What’s the trouble with doing business in China?

Plenty, according the presidential candidates. For all their sparring, President Obama and Mitt Romney agree on this: China lurks as a threat to U.S. businesses.

Their campaign ads have drawn the ire of Henry Kissinger, the former secretary of state whose diplomacy reopened economic and cultural exchanges with China 40 years ago after a generation of isolation and hostility. Kissinger described the candidates’ language labeling China a cheat in business as “deplorable.”

But the tide of opinion in Washington may be going against Kissinger. One indication of the shift came with the recent bipartisan congressional report condemning two Chinese telecom supply companies, Huawei Technologies and ZTE. Investigators said the firms were neither trustworthy nor transparent enough to supply telecom equipment to the U.S.

Aside from the national-security concerns, the report gave further evidence that at least part of the U.S. economic malaise — stagnant wages, tepid growth, lost jobs to overseas factories — can be attributed to the unfair advantages of China’s companies. These include their receipt of below-market credit from state-owned banks, their appropriation of foreign technology without royalties, trade and regulatory barriers put up to favor them and China’s burst of acquisitions globally that give the country momentum for economic hegemony.

U.S. businesses are facing Chinese competitors wielding unfair business practices on a scale never seen before.

Some of the biggest companies in the world, of course, have the muscle to operate there. Yum Brands, which owns KFC, Taco Bell and Pizza Hut, plans to open more than 700 restaurants in China this year. GM manufactures more cars in China than in the United States. And Nike’s 35 percent margins in China are the envy of U.S. business. These companies get a lot of press but are exceptions. More typical are companies with a small market share and skimpy risk-adjusted returns.

While American chief executives can see the problems in China, many are under pressure from Wall Street to pursue the growth that China promises. The typical approach to entering China is to form a joint venture with a Chinese company in which the firms share product technology, process technology and know-how. In return, foreign firms such as DuPont, WalMart and Whirlpool supposedly share an ever-growing slice of the expanding Chinese market.

But most companies have to deal with Chinese competitors in a country that U.S. Trade Representative Ron Kirk has taken to task: “In 2011, the prevalence of interventionist policies and practices, coupled with the large role of state-owned enterprises in China’s economy, continued to generate significant concerns among U.S. stakeholders.” Kirk named China — for the eighth year — to his agency’s priority watch list for theft of copyrighted material and intellectual property.

U.S. executives have been slow to realize that the competition they face in China is not like what they have faced in most of the world. Their companies are not competing against other corporate rivals. They are competing against an entire country. Most firms in China operate with at least some support of the party’s political apparatus. The executive-staffing decisions at state-owned firms, for example, are vetted by China’s top bureaucrats, and about half of China’s firms are either partly or wholly owned by the government.

With the country and company working hand in hand, China has continued to surprise doubters with its economic power. The United States once ruled global trade. As of 2011, China became the top trading partner with seven of the Group of 20 countries: Brazil, India, Russia, Japan, South Korea, Australia and South Africa. China’s producers have grown so large that they can set world prices in industries as different as steel and antibiotics.

What we are witnessing is an escalation from competition between corporations to competition between nations — the opening of a capitalist cold war between the United States and China.

The China taboo

Why do U.S. chief executives stay quiet on the eve of a cold war? The answer is the China taboo, which has emerged from four key factors.

Laying low: First, chief executives make a practice of treading quietly and not complaining. They believe that speaking out invites China’s retaliation. But staying quiet gives China an opening to take advantage of U.S. firms. Solar-panel firms waited far too long to launch an official trade complaint; some went bankrupt before tariffs of up to 250 percent were implemented to help them.

Kirk actively pursues World Trade Organization (WTO) cases against Chinese firms, the latest contesting China’s export subsidies for autos and auto parts. Provisions of the Trade Act of 1974 allow the president to act alone to impose tariffs, quotas and “marketing agreements” on industries suffering “serious” harm by imports. President Obama used this power in 2009 to protect the tire industry. With political cover from business, the president can use this power more often.

