In the 25 years since Deng Xiaoping famously proclaimed that it is "glorious to get rich," multinational companies have invested more than $400 billion in China. Its once-closed economy has become a textbook case of exportled growth, expanding at a furious pace and increasing per capita income fivefold (Exhibit 1). In 2003, foreign direct investment in China topped $53 billion, and despite the government's attempts to cool off the red-hot economy, it shows no signs of slowing.

Who benefits most from this phenomenal wave of foreign investment? In some industries, such as consumer electronics, it has sharpened the competitiveness of Chinese companies and delivered vastly lower prices to local consumers. In others, such as automotive, the main winners have been multinational companies and their Chinese joint-venture partners. General Motors, for instance, earned more than $2,300 (before taxes) for each vehicle sold in China in 2003, compared with a mere $145 in the United States. Automotive joint ventures are only now beginning to share these gains.

Research by the McKinsey Global Institute¹ shows that these outcomes are shaped largely by government policies. In the consumer electronics sector, rules on foreign direct investment and market entry encouraged competition and thus forced Chinese companies (including Galanz, Haier, and TCL) to raise their game drastically. In contrast, more restrictive policies designed to create local champions in strategic sectors such as automotive have reduced competition, increased production costs, and allowed marginal players to survive. As a result, a small group of foreign carmakers and their local joint-venture partners until recently enjoyed profit margins four times higher than those anywhere else in the world, and Chinese consumers still face higher prices for vehicles than do their European and US counterparts. But production capacity is now increasing, and the situation is changing rapidly. Falling vehicle prices are prompting a surge in demand that by our estimates will make China the world's third-largest market for new cars by 2007.

The experience of these two industries holds a lesson for China's leaders as they open up other sectors of the economy and for other emerging markets seeking to integrate into the global economy: competition matters (Exhibit 2). Foreign direct investment can spark growth and create national wealth, but competition among companies, local and multinational alike, diffuses the benefits. Government policies designed to protect incumbents—high tariffs and joint-venture and local-content requirements, for example—also shield them from pressure to improve. Consumers quite literally pay the price.

Global giants in the making

China's consumer electronics industry² illustrates the way foreign direct investment benefits local consumers, workers, and companies. It barely existed in 1980. Today it churns out $60 billion worth of goods annually and ranks among China's most globally competitive industries.

Foreign investment came in two waves. During the early 1980s, investors—many from Hong Kong and Taiwan—set up shop in the Special Economic Zones to take advantage not only of their tax concessions but also of China's low-cost labor. These enterprises produced white goods for export. In the 1990s, multinational companies such as Nokia, Royal Philips Electronics, Samsung, and Sony ventured beyond the zones to manufacture goods for China's domestic market, now the world's fourth largest for consumer electronics. A typical large-scale consumer electronics multinational corporation in China now sells as many goods locally as it exports.

The government has taken a relatively hands-off approach to regulating the industry, mostly because the companies in it aren't politically sensitive, job-heavy state-owned enterprises. Joint ventures, though still mandatory in a few areas, such as the manufacture of mobile phones, have become optional for most products. Foreign companies are encouraged, but not required, to source components locally—though permits are still needed to import certain intermediate products. In practice, this requirement isn't a problem; imports of components total billions of dollars a year. In contrast to other industries, including automotive, few restrictions hinder private Chinese companies from entering the market or state-owned incumbents from expanding into additional product lines. Indeed, private Chinese companies now account for more than 20 percent of the industry's revenue. Although the government retains an ownership stake in many companies, the best of them—including Haier and TCL—are managed like private enterprises, with little government interference in day-to-day operations.

As a result, stiff competition prevails. Joint ventures, while voluntary, are common: foreign players gain the valuable distribution networks of domestic companies as well as their hard-to-replicate insights into Chinese consumer demand. In turn, Chinese partners get access to new technology, product designs, and production methods, to say nothing of global brands and distribution networks. (Foreign enterprises and joint ventures account for 80 percent of exports in the sector.) Some Chinese companies—for instance, Legend Holdings—have learned valuable sales and marketing skills by distributing foreign products.³ Rather than being trounced by overseas competitors, the Chinese have sharpened their skills by competing daily with the likes of HP, Nokia, Samsung, and Whirlpool and now dominate the domestic market in many product categories, including personal computers, refrigerators, and televisions.

