The past few years have forced policy makers in North America and Europe to re-examine the role of governments in guiding and promoting economic development. China’s relative success over this period has led some to speculate that the “China Model”– a strong central state driving economic development sans democratic discourse (or bickering) – might work best.

While we believe the China Model is nowhere as simple, or as effective, as some commentators might suggest, we do think it can be put to beneficial use in two areas – the enforcement of intellectual property rights and the allocation of capital.

Intellectual Property Rights

China has made progress in reducing intellectual property theft. In local bazaars notorious for counterfeit goods, “Giorgio Armani” and “Dolce and Gabbana” have been replaced by start-up brands like “Georgie Amanda” and “Dolce and Banana”. [Editor’s note: pun intended!]

Commentary on this issue has frequently centered on multinational brands doing business in China. However, our view is that multinational brands have a clear advantage given their history and proven value proposition and that often it is the homegrown brands that are the real losers. For example, a listed domestic sportswear brand like,安踏 (Anta) or 李宁(Li-Ning) must differentiate itself while competing with hundreds of domestic imitators offering similar goods at discounted prices. Despite increased efforts by management teams to build their own brands, companies operating in low-mid tier segments (which are most susceptible to imitation) find it extremely difficult (and expensive) to gain traction and build brand awareness. This environment has stifled R&D efforts, product development, and innovation.

We believe it is essential that the government begin playing a more decisive role in protecting and enforcing patents, copyright and trademarks. It is also critical that the fight for intellectual property protection is championed from within, rather than being seen as a “foreign agenda.”

Misallocation of Capital

China’s financial sector is dominated by large, state-owned commercial banks and insurance companies. This oligopolistic financial system currently lacks the skills, flexibility and risk management to serve as a reliable source of financing for small and medium sized businesses and too often results in a misallocation of capital and mismanagement of risk. This has resulted in instances of overcapacity, a transfer of wealth from consumers to state-owned corporations, and depressed levels of household consumption.

It is critical that China develops a capital market ecosystem with the specialization and expertise necessary to allocate capital, at the right price and risk level, to enterprises and consumers.

Reform Forthcoming

We believe our concerns are widely understood and that reform will continue. On April 13th, Premier Wen Jiabao stressed the nine steps necessary to ensure continued stable growth in the Chinese economy. These included strengthening the central government’s macroeconomic regulations, increasing the level of support to small and medium enterprises, focusing on improving domestic demand, improving investment quality and efficiency, breaking up industry monopolies, broadening access to central/western markets, and stimulating the participation of private and individual investors.

Lunar’s analyst team couldn't have scripted a better presentation.

Premier Wen’s intentions align closely with Lunar’s long-held investment thesis, and demonstrate that progress, however slow and steady, is being made, and government willingness to reform will assist the growth of great private enterprises in China.