China's Entrepreneurship Problem

During the 2008 Summer Olympics, China dazzled the world with Beijing's posh athletic venues and revamped urban landscapes. And as the US and Europe have struggled with economic crises in the years since, China's prodigious economic growth rates convinced many that it was only a matter of a time before China became the global economic leader. But there are many reasons to be skeptical. Critics have cited China's income inequality, aging population, poor urban migrants, property bubble, and corruption as reasons to doubt China's ability to maintain its rapid growth and global rise. Often lost in the discussion, however, is the fact that the cards are stacked against the Chinese entrepreneur. 

China is now experiencing a middle income trap — losing their competitive edge in labor-intensive industries and not yet gaining new sources of growth from innovation. China needs to create an environment conducive to the type of bottom up dynamism necessary for entrepreneurial growth, including granting entrepreneurs enhanced property protections and greater access to capital. 

The potential market for Chinese entrepreneurs is huge. Within China's borders, millions of inhabitants have foregone certain purchases due to cost, accessibility, and convenience. And many consumers haven't purchased certain goods or services because they lack the necessary expertise to correctly use them. Millions of Chinese innovators would love to flood the market with smaller, cheaper, more convenient products that don't appeal to the mainstream market's performance expectations. They would thrive off lower margins and low-end consumption. Official support and encouragement for disruptive businesses would allow innovators to create unusual and long-term value for their companies. 

But before that happens, China faces several difficult dilemmas. Promoting dynamism and consumption is very costly to its short-term goals. The first issue is the value of the yuan. China could allow its currency to rise to lessen its dollar dependence and hasten the transition, but this would harm exports and lead to widespread layoffs and social unrest.

An additional challenge is lending. Despite China's announcement last week to cut the reserve-requirement by 0.5 percentage points, it is still historically high. China's inflation fighting policies have hurt small and medium size banks and decreased bank lending to entrepreneurs. While inflation fears are easing, a limited stimulus will do little to discourage more lending to large, state-subsidized companies at the expense of aspiring innovators. 

Those large, state-backed companies are themselves another obstacle. The government has provided many of them with capped interest rates and other favorable lending terms. (As The Economist recently noted, systems that unduly favor certain borrowers over others end up subsidizing ill-judged and financially unsound projects.) Formed to create employment, not to maximize profit, they are neither motivated nor incentivized to disrupt themselves. Their growing clout will make it much more difficult for China to move toward a consumption driven economy. 

China's growth will soon slow as the "easy" phase of economic development ends. Fostering an environment that favors disruption is the prescription for continued growth. But rather than create an environment conducive to dynamism and disruption, China has opted for a myopic approach at the expense of individual entrepreneurs and innovators. 

Slowing total factor productivity will make it very tempting for Chinese state officials to focus on figuring out how to better manage state-owned enterprises. But officials would be wise to create environments for entrepreneurs and disruptive technologies to flourish rather than seek incremental improvements within their existing top-down system. 

In the United States, disruptive innovation has harmed a few but benefited many. In China, top-down capitalism has benefited a few but harmed many. An absence of disruptive innovation and entrepreneurship is suffocating China's future growth potential. The future of that growth potential will depend in large part on whether China suppresses or unleashes its would-be disruptive entrepreneurs.