New York Times, 25 October 2010
GYEONGJU, SOUTH KOREA — The past is not an infallible guide to the future, but a reading of how economies have developed suggests that China needs to get ready for a slowdown in economic growth in the coming years.
And that same history lesson could have Beijing praying that it can follow in the footsteps of vibrant South Korea, not stagnant Japan.
The gathering of finance officials from the Group of 20 major economies last weekend was aimed at securing short-term economic growth and currency stability. But the opulence of the resort where the Group of 20 met was a vivid illustration of how South Korea has avoided the so-called middle income trap and continued to push living standards closer to those of rich economies.
For decades, many countries in Latin America and the Middle East have failed in this task. In Asia, the Philippines is a prominent example.
“Many countries make it from low income to middle income, but very few actually make that second leap to high-income,” said Ardo Hansson, a World Bank economist in Beijing. “They seem to get stuck in a trap where your costs are escalating and you lose competitiveness.”
Not so South Korea. When war on the divided peninsula came to a halt in 1953, the south was poorer than the north. By 1997, though, the South Korean per capita gross domestic product (at purchasing power parity exchange rates) had reached 57 percent of the average of the Organization for Economic Cooperation and Development, a group of free-market democracies which Seoul joined in 1996.
The 1997-98 Asian financial meltdown set back many countries across the region. Investment, vital to sustaining medium-term economic growth, has still not recovered to precrisis levels in Malaysia, the Philippines and Thailand.
South Korea, though, after nearly defaulting on its debts at the end of 1997, pulled itself together and resumed its march up the value chain.
The key reason is that Seoul embarked on far-reaching market changes. In particular, the government reduced the power of the chaebol, the sprawling debt-heavy conglomerates whose links to the state created the impression that they were too big to fail.
But many did fail as South Korea injected more competition into the economy, liberalized imports and deregulated the financial sector, which was a captive source of financing for the chaebol.
“They really changed the rules of the game for the large corporations,” said Randall Jones, who heads the O.E.C.D.’s South Korea desk. “It became clear that being big and being close to government was not enough to keep you alive.”
Since the crisis, the South Korean economy has grown more than twice as fast as the O.E.C.D. average, propelling per capita gross domestic product to 83 percent of the group average by 2008.
“Korea is a success story because of what they’ve been able to do during the past decade, and it’s the wave of reform back in 1997-98 that gave them that second wind,” Mr. Jones said.
The lessons for Beijing seem evident. The chaebol can be likened to China’s state-owned enterprises, which generally enjoy cozy monopolies and favorable financing from state-owned banks that are themselves cosseted.
Beijing needs to emphasize the efficiency of investment, not its scale. It must foster innovation and make it easier for more productive private companies to enter sectors like finance and logistics.
“Part of it is just making sure that you are creating new sources of growth all the time,” said Mr. Hansson of the World Bank.
A particular lesson from South Korea is that investing in human capital is critical to avoiding the middle income trap.
“Korea, 50 years ago, already had very high levels of educational attainment,” Mr. Hansson said. “There has to be some sense in which making that final leap really depends upon widespread access to high-quality education.”
Emulating South Korea would help China to improve the structure of its economy and actually benefit from the loss of momentum that history suggests is looming.
According to data compiled by Angus Maddison, an economic historian, and cited by Morgan Stanley, about 40 economies have attained a per capita gross domestic product level of $7,000 over the past century or so.
Remarkably, the average economic growth rate of 31 of those 40 economies was 2.8 percentage points less in the decade after the $7,000 inflection point was reached than in the preceding decade.
Japan and South Korea reached the $7,000 mark around 1969 and 1988, respectively, whereupon their annual average economic growth rates decelerated in the following decade by 4.1 and 2.4 percentage points, respectively, Morgan Stanley calculates.
China’s per capita gross domestic product is less than $4,000 at market exchange rates, but Morgan Stanley said China had reached Mr. Maddison’s magic number, which is based on purchasing power, in 2008.
“If history is a guide and the law of gravity applies to China, China’s economic growth is set to slow,” Morgan Stanley said in a report.
China’s slowdown might be gentler given its continental-size economy and the potential for catch-up in the poorer interior. But the development experience of its neighbors, including Taiwan, is a benchmark too powerful to ignore.
Morgan Stanley has penciled in average economic growth for China of 8 percent a year between 2010 and 2020, down from 10.3 percent between 2000 and 2009.