Foreign investment has also been instrumental in developing the domestic supply chain. LG Philips LCD and Samsung created joint ventures with local suppliers. Sony transferred its tube-manufacturing facility to China. Dell persuaded its local supplier of plastic computer shells to build a factory near its plant in Xiamen. Motorola provides training and managerial programs for its 700 local suppliers, and Royal Philips Electronics helps local suppliers improve their productivity. As a result, China is now developing a competitive supply chain that extends as far upstream as semiconductors and serves both foreign and domestic companies. This development has in turn made the country an even more attractive base for foreign investment.

As a result, consumers in China have benefited enormously. From 1996 to 2003, an index of consumer electronics and home appliance prices declined by 33 percent, and the cost of some goods has plunged even more (Exhibit 3). Not surprisingly, domestic demand for consumer electronics has taken off.

Some state-owned consumer electronics enterprises shed jobs while restructuring, but overall employment has increased

The industry's workers have also fared well: since 1996, wages have increased by 45 percent, well ahead of inflation. Although some state-owned consumer electronics enterprises shed jobs while restructuring operations, overall employment in the sector has increased because of growth in domestic demand and in exports. For multinationals, the picture is more mixed. Some, including Motorola and Nokia, are highly profitable, although their market share is slipping because of strong competition from local competitors. Others, like Dell, have become profitable with a single-digit market share (though Dell's is growing fast). LG Electronics and Samsung view China as their new "home market." Yet margins for many players are razor thin, and this climate has encouraged some Chinese companies, such as Haier and Legend, to look abroad for future growth opportunities.⁴

A different story in automotive

At first glance, the impact of foreign direct investment on China's automotive sector might not seem very different. Foreign carmakers have invested more than $4 billion so far, and last year, when nearly two million new cars were sold, sales growth topped 50 percent.

Despite rapid growth, Chinese carmakers remain second-tier players: they compete in the market's low-end segments, and the cars produced by international joint ventures are sold predominantly under foreign brands. The biggest winners have been the multinational companies and their state-owned joint-venture partners, which have enjoyed limited competition and high returns.

The reason for this state of affairs lies in China's automotive policy, historically designed to route foreign technology to a handful of state-owned carmakers. Although the policy was updated in May 2004, its premise hasn't changed fundamentally.⁵ Foreign companies must invest in joint ventures and are limited to a 50 percent stake in them. Entry into the industry requires a government license, which took both Honda Motor and GM, for example, more than four years to obtain. In general, components must be sourced locally from state-owned suppliers, although this requirement will expire in 2006 under World Trade Organization rules. In China's domestic market, imported cars face steep tariffs, which are to remain at 25 percent even then and will thus continue to limit competition from imports. There are also nontariff barriers, such as complex approval requirements.

These policies raise production costs and reduce the level of competition. The need to source components from local suppliers adds 20 to 30 percent to the cost of vehicles made in China. Instead of taking advantage of the country's main asset—low-cost labor—foreign automakers employ capital-intensive production methods: the capital investment per unit of vehicle capacity is actually 25 percent higher in China than in Detroit (Exhibit 4). In India, by contrast, carmakers are less automated; they have substituted labor for capital.

Moreover, with little competition in China, managers lack incentives to improve their operations. Even in many joint ventures, the average productivity of auto assembly plants is far below best international levels. In fact, our research shows that the productivity of automotive joint ventures is lower in China than in other emerging markets, such as Brazil, India, and Mexico. Chinese plants are running at 100 percent of capacity, compared with an average of just 70 percent for all automotive plants in the world as a whole.

