Globalization and Its Implicationsfor

Long-Term Success of Enterprises Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.)

Vice-Chancellor, The Chinese University of Hong Kongand

Kwoh-Ting Li Professor of Economic Development, Stanford University

A Presentation for the Giti-Tire GroupAt Its 2006 Annual MeetingShanghai, February 7, 2006

Phone: (852) 2609-8600; Fax: (852) 2603-5230Email:LAWRENCELAU@CUHK.EDU.HK;WebPages:HTTP://WWW.CUHK.EDU.HK/VC/

mailto:LAWRENCELAU@CUHK.EDU.HKhttp://www.cuhk.edu.hk/VC/

Lawrence J. Lau, The Chinese University of Hong Kong 2

A PreviewIntroductionGlobalization and Its ImplicationsMaintaining Long-Term Competitive AdvantageThe Advantages of an Active Controlling ShareholderConcluding Remarks

Lawrence J. Lau, The Chinese University of Hong Kong 3

Globalization: Unprecedented Growth in International Trade and Investment Flows

The volume of world trade has been growing at an average annual rate of 12 percent per annum during the past decade, which is between 3 and 4 times higher than the rate of growth of world GDP, estimated at between 3 and 4 percent per annum. The volume of Chinese international trade has been growing even faster, at approximately 30 percent per annum during the past few years, also much higher than the rate of growth of Chinese real GDP.World direct investment has also grown significantly. Annual global direct investment may be estimated at approximately US$400 billion. The U.S. is now the worlds leading recipient of foreign direct investment (FDI) with an annual average of approximately US$100 billion and China is the second largest recipient with an annualaverage of approximately US$60 billion.

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The Unprecedented Growth in World Trade and Capital Flows is the Result of:

The falling costs of transportation and communicationresulting from the declines in real telecommunication costs and shipping costs, coupled with the logistics technology revolution, and facilitated by the worldwide use of English as the medium of business communication.The reduction of tariffs and other barriers to international trade in goods and services and to international capital movements through the agreements on World Trade Organization (WTO) and various free trade areas (FTAs).De-verticalization or fragmentation of productionfiner and finer intra-firm as well as inter-firm division and sub-division of labor around the world, through out-sourcing and specialization by enterprises in niches of core competenceinternationalization of supply chains. A product may have gone through several different countries from start to finish.

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The Unprecedented Growth in World Trade and Capital Flows is the Result of:

The entry of new players into the global marketplaceChina, India, Russia, Eastern Europe, Brazilas both suppliers of exports and the demander of imports.Rising volume of trade in services such as tourism, financial services and professional services as well as previously non-tradable services (software-outsourcing, data processing, call centers, back offices).

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International Trade Permits Economies of Scale and Specialization to be Realized

International trade enlarges the market and permits greater specialization and the exploitation and realization of economies of scale and learning-by-doing by the individual enterprises. And with the growth of markets, their integration as well as segmentation become possible.International trade also facilitates the exchange and transfer of new concepts, ideas, business models, methods and technology.

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Globalization:Growth of Foreign Direct Investment

Falling barriers to as well as incentives for foreign direct investment. National treatment for foreign direct investment is becoming increasing standard under the World Trade Organization (WTO) andsimilar agreements. Foreign direct investments (FDI) often follow tradee.g., to secure long-term supply of raw materials and natural resources; and trade often follows foreign direct investmentse.g., production by captive subsidiaries. A large proportion of world trade consists of intra-industry and intra-firm trade.50 percent of Chinese exports and imports consists of intra-firm trade, that is, trade between a parent company and its subsidiary.Foreign direct investments are also motivated by the desire to provide cross-border services, e.g. AIG, McDonald.

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Globalization: Foreign Direct Investment Leverages Intangible Capital

FDI (and exports) permit the leveraging of intangible capital (patents, technology, knowhow, goodwill, brand name, reputation, business methods) over a much larger market. Intangible capital has several characteristics:

It is much more industry-specific than location-specific. It is much easier for an existing firm to enter the same industry in a different geographical market than to enter a different industry in the same geographical market.The creation of intangible capital (e.g., a patented product or process) often requires a high fixed cost of development, but once created, the expanded application of such intangible capital has low marginal cost (e.g., Coca-Cola, an already worldwide brand, expanding into a new market; introduction of existing drugs into a new market) and hence high marginal profit.The protection of the intangible capital in the new market often requires direct supervision, management and control and hence direct investment. Franchising without active monitoring does not work in many economies.