Dependency: Second, the U.S. and its firms have become dependent on China for critical products and know-how. China has even become America’s biggest supplier of components critical to the operation of U.S. defense systems, including missiles, supercomputers and other equipment.

An eye on Wall Street: A third factor is a fear of driving down stock prices. Executives worry that if they complain about the challenges in China, they will cast doubt on their rosy profit and growth predictions for China operations. That will make investors nervous, and the companies’ stock prices would tumble.

A good indicator of the sensitivity of stock prices came this past spring. As companies — including Apple and Caterpillar — noted softness in their China business, their stock prices dropped as much as 5 percent. The same thing happened to the stock prices of Japanese firms such as Honda and Toyota during China’s recent anti-Japanese protests.

The war of beliefs: A final factor is propaganda and political correctness. As Kissinger reminds us, it has become difficult to publicly criticize China without being labeled a China-basher or worse. Even in the classroom, business professors have to keep their beliefs to themselves lest they appear to be spinning conspiracy theories. China, which repeatedly stresses cooperation in its propaganda, has begun to win the war of beliefs and to chill conversation in American business schools and the C-suite of American companies.

The China taboo leads to some worrisome results. American companies misallocate resources, wasting money investing in China without adequate analysis of the risks. They unintentionally legitimize an authoritarian regime. Most worrisome, they invite China’s companies into our markets, where the Chinese firms position themselves not only to shape our markets, but also our political processes and even democratic principles. With the recent approval of plans by three state-backed Chinese banks to expand in the United States, the Federal Reserve has given China leverage to influence U.S. business through loans and investment and has opened the banking system to possible cyberthreats.

Four solutions for businesses

In contrast to American outcries against Japanese unfair practices in the 1980s, Americans have played into Chinese hands because of the China taboo. U.S. leaders don’t act tough or even talk tough beyond taking potshots at China. This leads to two self-fulfilling, self-defeating prophecies. The first is that companies decide they can’t win in a market controlled by the Chinese government, so they don’t craft strategies to do so. In other words, they don’t call on the U.S. government for help, and their attitude dooms them to lose technology and market share. The second is that companies decide that the U.S. is a declining market and China a high-growth market, so they withdraw money from the U.S. and invest in China. U.S. capital then serves to stimulate job growth in China at the expense of American job growth.

Executives don’t have to passively cede the advantage to the Chinese as America’s political leaders sort out a strategy to compete with China. Here are four actions business people can take today:

Break the China taboo: The first action is to have the courage to speak out about how hard it is to do business in China. Andy Grove, former chief executive of Intel, wrote in a 2010 essay that if China wanted a trade war, “treat it like other wars — fight to win.” Yet most chief executives today — and I’ve talked to hundreds of them — will simply not go on record criticizing China.

Many chief executives tell me regularly that they don’t know what to do. They are damned if they enter China because of the risk and fear of becoming controlled by the Chinese government. And they are damned if they don’t, due to the size and growth of Chinese markets and the promise to create shareholder wealth. But they wouldn’t dream of starting a public conversation about the bind they are in, because that might hammer their stock price or provoke Chinese retaliation. The subject is taboo.

A few chief executives, such as Daniel R. DiMicco of steelmaker Nucor, echo Grove. DiMicco publicly accuses China of currency manipulation and flagrant violations of trade codes. In March, DiMicco declared, “China’s latest five-year plan calls for its major steel companies to invest overseas in order to get access to key steelmaking technologies. Let’s be clear about what is happening here. This expansion into foreign markets is driven by government policy, not company profitability.” Other executives need to be similarly outspoken.

Practice corporate patriotism:Millions of U.S. jobs have been exported to China and other countries, by some estimates 2 million in the past 10 years. Yet rising wages in China, along with growing spending on social benefits, mean the country no longer offers the cheap labor it once did. It is time for chief executives to repatriate U.S. manufacturing.

One chief executive of a well-known multibillion-dollar consumer-durables company confided in me that, with available new technology, he could shift all his manufacturing from China back to the U.S. and make his product just as cheaply. What stopped him? He was worried the Chinese would retaliate by disrupting his supply chain during the switchover or by denying his firm access to the Chinese market.

