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From oxcart to Wal-Mart: Four keys to reaching emerging-market consumers

To get products to customers in emerging markets, global manufacturers need strategies for navigating both the traditional and the modern retail landscapes.

In emerging markets the world over, multinationals struggling to get their products to consumers confront a bewildering kaleidoscope of strategic and operational challenges. At one extreme, they must grapple with traditional retailers: the chaotic array of shops, kiosks, street vendors, and other small proprietors who seem to offer neighborhood customers a little of everything, whether it be groceries or branded goods, such as beverages, small electronic devices, and personal-care products. At the other, multinationals must deal with modern retailers—global giants, including Carrefour, Tesco, and Wal-Mart, as well as local leaders, such as CR Vanguard, in China, or Grupo Pão de Açúcar, in Brazil—that have become a powerful force in the emerging world’s fast-growing cities.

This duality has become more pronounced since we last wrote about reaching consumers in emerging markets, five years ago; our emphasis then was largely on the ubiquitous mom-and-pop shop. Today, retail landscapes in emerging markets can be divided into three broad categories (see exhibit, which focuses on grocery sales):

  • predominantly traditional markets, such as India, Nigeria, and Indonesia, where small proprietors account for 98 percent, 97 percent, and 85 percent of the market, respectively
  • predominantly modern markets, such as China, Mexico, and South Africa, where modern trade already accounts for more than half of sales
  • transitional markets, where small proprietors currently prevail but are being rapidly elbowed aside by modern retailers; in Turkey, for example, their share of sales has shot up to 46 percent in 2011, from 26 percent in 2005

As multinational manufacturers look beyond countries as their unit of strategic planning, they will discover stark variations within regions, cities, and neighborhoods. (For more on city-based strategy setting, see “Unlocking the potential of emerging-market cities.”) In Malad, a western suburb of Mumbai, the most important outlets for grocery sales are mom-and-pop stores, known as kirana, and the suburb’s giant fruit and vegetable mandi, or outdoor market. But as business-processing centers and new residences spring up in the district, modern retailers are muscling in. Malad now boasts ten supermarkets and three large hypermarts.

Even in predominantly modern retailing markets, such as China, where modern outlets account for nearly two-thirds of sales nationwide, traditional and modern stores live cheek by jowl. China’s ten largest grocery retailers, though growing fast, account for only 11 percent of total sales—far less than the ten largest US players, which account for 51 percent of sales in that market. China’s biggest retailer, China Resources Enterprise, commands a market share of 2.3 percent of total grocery retailing and 3.8 percent of modern grocery retailing. In a host of leading Chinese cities—among them Chengdu, Chongqing, Dailian, Shenyang, and Wuhan—modern retail outlets account for only about 50 percent of sales. By contrast, modern retailing represents more than 75 percent of sales in Beijing and Guangzhou, 80 percent in Shenzhen, and 77 percent in Shanghai, where residents can choose to buy their groceries at more than 100 hypermarkets.

Across the emerging world, in short, the retail terrain is diverse and unfamiliar. This article offers four road rules for companies to follow as they navigate it.

1. Embrace the duality of emerging markets

The starting point for any successful strategy is a recognition that manufacturers must engage effectively with traditional and modern trade outlets—and be prepared to live with that reality for the foreseeable future. In some emerging markets, notably India, regulations against big-box competitors explicitly protect small proprietors. Cultural preferences, poor infrastructure, and the geographic dispersal of emerging-market populations also assure a significant role for traditional outlets.

In our experience, companies that craft nuanced strategies embracing the traditional retailer can raise their revenues from emerging markets by 5 to 15 percent and their profits by as much as 10 to 20 percent. That’s because for all the appeal that large-format retailers hold for global manufacturers—big chains are familiar, easy to deal with, and can free manufacturers to focus on issues like strategy, product development, or recruiting—these retailers can command high listing fees and big discounts, as well as impose many conditions small proprietors cannot. They also are quick to weed out products that don’t sell briskly.

Some manufacturers have opted to focus on large retail chains to build a position of strength and then gradually developed the capacity to work with traditional outlets. Prantalay Marketing, a Thai seafood processor, increased sales of its ready-to-eat meals, launched in 2004, to more than $30 million within six years, in part by concentrating on Thailand’s large retail chains, including Siam Makro, Big C, and Tesco Lotus. The focus on modern retailing made sense because Prantalay’s prepared meals were frozen and required a reliable cold chain. Now the company is turning its attention to traditional channels and expanding its product lineup to include offerings, such as instant noodles, that do not require freezing.

Similarly, South Africa’s Tiger Brands worked through large retailers to consolidate its position in its home market. A consumer product giant whose brand portfolio includes everything from Purity baby food to Doom insecticide, Tiger accounts for close to 15 percent of sales at every major South African retailer. But as the company looks for future growth, it has begun acquiring businesses in other African markets. Given the greater importance of small proprietors in those economies, Tiger’s emergence as a regional player will force it to develop new capabilities for working through traditional retailers.