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Globalization is Enabled by the Information & Communication Technology Revolution

The information and communication technology revolution:

Caused large reductions in the costs of information transmissionand analysis, information storage and retrieval, and communication;Increased significantly the timeliness and reliability of informationinformation is now available and transmitted accurately in real time;Greatly facilitated inter-firm and intra-firm co-ordination by reducing the costs of communication, monitoring, and control (geographical distance is no longer a barrier), and thereby lowering the explicit and implicit transactions costs of fragmentation of production and out-sourcing.

The worldwide use of English as the language of business.

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Opportunities and Challenges ofGlobalization

Globalization of the world economy presents tremendous opportunities and great challenges.Opportunities arise because:

The entire world population have now become potential customers; the entire world is the potential market;Firms everywhere are scouring the globe for potential suppliers and sub-contractors to source and to out-source;The huge potential of economies of scale can be realized throughexpansions, mergers, acquisitions, consolidations, and formationof strategic alliances and partnerships;Investors everywhere are moving their capital around the world to seek the highest rates of return;The possibility of global cooperation and coordination (e.g., onthe prevention of global warming).

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Challenges from Globalization are the Results of:

Intensification of competition from both domestic and foreign firms for market shares and for capital, human resources and other resources (e.g., oil, iron ore, rubber);Increased unpredictability (footlooseness of suppliers, customers and investors; external shocks) and decreased ability for risk diversification because of rising synchronization of business cycles around the world;The social costs of job displacements and disruptions can be high;The possibility of monopolization and cartelization of world markets; (Monopolization and cartelization are the natural outcomes of a completely free and unregulated (global) market economy. They tend to result in higher prices and poorer qualities for goods and services and inputs and less innovation.) The renewed rise of protectionism and isolationism as a reaction to globalization;For smaller economies, greater vulnerability to external disturbances.

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Globalization as a Source of Economic Disturbances

Global competition can cause temporary as well as permanent disruptions in employment and economic growth. Technological obsolescence, whether domestic or imported, can also cause similar disruptions (e.g., Amazon.com wipes out mom-and-pop bookstores in the U.S.).In order to survive these disruptions and disturbances, the comparative advantages of an economy have to be continually created, maintained, preserved and renewed.The East Asian economic development experience provides an example of created as opposed to natural comparative advantage (human capital and R&D capital can substitute for natural resources).

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Sources of Macroeconomic InstabilityMacroeconomic instability can also derail economic growthexternal shocks; chronic balance of payment problems; a high rate of domestic inflation; a chronically high budget deficit; a high debt-to-equity ratio; chronic excessive or insufficient investment.Volatility in the exchange rate can also put a quick stop to economic growth. Examples include many Latin American economies, that would have nearly a decade of steady economic growth, only to see it come to a complete halt, with all the previous gains lost because of an external balance of payments crisis. The East Asian currency crisis of 1997-1998 provide another set of such examples.

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Growth and Structural Changeof the Chinese Economy

The Chinese economy has grown rapidly since 1978, with an average annual real rate of growth of almost 10 percent (9.9 percent in 2005).It is no longer only the Worlds Factory; it has also become the Worlds Market.Increasingly, foreign direct investors view China as a market rather than an export base.Chinese private household consumption of goods and services has finally begun to rise. It will become the largest source of Chinese aggregate demand.This change in the structure of aggregate demand requires adjustments in the composition of products, marketing and distribution.

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Maintaining Long-Term Competitive Advantage: Core Competence and Scale

An enterprise must create value, innovate and grow in order to survive and prosper in the long run.An enterprise must identify its core competence(s) and work hard to improve them so as to be among the worlds leaders in those segments of the industry. It must also focus resources on what it regards as its core competences and what it reasonably expects to be able become one of the worlds leaders eventually.An enterprise must also achieve efficient scale, not only in terms of technology (an efficient-scale plant), but also in terms of the size of the market. Technologically, the greater the scale of the plant is, the lower the average fixed cost. Also, the higher the market share is, the higher the ability to influence and control prices, and the higher the profit. (Microsoft is a prime example of a high market share resulting in high profit margins).

