companies to issue an annual internal control report which provides an assessment of the effectiveness of the company’s internal control system in relation to financial reporting. The internal control report must contain a statement that asserts that the management of the company is responsible for establishing and maintaining an adequate internal control system. The company’s external auditor must also review the internal control system and report on the assessment of management regarding the effectiveness of internal controls. In addition, Section 404 requires companies to disclose whether or not it has adopted a corporate code of ethics, and if a code of ethics for the company does exist, then it must also be disclosed. SOX also requires companies to immediately disclose any changes that are made to the corporate code of ethics (AICPA, 2006).

4. Chinese History:

China is one of the world’s oldest civilizations with written history dating back nearly seven millennia. Prior to the 20th century, China was governed by imperial rule for thousands of years, and its culture was shaped by the strong influence of Confucius, whose teachings constitute an ethical and philosophical system rather than a religion (Gunde, 2002). During the 20th century, China went through a massive upheaval beginning with the Wuchang Uprising in 1911. This traumatic Revolution ended the imperial system and replaced it with the Republic of China headed by Sun Yat-sen. Sun helped to create one of China’s first political parties, the Chinese Nationalist Party, commonly known as the Kuomintang (KMT), which fought hard to establish a democracy. In the early 1920s, the Communist Party of China (CPC) was created and remained in a continuous power struggle with the KMT for many years. When the CPC won control over China in 1949, the KMT retreated to Taiwan, where they remain to the present day. With the departure of the KMT, Mao Zedong and the CPC established the People’s Republic of China (PRC). The Communist Party of China continues to rule the PRC to this day as a single-party state (Schoppa, 2000). Mao Zedong was Chairman of the Communist Party of China (CPC) from 1945 until his death in 1976. After the CPC became the ruling party of China in 1949, Mao took control of the country and created various economic and political campaigns that resulted in the deaths of millions of Chinese citizens. The Great Leap Forward and the Cultural Revolution, two of Mao’s most infamous campaigns, devastated the Chinese people both physically and emotionally; the ill effects from these campaigns are still felt in China today. Despite his political mistakes, Mao was extremely popular with the Chinese people (Wills, 1994). Mao was able to create a cult of his personality, and the Chinese people worshipped

184 him almost as a God-like figure. Mao’s picture was displayed in nearly every building and home in China. All CPC party members were required to carry with them, at all times, a copy of Mao’s “Quotations from Chairman Mao Tse-Tung,” also known as the “Little Red Book” (Barme, 1996). There are over one billion copies of the “Little Red Book” in print, making it one of the most published works in history, second only to the Bible (Wikipedia, 2006). Although many years have passed since Mao’s death in 1976, he is still a prominent figure in China today; and the Chinese people continue to consider him to be one of the greatest leaders in Chinese history (Barme, 1996).

5. Chinese Culture:

The Chinese people have gone through major upheaval both politically and emotionally in the past few decades. The constant change and corruption occurring throughout China has left many citizens distrusting everything except money. China’s culture places an enormous emphasis on the importance of making money, which is often the only way for Chinese people to find any type of freedom in a country with innumerable restrictions (McGregor, 2005). Not surprisingly, the Chinese people are currently moving away from traditional values and are now focusing on more modern values (Jinhui and Lin, 2002). Values in China are shifting as citizens adapt to the new capitalist society emerging in their country (Reich, 2006). China’s pervasive emphasis on the importance of money might help explain why bribery and corruption are so rampant throughout the country (Jinhui and Lin, 2002). A perfect description of the Chinese view on money is expressed by a Chinese citizen named Yang, “In China, you either have money or you have to be obedient” (McGregor, 2005, p. 7). The practice of gift giving in China is deeply ingrained in Chinese culture. The Chinese believe that gift giving shows respect to another person and helps to strengthen all relationships, whether business or personal (Seligman, 1999). Steidlmeier (1999) states, “China is one of those societies where reciprocity is a foundational pillar of social intercourse. To approach another and bring nothing is unusual, to say the least. To accept a gift and not reciprocate is perceived as morally wrong” (p. 121). The Chinese do not view traditional gift giving as bribery but rather as a standard practice to honor business associates and friends (Seligman, 1999). The Chinese believe that the difference between gift giving and bribery is in the intent of the parties in a transaction. If the intent is to express gratitude or respect for the other party, then it is considered a gift. However, if the intent is to coerce the other party into acting in the best interest of the party who is giving the money or other consideration, then it is considered a bribe (Steidlmeier, 1999). Obtaining a network of significant relationships, called guanxi, a concept taken from Confucianism, is vital to the Chinese way of life. Under the strict communist society in China, it is difficult for citizens to accomplish their goals without the help of guanxi. Because China does not have a reliable legal system, citizens must turn to personal power to help open doors and accomplish objectives. In China, future possibilities are not determined by personal ability or desire but are given to those citizens with the best connections at the top. Therefore, Chinese people work hard to cultivate successful guanxi networks for themselves and their families (Day, 2003). A guanxi network that includes powerful members of the Chinese government can prove invaluable by allowing for extra monetary compensation or exemption from oppressive Chinese regulations. When confronted with a problem, whether business or personal, Chinese people turn to their guanxi for help, and the number of significant connections in the network determines the number of possible solutions that are available to resolve the issue (Seligman, 1999). In the United States, our society is based largely on “religious guilt.” In the West, the people’s collective fear of committing sin and angering God keeps many potential criminals in check. The Chinese people are different from those in the West and are not

