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Economics March 20, 2017

Can Germany's Mittelstand solve China’s economic challenge?

Construction worker
The ballpoint pen. While a seemingly unremarkable product, its manufacture was being hailed as a “breakthrough,” because it is everything but unremarkable for the Chinese marketplace.

One of China’s premier manufacturers of steel had finally succeeded—after five long years—to domestically produce the kind of high-grade steel that it has been importing for ballpoint pens from Germany, Switzerland, and Japan.

In China, that steel has been a 120-million-yuan annual blow to the nation’s sense of self. How can the quality and innovation of something as simple as a ballpoint pen have evaded Chinese manufacturing for so long? And what does that say about the future of Chinese investment in businesses at home and abroad?

“Go Out” Policy Gone Wild

Much has been said in the last year about China’s fall from double-digit growth to its current single-digit slump. The popular media picture is misleading, however. For while China’s gross domestic product (GDP) growth is now at 6.7%, the nation’s economy remains among the world’s strongest—in absolute figures, Chinese GDP growth is twice as big as the GDP of a country like Austria.

There is no denying that this decrease in growth reflects an economic revolution, however. Having committed decades to attracting Western manufacturers to the country’s low-cost producers, China has had to abandon “cheap” for “better.” Labor costs (especially in manufacturing) have tripled in the last 10 years, driving business interest to cheaper producers in Vietnam and India. Production costs have also increased—due in part to increasing public dissatisfaction with low air quality and manufacturing’s subsequent real costs under better environmental governance.

That is to say that, yes, China’s key competitive advantage—cheap costs—have been fading away for a number of years. The Chinese government and many companies are therefore pursuing a new course. The strongest evidence of this—the country’s switch to quality and innovation in manufacturing—is the Communist Party of China’s latest Five-Year Plan (the thirteenth), in which the slogan “Made in China 2025” takes center stage.

Troubling, however, is how China has entered the quality and innovation marketplace. While not the only strategy, heavy foreign direct investment (FDI) in the US and Europe has become a key element.

Chinese investment in Germany alone has been notable. In 2012, the Weichai Power unit of Shandong Heavy Industry Group invested a whopping €738 million to take a controlling stake in Kion, Germany’s premier manufacturer of forklifts. That was the biggest foreign investment deal in Germany until just last year, when another Chinese manufacturer—appliance maker Midea—paid a record €1.2 billion for a controlling stake in Kuka, a German robotics company. According to a study by the Mercator Institute for China Studies and the Rhodium Group, in 2016 Germany alone drew in €11 billion of the €180 billion that China invested abroad—more than any other single country.

While the “go out” policy has flipped the table, such that China makes more FDI than it takes, it remains to be seen whether buying quality and innovation abroad can yield the same results for Chinese manufacturing as creating it directly.

Made in China via Germany?

Perhaps that is why the story of Taiyuan Iron and Steel’s ballpoint pen success has resonated so strongly with the Chinese public. Indeed, if “Made in China 2025” will be successful, it may have to take the “Made in Germany” approach—a national commitment to the “Mittelstand” (German; small and medium manufacturing enterprises) that has driven quality, innovation, and economic growth for generations.

As a professor at ESMT Berlin, I have witnessed an influx of Chinese executives who are interested in learning the characteristics and strategies that have made the German Mittelstand so successful. These include certain traits that seem wholly contradictory to the “go out” mandate. These often family-owned and unrenowned Mittelstand companies prioritize quality over all else. They typically forego big mergers and acquisitions to instead invest heavily in research and development. They do not focus on short-term financial wins, but instead enjoy a leadership culture that wins employee loyalty. Indeed, many employees remain with Mittelstand companies for decades and are as committed to quality outcomes as their employers. The result is that Germany’s Mittelstand brands—the so called “hidden champions”—are worldwide leaders in their market segments.

Chinese students at ESMT come to learn that what Germany counts on is that such a quality- and loyalty-driven manufacturing strategy serves as the ever-burning engine of true economic sustainability.

Will the FDI strategy of buying quality and innovation be too high a cost for China, especially given public pushback? Foreign political resistance to Chinese FDI may be less threatening in the long-run than the implication of a heavy FDI strategy itself—namely, the idea that quality and innovation can be merely gobbled up abroad.

The alternative insights to be derived from the German Mittelstand are there. China’s leadership may be challenged to reconsider the impact of its FDI strategy and to embrace a model where domestic champions—Taiyuan Iron and Steel, among others—are called to move the economy forward. China’s push for quality and innovation may find real and sustainable value therein.

This article was originally published by People's Daily China.

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