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Enlarging the Market and Achieving ScaleAn enterprise also needs to achieve the necessary scale to spread the costs of creation of intangible capital (such as R&D and brand-building) so that it can compete effectively with other enterprises around the world.Merger and acquisition and consolidation are yet other ways to enlarge the market share and achieve efficiency.Exports will also enlarge the market and permit diversification of the customer base. Large foreign enterprises, with their more efficient scales and lower costs will out-compete domestic firms focusing solely on the domestic market in an open economy. Thus domestic enterprises must grow in order to compete effectively.

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Maintaining Long-Term CompetitiveAdvantage: Investment in Intangible Capital

Intangible capital includes education, human capital, Research and Development (R&D) capital, intellectual property (patents, copyrights, trademarks, trade secrets), goodwill, advertising (brand names), reputation, know-how, business models and methods, organization, and software).Continual investment in intangible capital is the key to innovation and the creation of and maintenance of long-term competitive advantage.

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Maintaining Long-Term CompetitiveAdvantage: Investment in Intangible Capital

Investment in R&D capital is a must in the long run. Examples (Taiwan Semiconductor Manufacturing Company (TSMC), Samsung.)The product cycle is becoming shorter and shorter. An enterprise must have new products in the pipeline.The importance of the effects of history and reputation (first-move advantage, e.g. Taiwan Semi-conductor Manufacturing Corporation (TSMC) is the worlds first pure foundry and is still the industrys leader).It must also try to develop its own brands. Branding is market power and it allows higher margin and provides some protection against competition (Examples: Nike, Lenovo, Exxon (the power of a unified brand)).

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Maintaining Long-Term CompetitiveAdvantage: A Business Information System

Investment in information and communication: knowing your customers and your competitorsA system for intra-enterprise coordination, cooperation and monitoringCreating a system of incentives and responsibilities that is linked to the information systemLinking authority and accountability

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Maintaining Long-Term Comparative Advantage: Human Capital

While an enterprise must operate efficiently, efficiency does not only imply that it is necessarily a low-cost or low-wage producerbut it must also be a high-labor-productivity producer. The total labor compensation must be commensurate with labor productivity. It is no use having low-wage workers who are not up to the standards required for the work.A high rate of labor turnover is costly to the enterprise.

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Mutual Investment by Employees and Enterprise is Win-Win

The enterprise invests in the human capital of an individual employee in the form of on-the-job training and other forms of formal and informal training and education.The individual employee invests in the enterprise by acquiring enterprise-specific skills (human capital) that are only useful in that enterprise.The employees as a group subscribe to a enterprise culture and norm, facilitating cooperation and coordination.

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Mutual Investment by Employees and Enterprise

As a result, the individual employee is worth more to the enterprise than to any other enterprise. This is win-win: The enterprise will be able to pay the employee a higher wage/salary than he or she otherwise will receive at another enterprise. The enterprise will incur additional training costs and coordination costs and loss of productivity if it replaces this individual with a new employee.Thus bound, both the employee and the enterprise have the incentive to make investments jointly for the future.Of course, the longer the time horizon, the better for the employee and the enterprise.It is therefore win-win for both the enterprise and the employee to have an implicit long-term contract, conditional only on continued satisfactory performance.

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Maintaining Long-Term Competitive Advantage: Real Wage Flexibility

Real wage rate flexibilitythe annual year-end wage bonus system used in many parts of East Asia provides risk-sharing between the enterprise and the employees (and provides an incentive for hard work, reduces labor turnover and enhances the savings rate).In the industrialized economies of the West, the wage rate is not downward flexible, frequently making it necessary to lay off workers in times of an economic recession.

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The Importance of Risk-Sharing between the Enterprise and the Employees

Globalization greatly increases the uncertainty and the volatility of business. It is neither optimal nor sustainable for either the enterprise or the employee to bear the complete burden of such risks.Two well known household names in the worlds aviation industryPan American World Airways (PanAm) and Lockheed Aircraftare no more. They provide important lessons for enterprise-employee relations.PanAm was very prosperous before the deregulation of the airlineindustry. It had monopoly routes between many cities in the world. Its pilots and flight attendants were among the most highly paid. This was viable when there was no competition. But when the airline industry was deregulated, it faced stiff competition from new entrants on all of its previously monopolistic and profitable routes. It soon began to lose money every month.