Slower, though, can mean a better balance. In Japan and South Korea, consumption and labor income rose sharply as a share of gross domestic product in the decade after the growth rate peaked, while their service sectors expanded strongly.
China’s new five-year plan proclaims the same goals.
“China is not unique,” said Steven Zhang, a Morgan Stanley economist in Shanghai. “It will follow the pattern of Korea and Japan and, after the inflection point, consumption will take off and investment will decline.”
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| The Pulpy fruit-based drink has been developed by Coca-Cola |
Introduced in China by the Minute Maid unit of the US beverages group and then rolled out across Asia and Latin America, it is now set for launch in other regions, including eastern Europe.
Pulpy is Coca-Cola’s first international product to be developed in the emerging world and make a significant – though undisclosed – contribution to group-wide sales. “This is one of the most successful Coca-Cola innovations of the 21st century,” says Joanna Lu, a Coke marketing director.
The success of the drink highlights the growing importance of innovation in emerging markets. Not only do China, India, Brazil and other countries offer companies fast growth prospects; they also generate opportunities for developing new products, services, manufacturing techniques and business processes.
These innovations do not yet involve transformational technological shifts – such inventions remain the preserve of the developed world with its long-established universities and commercial laboratories. But the emerging world is spawning product improvements with commercial implications that are game-changing. They do not win Nobel prizes but they do make money.
Multinationals that dismiss such innovation as localisation do so at their peril. The advantages competitors gain in emerging markets will be deployed in the rich world too. Christoph Nettesheim of Boston Consulting Group, a management consultancy, says: “The danger for many [multinationals] is that they don’t see the emerging market innovations coming because they are not yet coming direct into their home markets. But they will.”
There is a precedent: in the 1970s, Japanese groups advancing in world markets were often dismissed as low-cost, low-quality copycats. But later they were recognised as innovators, notably in miniaturisation and just-in-time manufacturing. While Japanese companies are themselves now under pressure from revived western groups and new east Asian rivals, their innovations are imitated everywhere.
Emerging market innovation is not new. More than 20 years ago, Hindustan Lever, the Indian consumer product affiliate of the Anglo-Dutch Unilever, pioneered mini-sachets as a way of taking its soaps to poorer consumers. What is new is the growing volume of such innovations, the internet-boosted speed with which they capture markets, and the increasing role played in innovation by local companies, notably Chinese, Indian, Brazilian and South African.
Certainly emerging economies make plenty of shoddy products and not a few rip-off copies of western and Japanese originals. But mere imitation does not sustain a business for long, given the fierce competition in the biggest economies, especially China. As Dieter May, a vice-president of Nokia, the Finnish mobile phone maker, says: “They don’t need to steal any more. That’s history.”
With China last year overtaking Japan as the world’s second largest economy, its companies are leading the charge. Huawei, a leader in switching technology, competes head on with Sweden’s Ericsson, even in Europe. Mindray, a medical equipment maker, has developed monitors priced at 10 per cent of western rivals. Haier, a white goods company, makes novel low-cost mini-fridges.
Elsewhere, India’s Tata Motors sets new standards for low-cost cars with the $2,500 Nano. Ranbaxy, the pharmaceuticals company, developed an anti-malaria drug from scratch. SAB Miller, the South African brewer, has developed a low-cost beer based on sorghum, a local crop that replaces costly imported malt. In Brazil, Embraer is a world-class maker of small commercial jets. Even in Russia, where business conditions are particularly tough, there is commercial innovation: Kaspersky Laboratories, a software group, exports world-beating own-brand security programs.
In services, Bharti Airtel has grown into India’s biggest mobile phone company by outsourcing almost everything from the transmission network to billing. Dr Devi Shetty has devised mass heart surgery at his 1,000-bed hospital in Bangalore.
Some companies have transformed whole global sectors. In outsourcing, Indian groups headed by TCS and Infosys have revolutionised information management by splitting work done by expensive on-site consultants from that carried out cheaply offshore. Kris Gopalakrishnan, Infosys chief executive, says: “We have changed the industry.”
Emerging countries have far to go before they match developed economies in science. Only Russia has significant numbers of science Nobel prize winners. But China beats the world in turning out engineers and scientists – 2m a year, five times the US total, according to Research-Works, an Asia investment company.
