09/06/2010 04:50 am ET Updated May 25, 2011

Is China Serious About Major Economic Reform? Probably Not

Of late, many propaganda pieces in the Chinese press have appeared extolling the importance of innovation, value-creation and a fundamental re-balancing of China's manufacturing-led economy to a consumer-driven one.

On the ground, a big question remains whether the government truly believes its growth model has reached its peak.

Infrastructure Investment. The key strategy continues to be urbanization which entails: a) massive infrastructure investment inland, b) upgrading non productive rural workers into higher-productivity manufacturing workers. The structure of the governments' gargantuan 2008 stimulus package is consistent with this framework. Factories are being built on hinterland farmlands, as are transportation networks to ship raw and semi-finished goods between lower-tier cities and the coast. The Party likely believes China can, as a whole, maintain is low-cost labor pool for at least the next decade, hence its reasonably calm reaction to recent labor unrest at Foxconn in Guangdong province.

As a result, mobilization of resources and scalification of markets remain core growth planks and this is inconsistent with any leap up value chains. That said, the Chinese model is appropriate for making an incremental crawl up the value ladder. And, here, China has been successful in industry after industry, ranging from green technology to autos. But no industry has had anything close to a paradigm shift in terms of setting global standards of innovation.

A Consumer Economy? In terms of stimulating consumer demand, there has been precious little the government has done that would relieve epic savings anxiety of both the middle class and the urban mass market. This would involve, most critically, fundamental restructuring of health care. Le Keqiang, Hu Jintao's heir apparent, is charged with leading the task force to address this need. But most observers are skeptical insurance pools are deep enough or inclusive enough to fund significant health care reform. So the effort is proceeding, and will proceed, in a piecemeal fashion. However, as a percentage of total economic activity, the consumer sector will increase, largely driven by industrialization of and growth in lower-tier markets. (This is the major story of the past couple years. Auto sales, for example, are exploding outside of Tier I cities. The same goes for luxury products.)

Corporate Governance Hurdles. To generate more innovation in state-own enterprises, a key issue is corporate governance, or lack thereof. In China, shareholder rights are extremely weak and there is rarely (never?) an empowered board charged with ensuring that management maximize long-term shareholder value. Goals of maintaining Party control and responding to the market are in opposition. CEOs are judged in implementing the party line and competition is, at best, "managed," orchestrated from above, within the corridors of Party power.

Service Sector Stagnation. The service sector, and modernization of it, also remains a huge challenge. It is currently designed to respond to, again in a mobilized manner, the needs to the masses. (Ten years ago, who would have anticipated such growth of the retail arms of the Big Four banks?) But the emerging middle class, whose needs are more sophisticated and require a greater degree of personalization, have been ignored. Again, key service industries (health care, financial services, real estate, etc.) remain "strategic" industries -- vital to the Party's macro- management of the country -- so significant reform is nowhere in sight. (The biggest star in retail banking innovation is China Merchant's Bank, not one of the big boys.)

Brittle Company Structures. Corporate structure is also a huge barrier for innovation. Large SOEs are burdened by: a) byzantine hierarchies that preclude a bottom-up flow of new ideas, b) imperial CEOs who issue ambiguous instructions to generate anxiety and construct rival power factions to ensure competition is horizontal, not vertical, c) minimal investment in R&D, and d) dominance of (short-term) sales relative to marketing (a balance of short-term sales and long-term equity generation) functions. I am not aware of any large local company that has made huge strides in instituting an empowered marketing function. However, our experience with COFCO, China's largest food conglomerate, suggests it is at least trying nobly to impose a "framework" for innovation and brand development. Haier and large local appliance manufacturers remain stuck in the past.

The local brands that have made the most progress moving beyond scale/huge market capitalization and towards value creation (Anta, Lining, dairy companies such as Meng Niu and Yili, fashion) are, relatively speaking, independent of the state. These are the companies fueling JWT's growth amongst local clients. However, smaller private enterprises are increasingly starved for capital. Key question: when will banks begin lending based on objective assessment of return? Many doubt that day will arrive anytime soon.

By the way, Chinese companies are, rightly, focused on the China market. They are pragmatic. Few brands really want to "take over the world." Recent cases like Geely's takeover of Volvo is vanity project, a misguided attempt to grab a part of the booming luxury car segment. Lenovo could only go global via a takeover of IBM's international PC operations and results have been decidedly mixed. "International" Chinese brands will only succeed, for the foreseeable future, in emerging economies where the basic price-value equation of Mainland goods remains a genuine competitive advantage.

Political Reform: Taboo. Underlying all of this is slow progress on the political reform front. Can the government instill significant intra-party checks and balances to institutionalize more efficient governance? (This is what party apparatchiks mean by "democracy.") So far, this type of reform remains taboo, except in lofty think tank debates.

Is the government wrong to go slow? Probably not. Despite having become the world's second largest economy, China is still a poor country on a purchase power parity (PPP) basis. Vast expanses of the country require strong central government to continue the Middle Kingdom's Great Urbanization Project. That said, even "Friends of China" are right to encourage the Party to begin the process of institutional-based reform, because the day when it becomes a necessity, rather than a theoretical "good," will arrive sooner or later, perhaps unexpectedly.