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The Importance of Risk-Sharing between the Enterprise and the Employees

The high wages and salaries of the PanAm employees made it impossible for PanAm to compete with its competitors, which had much lower wages and salaries. The high wages and salaries which had been possible because of the previously monopolistic market under which all costs could be transferred and borne by the customers of the airline became viable no longer.The employees of PanAm could have shared the risk and saved their jobs by accepting a reduction in their wage and salary levels, but they were unwilling to do so. As a result, PanAm declared bankruptcy and the airline disappeared. (By comparison, the current United Airlines employees faced the same problem, and they agreed to salary reductions in exchange for shares in the company so that their jobs could be saved.)

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The Importance of Risk-Sharing between the Enterprise and the Employees

Lockheed Aircraft, a major commercial aircraft manufacturer, pursued a different strategy. It offered no security to its employees. It hired large numbers of employees when it received orders/contracts, and laid them off immediately when there were no orders/contracts. As a result, there was little employee loyalty. And the better employees self-selected to work for longer-term oriented enterprises.R&D projects that require steady inputs and provide a return only over the long run cannot be effectively undertaken under conditions of unstable employment.Lockheed Aircraft is also no more.

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The Importance of Risk-Sharing between the Enterprise and the Employees

Traditionally large extended families in China and East Asia provide a form of risk-sharing. When one branch of the family faces difficulties, the other branches will lend a helping hand. This is a form of self-insurance within the extended family.The economic fluctuations in the world affect the fortunes of the enterprises. Laying off employees when times are bad and re-hiring them when times are good is costly to both the enterprise and the employees, not to mention the society. Layoffs can be avoided if there is some real wage flexibility (through, for example, the annual year end bonus system).Years ago, the Hewlett-Packard Corporation faced some difficulties and the employees voted between the alternatives of taking a 10-percent pay cut and reducing work hours by 10 percent or laying off 10 percent of the employees. The employees overwhelming voted for the reduction of pay and work hours.

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The Importance of Risk-Sharing between the Enterprise and the Employees

The price of oil and hence the price of gasoline affects the sale of new cars, and hence the demand for original equipment tires, as well as the usage of the cars, and hence the demand for replacement tires. How to hedge against these uncertainties and share these risks? One possibility is to adopt a form of wage bonus system used in someregions of East Asia, and to use overtime in times of exceptional prosperity instead of hiring additional new employees.The annual year-end bonus is really for risk-sharing in the current period; employee stock ownership is for risk-sharing in the future. Employee stock ownership plans (with possibly a discount and a vesting period) and stock options plans are different types of schemes designed to align the interests of the employees with those of the enterprise and to instill employee commitment and loyalty to the enterprise.

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Maintaining Long-Term Competitive Advantage: Building an Enterprise Culture

With an enterprise culture accepted and adopted by employees, it is much easier to:Make sure that everyone speaks the same language, shares the same expectation and goals, complies with the same norms, and moves in the same direction;Assure that everyone feels a sense of ownership towards the enterprisethat everyone is a stakeholder if not a shareholderas well as a sense of mutual responsibility and obligation for the enterprise. For example, it is the responsibility of every employee to protect the brand name; thus, the after-sale servicing of tires made in any plant is the collective responsibility of all employees.

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Maintaining Long-Term Competitive Advantage: Building an Enterprise Culture

There should be mutual trust among the employees at all levelseveryone can trust that someone else will protect their backs! A successful enterprise culture greatly facilitates team work and reduces coordination costs within the enterprise, and helps to bring about a high-morale, highly motivated work force working cooperatively.An enterprise that develops and maintains its unique culture is an enterprise that intends to stay for the long-haul. :

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Maintaining Long-Term Competitive Advantage: Building an Enterprise Culture The enterprise culture of Giti-Tire is founded upon the following 5 principles:

PioneeringPrudencePride of WorkmanshipCustomer LoyaltyCommitment

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The Advantages of an Active Controlling Shareholder in the Age of Globalization

One of the advantages of having a controlling shareholder participating actively in the management of an enterprise in the age of globalization is that decisions can be made expeditiously.Moreover, a controlling family tends to think in very long terms, taking into account the interests of not only the current members but also of the descendents in the future. They also tend to be more patient and do not worry about short-term fluctuations of either the business or the share price in the short term. A family enterprise is therefore much better positioned to survive and prosper in the long run. Furthermore, since the major shareholder/owner is also active as the manager of the enterprise, the so-called principal-agent problem does not arise because the incentives of the owner and the manager are automatically aligned.

