China: A Matter of Trust

In early 2013, ten Kellogg School faculty members visited companies in China and met with executives from both local and multinational companies. The following roundtable discussion is part three in a series of four (read parts one and two). Our professors examine the importance of building trust in the Chinese marketplace—an environment where a lack of trust sometimes limits growth prospects.

Jin Li, Assistant Professor of Management & Strategy: As a native of Shanghai, I probably experienced less culture shock than my colleagues, but one element of the competitive landscape did truly surprise me: the huge emphasis on building trust. The Chinese constantly worry about air, water, and food quality. Even big international brands such as McDonald’s and Nike must constantly worry whether Chinese consumers will place enough trust in the quality of their goods and are forced to dedicate significant resources to building that trust. McDonald’s, for instance, takes great pains in advertisements and on menus to signal that its products are safe and healthy. They advertise, for example, that the soy they use is not genetically modified.

Kellogg School professors spot some familiar arches in China.

Eric Anderson, Professor of Marketing: For some companies, maintaining high quality and constantly earning consumer trust are expensive. Haagen-Dazs, for instance, imports all of its ice cream from France. Of course, and particularly for a frozen product, this is totally inefficient from a cost-of-production perspective. But Haagen-Dazs isn’t confident that it could consistently manufacture a high-quality product in China, and a compromise in quality could severely damage the brand. Maintaining product quality is critical to its ability to maintain its place in the premium ice cream space.

Craig Chapman, Assistant Professor of Accounting Information & Management: A general lack of trust in the Chinese economy also extends to accounting systems and finance. One consequence of rapid growth combined with frequent misaligned incentives is the risk of inadequate financial reporting systems. Recent press coverage of Volvo China, for example, suggests that its (overstated) sales figures for 2011 were primarily based on information provided by sales staff whose compensation depended on how many vehicles they reported sold.  Perhaps a figure based on vehicle registrations would have been a more sensible choice.

Similarly, in certain situations there are strong incentives for companies to manipulate their reported earnings. The body responsible for approving stock market listings has a backlog of about 800 companies. Before they’re listed, these applicant companies are required to show continually improving earnings for three years—which may actually turn into four years, given delays in the approval process. As the rate of growth of the Chinese domestic economy slows this year—and exports may be harder as the renminbi appreciates—it will be interesting to see whether the quality of earnings reported by companies in the listing queue deteriorates.

Dylan Minor, Assistant Professor of Managerial Economics & Decision Sciences: Due to unreliable financial reporting, as Craig suggests, and general accounting corruption, many companies are unable to secure critical financing on their own. Lenders are most concerned about midsized companies, which aren’t listed in major international markets and don’t follow the more stringent international standards. There are no auditors or third-party accountants to verify their accounting numbers, making corruption common. Leaders at the People’s Bank of China―roughly the Chinese analog to the U.S. Federal Reserve―shared an interesting funding model geared toward fixing this problem, where companies voluntarily band together to secure financing as a group. The model is similar in spirit to the microfinance model, but the parties involved are companies rather than individuals: borrowers gain financing by promising to collectively make sure repayments are made. This mode of operation has apparently helped spur growth.

Robert McDonald, Professor of Finance: Midmarket companies are indeed in a tough position: they have little financial strength, they’re trying to grow, and loans are very expensive. The largest five banks in China all have some public ownership, and state-owned enterprises (SOEs) still dominate many industries. Banks are much more likely to lend to the SOEs and at lower rates because SOEs are less likely to fail. This leads to a lower cost of capital for SOEs and distorted competition.

Editor’s note: Visit our site next Thursday, June 27 to read part four of our series, China: The Growth Strategies of Local Companies. Read parts one and two here: The Siren Song of Rapid Growth, and To Adapt or Not to Adapt?

Photo credit: HorsefaCe at Wikipedia Commons (The People's Bank of China) and Kendra Busse (McDonald's).