Go into most shops nowadays and you will find an infinite variety of goods made in China. These goods can range from low-priced sweaters and socks to high-value electronic products such as VCRs or tape recorders. China is a huge manufacturing base for firms from all over the world which invest in China to benefit from China’s low-cost but highly skilled and disciplined workers.

But one little noted fact during China’s era of reform is that, although a massive amount of foreign direct investment (FDI) has flowed into China, indigenous private firms have not developed nearly as fast as their market and business potentials would allow. Many goods sold around the world are made in China but very few are made by indigenous Chinese companies themselves.

The size of a firm is a rough, although imperfect, indicator of a firm’s growth potential. A comparison with the size of firms in India is helpful here. Although India’s economy is about half the size of the Chinese economy and has a lower growth rate, India is now home to a number of large - and globally competitive - firms.

Today, the largest private firm in China is the Hope Group, located in Sichuan province, and run by four brothers. This agribusiness conglomerate generated annual sales of $600 million in 1999. The largest private firm in India, Tata Group, generated sales of $7.2 billion in 1995, and its tea business division alone generated sales of $163 million in the same year.

Another example comes from the pharmaceutical industry. In 1997, the largest pharmaceutical firm in China was Sanjiu, with sales of $670 million. Contrast Sanjiu with Ranbaxy Laboratories Limited of India, one of the largest Indian pharmaceutical firms. In 1995, Ranbaxy generated sales of $2.27 billion, despite the fact that Chinese pharmaceutical market was three times as large as the Indian market.

A comparison with South Korea during a comparable stage of economic development tells the same story. South Korea’s economic takeoff is commonly dated to the years between 1960 and 1980. During that period, a number of globally competitive Korean firms emerged, such as Hyundai and Samsung (their later corporate governance problems notwithstanding).

China, on the other hand, has not produced a similar group of competitive indigenous firms during the more than twenty years of its “economic miracle” from 1978 to 2001. All China’s large firms are state-owned enterprises, which are large only because they are granted a monopoly custodianship over the country’s most valuable assets – oil fields or savings assets from Chinese households. In brief, China’s economy has taken off but very few of its firms have.

Firm size itself is not and should not be a goal of government. Whether economic growth is driven by many small firms or a few large firms is less important than the fact that the economy grows. But in the case of China, the failure of competitive indigenous firms to grow under very propitious conditions raises troubling issues and indicates some of the inherent inefficiencies in China’s economic system.

One source of inefficiency is the fact that China’s goods and asset market is fragmented and has become more fragmented during the twenty years of reform. A dramatic illustration of this is that the average distance over which freight is shipped has shrunk during a time when the government has invested massively in highways, air cargo facilities and railways. China is increasing its sales and exports to the rest of the world but internal trade has declined. A fragmented market makes it more difficult for a firm to expand beyond its own location and to grow in size.

The second factor is that China’s financial system allocates its vast savings pool inefficiently. It allotted subsidized credit and cheap equity capital to China’s most inefficient firms – SOEs – while systematically denying financial resources to China’s dynamic private firms. The result is that both SOEs and private firms fail to become competitive.

To illustrate the consequences of China’s system for financial allocation, imagine a personal computer of an early 1990s vintage equipped with a Windows 2000 operating system. Now further imagine another computer, the most high-powered on the market in 2001 but one equipped with a DOS operating system from the 1980s. This is an inefficient combination of hardware and software and the likely result is poor performance from both computers.

This brings us back to the earlier point about why so many Chinese goods are flooding stores around the world but not those made by indigenous Chinese companies. Because Chinese indigenous firms are uncompetitive, foreign firms find it profitable to invest and produce in China. Foreign firms use capital and labor efficiently, and they respond to market opportunities quickly. SOEs, however, do not bother with efficiency and are not market savvy. Private firms do not have sufficient resources to capitalize on their superior software capabilities.

This inefficiency also has an impact on overall performance. Indians save about half of what Chinese save and India gets one tenth of FDI which China gets every year. Yet India’s GDP growth in recent years is about 80% of Chinese growth rate. India is doing something right. It is using its capital more efficiently because its government does not discriminate against private firms and its financial resources fund efficient firms. It is time for China to learn from India’s example.