185 guided by feelings of guilt; rather they are guided by feelings of shame. In China, shaming oneself and one’s family is the ultimate humiliation. The Chinese people often feel corrupt behavior is acceptable as long as they do not get caught, exposed, and publicly humiliated. The Chinese government must combat corruption in the country by having a firm top-down control structure that increases the chances of its citizens getting caught and shamed when committing a crime (McGregor, 2005). The United States is based on the common law system where judges are impartial and fair. However, China is based on the civil law philosophy where judges act as inquisitors. Because Chinese judges are supervised by a committee of Communist Party members, all decisions are ultimately political and not impartial. Moreover, in stark contrast to the American legal tradition, the Chinese judiciary presumes that the accused or indicted individual is guilty rather than innocent (McGregor, 2005). In the past few decades, China has been reforming its legal system and has created hundreds of new laws. Although China now has an extensive legal system in place, proper enforcement of laws, regulations, and court judgments by Chinese officials is often non-existent (Pei, 2005). Chinese citizens often compensate for a lack of law enforcement by deciding to settle disputes among themselves. At the same time, however, Chinese law is ruled by a presumption of government control. That is, the Chinese consider behaviors and actions that Americans take for granted as their right to be illegal unless there is a law or regulation that allows it. The Chinese do conceive of the individual as having the liberties that are foundational in America (McGregor, 2005).

6. Chinese Culture and the Foreign Corrupt Practices Act:

The Chinese government has kept a tight reign on its economy through its use of state-owned enterprises (SOEs). However, in recent years China has been working towards the privatization of SOEs in an effort to improve corporate governance and market growth throughout the country (Norton, 2004). Many SOEs in China are extremely unprofitable and inefficient, which is hindering the country’s economic growth. China is hoping to improve its economy by privatizing many of the SOEs and promoting positive company performance (McKinsey Quarterly, 2004). Although many SOEs have now become public companies, the government still controls a large majority of the Chinese economy. This factor has a great effect on the application of the Foreign Corrupt Practices Act in China since the FCPA does not allow payments to foreign officials. U.S. companies must be very careful while doing business with SOEs: payments made to SOEs would fall under the FCPA anti-bribery provisions since they are largely controlled by the Chinese government and its CPC party members (Norton, 2004). China does have anti-corruption laws such as those stated in the Chinese Criminal Code and the CPC’s Regulations on Disciplinary Penalties. However, China does not enforce these laws with any regularity (Norton, 2004). China is a country with a “system of checks and no balances” (McGregor, 2005, p. 96). Corruption among local government authorities is common and often condoned in the Chinese business world (Norton, 2004). The Communist Party in China wants to maintain a culture that provides for the ruling elite to remain above the law. Members of Chinese “high society” are often allowed to build personal assets through any means possible, whether corrupt or otherwise, while the government looks the other way (McGregor, 2005). The Chinese ruling elite are wary of what the future may hold for communism in the country and do not want to wait to turn their power into wealth. The privileged members of Chinese society are “cashing in” as fast as possible and are willing to commit acts of bribery and corruption to speed up the process (Pei, 2006). China has become one of the most unequal societies in Asia, and this trend is expected to continue since the wealth of the elite is continuing to rise while the wealth of the common citizens continues to fall. The ruling class is comprised mostly of