New factory technology allows more firms to forgo China. In fact, executives have warmed to this notion. In April, the Boston Consulting Group found that more than a third of companies with sales over $1 billion plan to shift manufacturing to the United States from China. Industries with particular interest in such a move included transportation goods, appliances and electrical equipment, furniture, plastic and rubber products, machinery, fabricated metal products, and computers and electronics. Seventy percent of the executives agreed that “sourcing in China is more costly than it looks on paper.”

Openly complain and demand U.S. government action: Many people argue in favor of economic efficiency — investing capital and hiring labor anywhere in the world to reap the highest returns — that is theoretically achieved by an across-the-board opening of the U.S. domestic market. But this hurts American businesses in the long term. Fierce free-market competition with countries such as China drives down prices, which may make goods cheaper for consumers but comes at the expense of healthy profit levels. With falling profits, U.S. businesses in turn invest less in research and development and worker training. They ultimately liquidate assets needed for long-term prosperity in America.

Business people should identify how China takes unfair advantage of their industry and lobby the government to respond. DiMicco, for example, cites the need for action on China’s currency manipulation and flagrant violations of trade codes. The wind and solar industries have urged further investigation into the renewable energy markets, prompting Kirk, the U.S. trade representative, in late July to call for an International Trade Commission investigation. That followed announcements in May and July of duties of as much as 73 percent on wind towers from China.

U.S. businesses should also recognize and exploit their home advantages. As one example, Chinese companies should be denied access to U.S. capital markets until they allow U.S. regulators — the Public Company Accounting Oversight Board — to inspect Chinese audit firms that do work for U.S. listed companies. Otherwise, the Chinese firms can tap U.S. capital without the transparency and financial-statement verifiability of U.S. firms. A U.S. listing — and capital — could be withheld.

Limit your China exposure: Many U.S. companies are expanding in China with something approaching strategic abandon. But experience shows that many companies have a hard time building profitable businesses in China. The most recent annual survey by the American Chamber of Commerce in China showed that
61 percent of companies had operating margins less than or comparable to elsewhere in the world. That level of profitability hardly justifies a gold-rush mentality.

In a study released in April of 254 executives, the Shanghai-based China Europe International Business School found that foreign firms cited competition with Chinese firms as one of their biggest challenges, second only to finding and retaining people. We can guess that “competition” with foreign firms comes in the form of unfair practices by state-owned firms trying to squeeze foreign competitors.

Smart business leaders will cut back their China exposure.

A post-taboo strategy

There are other strategy choices, given the risk and uncertainty of doing business long-term in China.

One is allying with other countries around the world to build unassailable global market share that Chinese companies cannot challenge and to lock out Chinese firms until they comply with the intent of WTO rules.

Another is to use “guerrilla” tactics to storm niches in China’s markets with constantly shifting product and service strategies.

A third is to destroy China’s advantages before its companies become competitive in your industry and do so with the help of the U.S. government.

China is not only a fleet-footed free-market street fighter. It is also a muscle-bound sumo wrestler that can crush any business to further its national development. China has the money, the home market to build economies of scale, and the power of the state to intervene to help out domestic companies.

And yet U.S. executives can recognize that the battle is for competitive advantage with a superior strategy. That strategy will include the backing of the U.S. government and cooperation with the government to accelerate decisions and approvals. It will also include changing the way U.S. capitalism works to supplement free-market ideals with government intervention and guidance of markets. This is what I call “strategic capitalism.”

Using strategic capitalism, China has given Chinese companies a significant competitive advantage.

We indeed face a turning point. Business leaders can give into a self-fulfilling, self-defeating prophecy that the biggest country’s companies will inevitably win. Or they can take an approach urged by ancient Chinese strategist Sun Tzu, crafting clever strategies to defeat rivals with speed and innovation that the China heavyweight cannot match.

Richard A. D’Aveni is Bakala Professor of Strategy at Tuck School of Business at Dartmouth College. “Strategic Capitalism,” his fifth book, was published in September.