Other manufacturers have moved in the opposite direction, securing market position through traditional retail outlets, then turning to larger establishments in the quest to expand. Consider the case of Wanglaoji, a 184-year-old herbal tea transformed by JDB Group, a Hong Kong soft drink marketer, into China’s best-selling beverage. Until 1995, when JDB acquired the rights to the Wanglaoji trademark from state-owned Guangzhou Pharmaceutical, the drink was primarily seen as an herbal elixir for cooling “overheated” internal organs.

JDB launched a rebranding effort whose masterstroke was a decision to market the drink through restaurants specializing in spicy Sichuanese cuisine. JDB pitched Wanglaoji as a healthy and refreshing antidote to Sichuan’s famously fiery hot-pot dishes, forged partnerships with select restaurants, and gave “Wanglaoji-trusted outlets” lavish incentives, including product discounts, free promotional materials, and generous contributions to holiday marketing campaigns. The results of the repositioning were dramatic: between 2002 and 2008, sales soared from less than $30 million to more than $1.5 billion. With consumers clamoring for the drink in shops as well as restaurants, JDB found modern retailers eager to carry its red cans. Today, the brand boasts sales of roughly $3 billion in China, topping sales of that other popular red-can beverage, Coke. It is widely available in a variety of hypermarkets, minimarts, and convenience stores, as well as in hot-pot restaurants.

2. Segment and conquer

Because multinationals can’t be everywhere at once, it is essential for manufacturers to pick their shots by segmenting and prioritizing sales outlets carefully. Sophisticated segmentation strategies are especially crucial in targeting traditional trade channels, for a single country may have millions of outlets. (China, for example, has anywhere from 3 million to 8 million sales outlets, depending on what kind are counted, while India has 8 million to 15 million.) In mapping routes to market in emerging economies, we urge manufacturers to focus on a geographic region or cluster of cities and to achieve complete coverage at outlets with significant potential before going on to the next market. (For more on the advantages of creating a stronghold in one area before moving to the next, see “Building brands in emerging markets.”)

To navigate these markets effectively, manufacturers should look beyond the current sales of priority outlets. Sales data for traditional stores in emerging markets are notoriously unreliable; even when accurate, they often reflect little more than how much effort the manufacturer has expended to date in supporting the store in question. It’s far better to estimate potential sales by using forward-looking parameters, such as store size, proximity to workplaces or schools, traffic volumes, neighborhood wealth, or shelf space.

One leading global food company used census and publicly available transportation data to classify sales outlets in the Middle East according to outlet size (six segments, ranging from more than 130 square meters to 30 square meters or less) and a mix between traffic volumes (high, medium, and low) and incomes of surrounding households (high, medium, and low). The result was a grid with 36 cells, which were then aggregated into six distinct segments, enabling managers to make strategic choices about which outlets merited greater investment and which should get only basic maintenance.

The next step is to specify precisely the combination of service, support, and incentives each outlet segment merits. Coca-Cola refers to this process as defining the “picture of success.” What should a store look like? How should Coca-Cola products be displayed, stored, priced, and promoted? Big stores in rich, high-traffic areas will get more attention than small shops in poor, low-traffic areas—but there are numerous variations in between. For each segment, managers tailor a specific set of value propositions. Should the company supply coolers and, if so, how many? What kind of signage and other promotional materials should it provide? Which Coca-Cola products should be supplied and in how many variations of packaging? How frequently should sales staff visit?

In emerging markets, manufacturers must go to great lengths to craft a combination of retailer incentives ensuring that the picture of success comes out right. Big chains, of course, care most about discounts and fatter profit margins, together with better merchandising, more expensive displays, more frequent deliveries, and more frequent visits by salespeople. Some traditional retailers may value these things too. Smaller retailers, however, may prefer free equipment, brand promotions, flashier displays, and outside signage to help them stand out from the crowd. In many cases, manufacturers can win the loyalty of small proprietors by paying electricity bills or providing health insurance for the owner, employees, and members of their families. In some cities in Mexico and India, where shopkeepers take special pride in their establishments’ appearance, offering to pay for a new paint job every six months may be the lowest-cost way to secure a partnership.

Manufacturers must calibrate their concessions carefully. All “gives” to retailers should be compensated by “gets”—for example, requirements that retailers guarantee certain sales volumes or provide superior shelf space. One leading multicategory food company in Mexico offers to install high-end shelves and displays in smaller stores in exchange for a retailer’s commitment to display its products prominently. The degree to which retailers actually deliver these “gets” provides valuable information to manufacturers as they periodically reevaluate the potential of outlets.