Many of the best leave, with about 30 per cent of US science and engineering PhD graduates born in China. Win Yinga, head of China Capital Group, a Chinese venture fund, says: “Our education institutions are weak. They are set up for rote learning and not for creating innovation-minded graduates.” But there is progress. Western-trained Chinese academics are returning home in growing numbers. China produces more peer-reviewed scientific papers than any country bar the US.
But scientific pre-eminence does not necessarily lead to economic success, as is demonstrated by Russia’s struggle to diversify out of commodities. Commercial innovation matters more, as China’s rise shows. In dollar terms, Chinese research and development spending has already exceeded Japan’s and is set to beat that of the European Union and match the US in the next 20 years. With R&D labour costs only 20-50 per cent of those in the west, the numbers employed are greater than in the US, EU or Japan.
Top companies are starting to deliver. In 2008, Huawei registered more patents than any other company, according to Wipo, the global patent office. Last year it was second after Japan’s Panasonic. But there is a long way to go: ZTE, another electronics maker, was the only other Chinese entry in the top 100.
Western multinationals complain that Chinese companies steal technology in a government-backed modernisation drive. But many blueprints were handed over voluntarily in co-operation deals: multinationals bet that the risks would outweigh the rewards of entering China. Now, Chinese companies are entering world markets, sometimes in partnership with western rivals, for example in high-speed trains where China’s CSR is working with General Electric of the US and Germany’s Siemens.
Sceptics dismiss many emerging market innovations as incremental improvements. But for business, that is beside the point, when such improvements lead to better products, services and processes. Peter Williamson, international management professor at Cambridge university, says: “The innovations may be incremental. The effects are not.”
Leading multinationals agree. Engineers at Siemens’ Indian affiliate developed a low-cost x-ray scanner camera that is so good it will be used in developed-world equipment. Peter Löscher, Siemens chief executive, says: “A good idea or product from, for instance, India can be plugged into a global system of sales and manufacturing. It helps increase a company’s competitiveness not only in emerging markets but also in industrialised countries.”
Scores of multinationals do the same. GE sells Indian-developed electrocardiograms and Chinese-devised ultrasound scanners around the world. Nokia uses Indian and Chinese software skills to develop smart handsets. Vodafone launched a mobile money transfer system called M-Pesa on Safaricom, its Kenyan affiliate. Similar schemes aimed at the unbanked have been introduced elsewhere in Africa and now India.
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Multinationals are also boosting R&D in the emerging world, mainly in China and India. Siemens has 12 per cent of its 30,000 R&D workers in Asia, up from 7 per cent five years ago. Microsoft, the US software group, heads a list of about 100 big companies with Chinese R&D centres. GE is one of more than 50 with Indian centres. Navi Radjou, a business expert at Cambridge university, says: “Once business solutions flowed only from west to east. Now they are flowing from east to west as well.”
Companies are not simply seeking geographical spread – or satisfying political pressures to localise R&D. They want the ideas generated by people working in different cultural and economic conditions. Cost-cutting ideas are key.
Many multinationals once targeted only the wealthiest segments of emerging societies. Now they are driving down into the fast-expanding middle-income groups. As Abbas Hussain, emerging markets chief at GSK, the UK drugs producer, says: “We need to push products down the pyramid.”
But cost reduction alone is not enough. Emerging market consumers want quality, convenience and flair as well, says Jean-Philippe Salar, Mumbai design studio chief for Renault, the carmaker. “Indians want dynamic-looking cars. The look is very important.” Moreover, with consumers in the developed world facing austerity, they too want cheap alternatives. Mr Salar says: “India is a perfect place to design new cars. New vehicles must be frugal, small and light compared to those of the last 10 years.”
Mr Radjou suggests mobile phone banking – developed by Safaricom – could be extended to developed states. Even in the US, some 17m adults have no bank account. Some western governments are studying the low-cost hospital treatments pioneered in India. Others buy cut-price medical equipment such as GE’s Chinese-developed ultrasound scanners.
Implementing global innovation is hard. Executives from the developed world often underestimate emerging market colleagues. Communication lines break when they stretch across cultural divides.
But businesses have little choice but to innovate in emerging economies, because that is where their customers are. As Mark Foster at Accenture, the consultancy, says: “Innovation doesn’t happen in black boxes. It happens in markets.”
Additional reporting by Kathrin Hille, James Fontanella-Khan and Jonathan Wheatley