186 government officials and top communist party members (Cody, 2005). Political power has given the Chinese elite staggering wealth and privileges which they are extremely reluctant to part with despite the fact that corruption in the country has hampered international business dealings. China is in need of massive reforms to control the corruption among its government officials and party members. However, future necessary changes will be hard to obtain as long as the ruling elite remain firmly in power (Pei, 2006). Because compensation in China lags behind many other countries, the Chinese people often try to supplement their income with bribes, kickbacks, gifts, and other forms of remuneration. This is considered to be standard practice in the Chinese economy despite laws in China that prohibit bribery (Seligman, 1999). U.S. companies often feel that they are competing on an uneven playing field since they are prohibited from making illegal payments under the FCPA, while Chinese businesses, who are not restricted by the FCPA, regularly engage in corrupt activities (Norton, 2004). Although there are also regulations in China regarding gifts, the laws are ignored, and gift giving is expected in business relations (Seligman, 1999). Since many U.S. companies are much more affluent than their Chinese counterparts, the Chinese officials and executives expect to receive lavish gifts from Western businesses. However, the FCPA does not allow U.S. companies to give gifts to foreign officials. This policy often leaves U.S. businesses in an embarrassing situation because the Chinese people incorrectly believe that the company is acting stingy and impolite by refusing to give gifts (Norton, 2004). The Chinese economy has been strictly controlled and regulated by the government for many decades. Due to severe government oppression in Chinese culture, accounting and business practices in China have become both secretive and opaque. China must learn that greater transparency and effective corporate governance will result in a more stable global marketplace and will increase international investment for its companies. In order to avoid FCPA accounting violations in China, U.S. companies must keep in mind that Chinese businesses often do not operate in a transparent corporate environment. U.S. companies must protect themselves from violating the FCPA regulations by demanding more disclosure and more documentation from its Chinese business partners (Milkiewicz and Wei, 2003). When doing business in China, U.S. companies should not always fall back on the FCPA regulations as the reason for not committing corrupt practices in China. Although the Chinese may not regularly follow their own rules and regulations against bribery and corruption, U.S. companies should cite them when dealing with business partners in China. In contrast,Chinese organizations might feel more compelled to follow their own laws regarding corruption, especially when U.S. laws often do not apply to its companies. U.S. businesses stand a better chance of achieving legal and regulatory compliance when its Chinese business partners also try to comply with laws against corruption (Steidlmeier, 1999). In recent years, China has been working towards incorporating foreign laws into its domestic legal system. China has been more favorable to Western laws recently in order to better integrate its economy with its international business partners (Day, 2004). Chinese businesses are finally recognizing that strong economic growth is often related to effective corporate governance practices. In addition, the Chinese government has recognized that global investors are going to continue to demand more effective corporate governance policies around the world. Therefore, Chinese officials have placed the task of increasing corporate governance at the top of the government’s agenda and great strides towards this goal have been made in only a few short years (Dallas, 2004). After Mao’s lengthy reign, China has had to focus on rebuilding its legal system since its previous laws under Mao were often politically motivated and usually ignored by government officials. Originally, the Chinese were opposed to any foreign elements corrupting traditional Chinese society.

187 However, Chinese thought has now shifted, and many Chinese believe that foreign capitalist ideas will actually help to advance socialism in modern day China (Day, 2004).

7. Violations of the Foreign Corrupt Practices Act in China:

In 2002, Syncor Taiwan, which is owned by Syncor International Corp., agreed to pay a $2 million criminal fine for violations of the Foreign Corrupt Practices Act. The parent company, Syncor International, also agreed to pay the Securities and Exchange Commission (SEC) a $500,000 civil penalty in relation to the charges (Darrough, 2004). The FCPA violations were discovered when Cardinal Healthcare began a due diligence investigation into Syncor International in order to acquire the company (Miller & Chevalier, 2005). During the investigations, it was discovered that a number of Syncor’s foreign subsidiaries were making illegal payments to foreign doctors employed in state- owned hospitals, in order to influence the doctors’ decisions about doing business with Syncor. While there were FCPA violations at Syncor in multiple countries, the illegal acts committed in Taiwan far outnumbered the misdeeds committed by the other foreign subsidiaries. The SEC found that Syncor violated the FCPA anti-bribery provisions as well as the FCPA internal control and accounting provisions. Syncor not only had to pay fines to the SEC but had to agree that it would work with outside consultants to develop more effective internal control policies and better corporate governance within the company (Darrough, 2004). In 2004, Lucent Technologies made worldwide headlines due to possible violations of the U.S. Foreign Corrupt Practices Act in China. Lucent fired four top executives at its Chinese operations, including the president, COO, a marketing executive, and a finance manager. The FCPA violations at Lucent were discovered during an investigation of its international operations due to another unrelated bribery scandal in Saudi Arabia. Lucent did not disclose details of the violations but did state that they will not have a material impact on the company’s financial statements (Lemon, 2004). Although Lucent has remained quiet about details of the FCPA investigation, the company said that it was unsure what impact the layoffs and “internal control deficiencies” will have on its future business operations in China (Keenan, 2004). After Lucent’s investigation of its international operations, the company found that its FCPA compliance controls and policies were effective in every country but China. Lucent has since been working on improving its internal control policies in China to help prevent future FCPA incidents or violations from occurring (Taub, 2004). In 2005, InVision Technologies was charged $1.1 million by the Securities and Exchange Commission (SEC) for violating FCPA regulations by authorizing improper payments to foreign government officials in China, the Philippines, and Thailand (SEC, 2005). General Electric (GE) has now acquired InVision and has since named the company GE InVision. GE discovered the FCPA violations while performing due diligence in acquiring InVision (Geren and Shaheen, 2005). The SEC and the Department of Justice were quite lenient on GE InVision despite its clear violation of U.S. laws. This was due to the company’s voluntary disclosure of the FCPA violations and its willingness to fully cooperate with the government regarding the charges and the investigation (Wilmer Cutler Pickering Hale and Dorr, LLP, 2005). InVision previously did not have an adequate system of internal controls that would help detect and prevent FCPA violations. The Sarbanes- Oxley regulations require companies to establish and maintain an effective internal control system. In order to comply with SOX law, GE helped InVision to implement an effective corporate compliance program to increase corporate governance and internal control within the organization (SEC, 2005).

