China's private sector has just begun to grow

Hong Kong: Only very few domestic Chinese companies have meaningful size, but the emergence of a corporate mid-tier is necessary if China's economy is to move to a new stage of development.

As it stands today, China's corporate landscape is polarised between a few very large state-owned groups and a myriad of small, private companies. Many of the former are in north China, many of the latter are in the south and coastal provinces.

In many ways, China is a tale of two economies, where size, ownership, and geography match almost perfectly. What's largely missing in China is the equivalent of Germany's famed Mittelstand.

In China, such a group would comprise companies with revenues between a hundred million and five hundred million US dollars.

Companies with revenues in the tens of millions of dollars are generally considered small elsewhere, but they are big in China.

Why are large companies important? Large companies are good since scale itself matters. Scale is a prerequisite for innovation.

If China is to develop its own brands and intellectual property, success will come from a changed corporate landscape, one populated by large-sized private companies.

This has been the path of Western economies, where market concentration has grown over time.

The issue in China is that the large companies are typically state-owned incumbents, not enterprises that have reached the top through hard work.

To be sure, anti-trust measures are needed to prevent abuse of market concentration, and China is preemptively taking steps to introduce such legislation, but market concentration is generally a good thing. Fragmentation isn't.

Some express surprise at the absence of a mid-tier segment in China's economy. They suspect market definition obfuscates the truth and, certainly, market definition is a critical and complex issue.

But irrespective of technicalities, many believe as a matter of faith that China is large enough to support such companies.

After all, reforms began in 1978, a quarter of a century ago. Yet this is misleading. Most private companies are the result of only a decade or so of entrepreneurial activity.

A more meaningful date for China's private sector is not 1978, when a Communist Party conference initiated reform after the Cultural Revolution, but 1992, when Deng Xiaoping visited Southern China and inaugurated a new stage of capitalistic development.

And this was only eleven years ago — not enough time for most private companies to reach significant size.

But there are other, deeper reasons for industry fragmentation in China. The private sector is small and weak because private ownership does not yet enjoy formal legal protection. If changes to China's constitution reportedly under discussion materialise, this could all change.

The elimination of de facto subsidies to state players, who undercut private companies on price and block the latter's attempts to grow to scale would help, as well.

Mainland China's fragmented markets are also found in Taiwan, suggesting deeper (dare one say it, cultural) motivations at work.

One such cultural motivation is the preference to be one's own boss. This trait gives venture capitalists nightmares, but little prevents the employees of one Chinese company from setting up shop across the street and producing the very same thing.

Legal protection would help but not all products are based on distinct intellectual property.

Chinese companies thus serve as training academies for employees who move on to do business on their own. Instead of a company growing larger in size, it spawns many small offspring.

To be sure, this fluidity is encouraged by weak protection of intellectual property rights. In turn, this lack of protection shifts the focus of corporate competition to price.

Price competition is also prompted by players acting on non-commercial principles -- state-owned enterprises with access to bank lending. In the absence of product differentiation based on research and development, price is everything.

This holds true not only when companies sell, but also when they buy. To make sure bargaining power rests with them, procurement is spread across many different suppliers, rather than consolidated in a few deep and longstanding relationships.

Because of this, the ability of upstream companies to achieve economies of scale is also limited.

Another explanation for China's industry fragmentation is geography, for the fabled China market is in truth not one market, but several.

This point was made decades ago by William Skinner, an American social scientist, who identified eight macro-regions in China which persisted through history as distinct economic markets.

Today, the most visible distinction is between the north and south. There are few truly national brands and many regional ones.

Personal tastes and preferences also differ by geography -- think of Chinese food.

Limited infrastructure in China handicaps a company's quest for scale. I am thinking not only of highways, tunnels, or bridges, which China has plenty of, but of support services as well, be they upstream or downstream.

Because such services are not available from outside third parties, a company must internalise these functions if it wishes to control quality and price.

In this process, a conglomerate is born. In other words, the issue in China is often less the absence of large companies. Large companies exist -- that is to say, there are groups of companies with large overall revenues.

Rather, the issue is that these revenues often come from many not-so-related businesses.

Corporate diversification in China is also prompted by various limitations on growth (some sectors are still off-limits to private players, most notably telecommunications) and the perception of abundant opportunities.

It's a land grab out there, corporate leaders say, and to focus would be to miss them.

China's captains of industry see opportunities to build comprehensive empires and they feel it is too soon for them to specialise -- a Western-style approach. In the process, a 'jituan' (group) is born -- an amalgamation of businesses spanning multiple industries.

Because a group is perceived to be larger and hence more powerful than a mere company, it is something of a badge of honour in China. Many, even small, companies have the phrase 'jituan' in their names.

Finally, restrictions on capital (private Chinese companies find it difficult to get bank lending) and tax regulations which encourage the ongoing creation of new corporate entities are yet other reasons for China's industry fragmentation.

Industry structure is largely determined by capital intensity: the more capital required, the more concentrated an industry.

If capital is expensive, as has been the case for the private sector in China, this will slow the trend toward concentration.

All things considered, it is early days for China's private sector. The modern corporation began in North America with the railroads 150 years ago.

The railroads required lots of capital and complex organisational skills, leading to the development of the multiple-unit, hierarchical joint-stock corporation.

This journey is only now beginning in China but it is likely to take a shorter time.

In a few decades, China is likely to boast corporate giants that dominate not only their domestic market but are global leaders in their industries and, below them, a vibrant group of large and important companies.

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