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The Advantages of an Active Controlling Shareholder in the Age of Globalization

Family enterprises are more likely to invest in projects with long-term payoffs, e.g., R&D, goodwill, brand names, infrastructure.(Examples: Wallenbergs in Sweden; Samsung in South Korea). They are therefore more likely to sponsor educational programs for the employees and their families. Other (minority) shareholders, if any, and employees can free-ride on the fact that the controlling shareholder takes a long-term view and ownership of the enterprise.What is good for such an enterprise in the long run is good for the employees; what is good for the employees in the long run is good for such an enterprise. There is no conflict of interest between the enterprise and the employee in the long run.The only important issue is full disclosure and transparency when it comes to related-party transactions, that is, transactions between the enterprise and the controlling shareholder, to ensure fairness to the minority shareholders.

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Prospects of Future GrowthThe prospects of the automobile and truck industries in China are excellent. Even high-gasoline countries have thriving automobile and truck industriesGermany, Japan, South Korea all have prosperous automobile and truck industries. It will be the same in China even with the increase in the retail price of gasoline.The demand for transportation services will grow at a much faster rate than real GDP.

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Concluding RemarksA enterprise in the age of globalization must remain competitiveupgrading the human resources, investing in education and R&D, attracting outside talents, improving the quality of services, lowering the cost of doing business, providing incentives and motivation, and promoting an enterprise culture.Creation and maintenance of a stable and development-friendly environmentassurance of predictabilitya vision for the future that is feasible.Pursuit of win-win solutions to enable the realization of sustainable long-term benefits to all.

Globalization and Its ImplicationsforLong-Term Success of EnterprisesA PreviewGlobalization: Unprecedented Growth in International Trade and Investment FlowsThe Unprecedented Growth in World Trade and Capital Flows is the Result of:The Unprecedented Growth in World Trade and Capital Flows is the Result of:International Trade Permits Economies of Scale and Specialization to be RealizedGlobalization:Growth of Foreign Direct InvestmentGlobalization: Foreign Direct Investment Leverages Intangible CapitalGlobalization is Enabled by the Information & Communication Technology RevolutionOpportunities and Challenges ofGlobalizationChallenges from Globalization are the Results of:Globalization as a Source of Economic DisturbancesSources of Macroeconomic InstabilityGrowth and Structural Changeof the Chinese EconomyMaintaining Long-Term Competitive Advantage: Core Competence and ScaleEnlarging the Market and Achieving ScaleMaintaining Long-Term CompetitiveAdvantage: Investment in Intangible CapitalMaintaining Long-Term CompetitiveAdvantage: Investment in Intangible CapitalMaintaining Long-Term CompetitiveAdvantage: A Business Information SystemMaintaining Long-Term Comparative Advantage: Human CapitalMutual Investment by Employees and Enterprise is Win-WinMutual Investment by Employees and EnterpriseMaintaining Long-Term Competitive Advantage: Real Wage FlexibilityThe Importance of Risk-Sharing between the Enterprise and the EmployeesThe Importance of Risk-Sharing between the Enterprise and the EmployeesThe Importance of Risk-Sharing between the Enterprise and the EmployeesThe Importance of Risk-Sharing between the Enterprise and the EmployeesThe Importance of Risk-Sharing between the Enterprise and the EmployeesMaintaining Long-Term Competitive Advantage: Building an Enterprise CultureMaintaining Long-Term Competitive Advantage: Building an Enterprise CultureMaintaining Long-Term Competitive Advantage: Building an Enterprise CultureThe Advantages of an Active Controlling Shareholder in the Age of GlobalizationThe Advantages of an Active Controlling Shareholder in the Age of GlobalizationProspects of Future GrowthConcluding Remarks