188 8. Corporate Governance:

Although the Foreign Corrupt Practices Act was enacted thirty years ago in 1977, it has only yielded four convictions to date, in large part due to the fact that most cases have been resolved through plea agreements or settled before trial. Despite the low number of convictions, the FCPA regulations should be carefully regarded by businesses because the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) expect that prosecutions involving the FCPA will increase in the coming years due to the current business environment. Globalization has increased dependency on foreign profits for United States companies. Company executives are under constant pressure to hit profit targets and will often go to any lengths, even bribery, to achieve their goals (Leander, 2006). The recently implemented Sarbanes-Oxley laws and regulations are expected to influence future violations of the FCPA. Due to accounting reforms and an emphasis on improving corporate governance, SOX is inadvertently increasing FCPA enforcement (Burr, 2005). Under Sarbanes-Oxley, the CEO and CFO of the company must certify that the financial statements are accurate and can face criminal liability for errors or omissions. This SOX regulation is expected to increase corporate disclosures about possible FCPA violations and decrease the possibility of company executives hiding suspicious transactions from shareholders (Covington, Newkirk, Tillipman, 2005). Due to the increased regulations and disclosures relating to SOX, it is more likely that illegal foreign bribes or kickbacks will be discovered. SOX also requires the mandatory disclosure of any FCPA violations that occur in the organization. This disclosure provision can have a great impact on a company by exposing its weaknesses and ruining its good reputation (Leander, 2006). Businesses in China are often run by using a strict “top down” corporate policy. This behavior also stems from government oppression in China since that is how its citizens are taught to control people and situations (Milkiewicz and Wei, 2003). The Chinese must learn to operate organizations that are not run as dictatorships, and they must learn to treat others as equals. Chinese businesses are often lacking a proper internal control structure since they are largely controlled by one party, which in many cases, is the government (McGregor, 2005). U.S. businesses should note that internal control issues at Chinese companies could result in FCPA or SOX violations. Prior to Sarbanes-Oxley, the FCPA provided the only regulations related to internal controls. The FCPA requires companies to maintain internal control systems while SOX requires companies to go one step further and actually determine the effectiveness of internal control systems. If management identifies material weaknesses in internal control systems, these must be disclosed in the financial statements in order to avoid a SOX violation. Management should also keep in mind that if significant changes to the internal control system occur, these must also be disclosed under Sarbanes-Oxley. Inadequate internal control systems in China are often related to a lack of qualified personnel due to insufficient training of employees (Ge and McVay, 2005). U.S. companies can help combat internal control issues by partnering with Chinese companies and creating mentoring programs designed to teach effective corporate governance policies (McGregor, 2005). Company management should also consider implementing the COSO ERM Integrated Framework throughout the organization to enhance risk management and internal control policies (D’Arcangelo and Matyjewicz, 2004). Businesses operating in China are recognizing that the ability to attract foreign capital in the future will depend on whether or not successful corporate governance policies are implemented within the company. One of the fundamental stepping stones of a successful corporate governance system is independence from the company for the auditors and Board of Directors, which is required for U.S. companies under Sarbanes-Oxley. While this idea of independence originated in the West, Chinese regulations now require