What's more, despite policies seemingly designed to benefit Chinese companies, they have shown few signs of developing strong stand-alone capabilities in auto assembly. Interviews with industry executives suggest that most of these companies continue to rely on the foreign partner for new technology and R&D. Few of them have made much headway transferring best practices from joint ventures to wholly owned plants; given their sheltered existence, there is no need to do so.

Consumers in China pay for this protection. Cars made there still sell for 30 to 40 percent more than do cars in the United States or Europe. Foreign automakers in China, meanwhile, enjoy a pretax return on sales of more than 20 percent, compared with 5 percent in the rest of the world. According to Goldman Sachs estimates, Volkswagen, the country's leading foreign carmaker, garnered 70 to 80 percent of its earnings per share there in 2003.

Today, however, competition is heating up as new production capacity comes on line and more foreign players enter the market. In 2003, DaimlerChrysler, Ford Motor, GM, Honda, Nissan Motor, PSA Peugeot Citroën, Toyota Motor, and Volkswagen announced new plans to invest a total of more than $15 billion. During the past two years, prices for vehicles have declined by as much as 40 percent, which has contributed to a big increase in demand. At this rate, car prices will reach international parity within three to five years. Profit margins for foreign carmakers are beginning to erode as a result.

Even so, the ability of Chinese carmakers to become global competitors is an open question. Currently, no country can unambiguously claim to be the world's low-cost auto-manufacturing base, and Brazil, China, India, and Mexico are competing to fill the position. In the recent past, India had a more competitive auto sector than China, which could nonetheless catch up if its national auto policy evolved to stimulate competition. The new Chinese upstarts, such as Brilliance China Automotive, Chery Automotive, and Geely Automotive, may have the best shot, not the incumbent state-owned enterprises. The challengers already sell cars in China under their own brands and offer prices comparable to those for small vehicles in Japan and the West, though their cars suffer from lower brand and quality perceptions and they offer less after-sales service. To take advantage of China's low-cost labor, these challengers, like their Indian counterparts, are trading off some capital investment for more manual processes.

A model for growth

In the consumer electronics and the automotive industries, foreign direct investment has undoubtedly been good for China. In both of them, foreign companies have introduced new production methods and technologies far superior to those Chinese companies were using, and output and productivity have increased. The consumer electronics industry, however, enjoyed a second wave of benefits in the form of much lower prices and better product quality and selection for consumers. This development in turn unleashed a third wave of benefits as domestic demand exploded and China cemented its position in the global supply chain. In automotive, weak competition and the government's heavy hand have delayed the second and third waves of benefits.

The consumer electronics industry enjoyed a second wave of benefits: much lower prices and better product quality and selection

Consumer electronics could be a model for how to liberalize sectors in order to promote growth in China and other emerging markets. Opening up industries to foreign investment is just a first step; governments must also ensure that competition flourishes. China's retail, distribution, and financial-services sectors have opened their doors wider to foreign investment, but policy makers must remember that deregulation is equally important. In this respect, the revised automotive policy is a step in the wrong direction.

And it is not the only such mistake. Few global manufacturers can afford to ignore China, given its low-cost labor and fast-growing domestic market. The financial incentives and tax holidays offered by the country's local governments might influence a carmaker's choice of specific locations and the amount of capital and technology it decided to invest—but not the broader choice of whether to invest in China at all. From a national perspective, these incentives make little sense. As in other countries, local governments may be tempted to engage in bidding wars to win particular investments, but this approach means that multinational companies rather than China will benefit from them.

Furthermore, joint ventures aren't required to encourage the development of some local industries in China and certainly haven't created local champions in the auto business. To nurture Chinese companies, it will be more important to give them ways of accessing capital, whether foreign or domestic, and to promote competition in the domestic market.

China's economic ascent since 1978 has been astounding. To build more world-class competitors, the country must now unleash the processes of creative destruction and thereby weed out weaker companies and lift stronger ones. Innovation and risk taking are, after all, the heart of economic progress and growth. The consumer electronics industry shows that foreign direct investment is a catalyst, but only if competition flourishes.