The Economist just published an excellent article entitled “The flaws in Chinese business – Time to change the act.”

The beginning of the article focuses on the impact of the current downturn on Chinese business. Then it goes on to explain why China has mainly remained a producer of low-value-added goods. The most interesting is the list, towards the end, of all the factors that tend to prevent Chinese factories from investing in innovations and quality improvements.

That very little of this effort has been converted into strong brands is something of a puzzle. Foreign companies account for most high-tech exports. The simplest explanation is that anonymity suits many Chinese companies. In Dongguan, Yue Yuen […] produces sports shoes for leading Western names. Smaller firms make everything from tennis racquets to European luxury goods. Because wide publicity of the common origin would do those brands little good, the Westerners usually insist on contracts with clauses blocking disclosure.

Anonymity also spares Chinese companies from official and press scrutiny of labour conditions, which can be abysmal. But there are limits to this strategy, in as much as margins on undifferentiated production have proved low. Retaining customers means holding off competition from any country with lots of cheap labour, and, as southern China is finding out, businesses of this sort are vulnerable to being wiped out in a slump.

Factor No.1: avoiding lapses in quality is not a huge imperative because the factory’s reputation is not on the line. The large buyers in an industry often don’t know where their competitors source their products.

In Taiwan many of the companies that once were leaders in anonymous production have slowly developed high-quality products under their own names, notably Acer, Asus and HTC. The most glaring impediment to creating the same kind of operation in China is the country’s weak intellectual-property protection. Why invest in design or innovation when the results can be knocked off by competitors? Aware of this barrier, the government has passed new laws and has been vocal in supporting greater protection, but settlements remain trivial and enforcement patchy. Most Chinese patents granted to domestic applicants are still of a type known as “utility model” patents, mainly awarded for incremental improvements, rather than for innovation or new designs.

Factor No.2: innovations will immediately be copied. Moving up to higher-value-added production is not easy, and the factory owners don’t see examples of companies that reached success that way. So they stick to making “cheap stuff”.

[…] In state-controlled companies, senior managers are rotated at the behest of government. China Mobile is said to have 100,000 suppliers. One reason is that with its management and operating franchise subject to frequent government intervention (it was reorganised last summer), technological innovation must be done outside. Leading managers have low salaries and often let stock options expire even when they are in the money, which suggests that rewards are not closely tied to creating value for shareholders.

Factor No.3: in large state-owned firms, the managers have no incentive to experiment or copy what exists in the West. What for? Innovation? Raising the quality level? Increasing profits? They won’t benefit from it.

Medium-sized companies have their own conflicts. Factories inevitably occupy land that was once state-held. As a consequence, their shareholders often include local government. Officials have little interest in industrial efficiency: mergers, for instance, are unattractive if they mean losses of local jobs. Invariably, if there is a photograph on a wall at a corporate headquarters, it features a visit by a senior government official—showing who matters.

Blurred ownership distorts finance, management structure and long-term planning. To insulate themselves from the vicissitudes of China’s state control, companies go through all manner of legal contortions when they list shares. Haier, for example, is incorporated in Bermuda. Securities offerings must be approved by the government and the bulk of legal financing comes from state-controlled banks. With all these political ties, lack of innovation is hardly a surprise.

Factor No.4: the government pulls the strings, to a certain extent. The local officials are only interested in hiring lots of employees and paying the VAT. And raising money for investments is a political process.