189 independence as well so this concept is also familiar in the Chinese business community (Leung, Liu, Shen, Taback, Wang, 2002). However, U.S. businesses must still be careful to avoid violating SOX independence regulations because it is often difficult to find qualified individuals in China who are truly independent. The Chinese often are reluctant to take Board member positions due to the nominal fees received for their services. In addition, the Chinese government still controls a majority of the Chinese economy and has ties to many companies. Since most Chinese citizens have government or communist party affiliations, this might compromise their independence for those companies that are largely controlled by the government. Another factor that might affect independence is the strong ties between the Chinese, their family members, and members in their guanxi network (Ali and Gregoriou, 2006). United States companies doing business in China must continually guard against the possibility of violating the Foreign Corrupt Practices Act. Companies can mitigate the risk of FCPA violations by establishing a corporate compliance program. An effective corporate compliance program should include clear, written guidelines that are available to all employees and are strongly supported by management, as well as a successful training program for employees regarding FCPA regulations and the business environment in China. Successful compliance programs can decrease internal risk and fraud within the company, as well as reduce external corruption issues and FCPA violations (Norton, 2004). When a FCPA violation does occur, the presence of an effective compliance program can significantly reduce the penalties against a company. The SEC and the DOJ have stated that the existence of a corporate compliance program is often a significant factor that is considered when deciding whether or not to bring charges against companies for FCPA violations (Wilmer Cutler Pickering Hale and Dorr, LLP, 2005). As part of the compliance program, U.S. companies must teach local Chinese employees about the seriousness with which the United States takes enforcing its laws and the FCPA. Chinese employees must fully understand the FCPA regulations and should be familiar with what types of actions are considered to be illegal forms of bribery. Companies can teach employees about FCPA violations by creating real world case studies that will help guide them when faced with actual situations in the work place (Cook, 2006). Many Chinese companies are very opaque and secretive so accountants in China are not familiar with operating in a transparent environment. Therefore, in training programs, U.S. companies must stress accuracy and transparency to Chinese employees in order to avoid violations of the FCPA accounting control provisions. Another effective method U.S. businesses can use to help prevent FCPA violations is by creating contracts with local Chinese agents and distributors that specifically state that the other party understands the FCPA regulations and agrees that they will not take any actions that would violate U.S. laws (Norton, 2004). After a corporate compliance program is in effect, the company must continue to monitor the progress of the system to ensure that it is continuing to provide an adequate level of internal control. In order to enhance the effectiveness of a corporate compliance program, companies should also create a strict code of ethics that is supported by management and followed by all employees. It is important for companies to create a corporate culture that is focused on maintaining ethical and legal business practices, both domestically and internationally (Cook, 2006). Another method that companies can use to effectively combat possible FCPA violations is to establish a system for employees to use when they have questions or problems relating to FCPA issues or violations. Employees need to have a reliable source of information that they can use when they are unclear about a situation and whether or not it poses a potential threat to the company. It is also important for employees to have access to a “whistleblower hotline” or some other type of outlet that can be used to anonymously report any corrupt actions or bribes that they see taking place within the company (Cook, 2006). Unfortunately, whistle blowers in foreign countries are not protected from corporate

190 retaliation under the Sarbanes-Oxley regulations and, consequently, will be less likely to come forward with information in the future. However, companies should still make it a priority to have a system in place for employees to report corporate misdeeds (Stuart, 2003). In addition, management should support employees who come forward with information and should investigate any potential problems that are reported. If FCPA violations do occur, the company must act quickly to remedy the problem. Law enforcement looks more favorably on companies if they take immediate action against any FCPA violations that do occur (Norton, 2004).

9. Conclusion:

China’s vast population and increasing acceptance of capitalism opens new doors for American businesses that were previously closed. There are seemingly infinite business opportunities for U.S. companies in China, and the amount of possible profits from the largely untapped market are a veritable dream for executives. However, in order to achieve business success in China, U.S. companies and its employees, both foreign and domestic, must fully understand the implications of the Foreign Corrupt Practices Act and the Sarbanes-Oxley Act. If corporations are exposed as violating these U.S. laws, not only will they face possible monetary and criminal penalties, but they will also be shamed and disgraced with international news headlines and bad press that could easily influence the global marketplace and hamper success while doing business in China. As they venture into the business world of China, organizations must strive to protect themselves with solid corporate governance and internal control systems, in order to avoid violations of U.S. laws and regulations and ultimately help to achieve a higher rate of business success.

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