3. Balance cost and control in your route to market

Even the most sophisticated segmentation strategy can be undone by flawed models for transporting goods and serving retailers. Direct delivery with a manufacturer’s own trucks and trained employees is the preferred option for modern trade. But such costly support must be confined to outlets that really matter. Often, “basic availability”—with products delivered, say, by wholesalers—will suffice.

In Indonesia, Unilever, for example, services supermarkets and hypermarkets with its own vehicle fleet. But because the archipelago has thousands of islands, Unilever reaches minimarts through a network of distributors who work solely for the company in the categories it carries and serves independent small retailers and chains through another network. For ice cream vendors, who sell from freezer-equipped tricycles, Unilever relies on ice cream concessionaires. In India, Unilever has used a similar multiple-channel approach to gain access to more than half of the country’s population—all urban centers and 85,000 villages, which in some cases it serves with bullock carts and tractors.

Coca-Cola prefers direct delivery wherever possible. But in Kenya, where rural and urban roads alike are often too rough for Coca-Cola delivery trucks, the company delivers on bicycles and pushcarts to microdistributors, which in turn can reach retail outlets covering 90 percent of the country’s population. This vast network of small vendors has not only generated enormous goodwill for Coca-Cola but has also been cited by the International Finance Corporation as a model of how global companies can foster local entrepreneurs.

In many of these markets, companies must deal with thousands of distributors and wholesalers, which often struggle to realize the manufacturer’s brand goals or strategies for influencing the behavior of retailers. Executives at many leading global consumer companies argue that segmenting and prioritizing distributors is as important as segmenting and prioritizing sales outlets. The goal is to build the skills of reliable, high-priority distributors so they can help manufacturers achieve their strategic goals for different kinds of outlets—which sometimes means consolidating distribution networks.

In India, for example, Hindustan Unilever consolidated its distributors for the Mumbai market from 21 firms to just four megadistributors. Similarly, more than a decade ago Procter & Gamble shrank the number of its distributors in China. Acquisitions can be an excellent opportunity to reevaluate distributors; over three years, a leading fast-moving consumer goods company in Russia did exactly that, transforming a tangle of 300 overlapping players of widely varying capabilities into a core of 100 focused, high-performance stars.

4. Arm the front line with skills and technology

The many moving pieces in these sales and distribution networks demand a relentless focus on frontline execution. Xian-Janssen OTC, Johnson & Johnson’s consumer health care arm in China, requires its sales personnel to undergo five formal training modules over five years to master professional skills, such as salesmanship and team management. The company also coaches employees informally (with sales visit “shadowing”) and conducts weekly “education meetings” where difficult sales situations encountered during the week are reenacted and analyzed. What’s more, high-performing companies recognize that “what gets measured gets done,” so they set targets and offer incentives aimed not just at raising sales volumes but also at promoting proper retail execution, such as the quality of in-store product displays.

At the same time, companies are well advised to recognize the varying capabilities of their emerging-market sales forces and to find simple ways of standardizing the quality of sales visits as far as possible. For instance, Kang Shi Fu, a successful Chinese manufacturer of beverages and noodles, provides its salespeople with checklists that are tailored for each outlet segment and must be completed during every visit. Guidelines for Pepsi salespeople cover a host of specific duties, from greeting the retailer to checking inventory levels. Checklists and standardized approaches are useful both when manufacturers hire and manage their own sales forces and when they rely on (and closely supervise) those of distributors. “Shadow management” of this sort has proved effective for several leading global companies in China. Often, sales managers are “embedded” with distributors to train staff and offer advice on how to execute different strategies for different store types. Embedded managers also join visits with distributors’ sales teams to monitor performance and provide on-site coaching.

Technology is an increasingly important tool, with handheld devices for salespeople proving especially useful. A snack company in the Middle East uses satellite-linked devices, so their geo-coordinates can be tracked. If outlets aren’t visited in the right order, the devices are disabled, preventing the salespeople from completing their tasks. A central team can also periodically monitor the location of individual salespeople, to ensure that they truly are on sales visits and not engaged in side jobs. These handhelds come preloaded with detailed instructions on each outlet the salespeople are about to visit— for instance, its outlet segment, historical sales information, specific products to sell, and key action steps to complete from the last sales visit. Not long ago, such functions involved a specialized mobile device and high hardware costs. Today, an app on a low-cost smartphone can perform many of these tasks.

Eventually, mom-and-pop stores may go the way of buggy whips, and the descendants of today’s village children in countries such as China and India may scoff at the idea of buying products and services anywhere but in climate-controlled malls or online sites. For now, though, manufacturers staking their futures on these booming economies must forge lasting relationships with a diverse set of retailers—before competitors do.

The rise of the African consumer

The single-largest business opportunity in Africa will be its rising consumer market. A McKinsey report, one of the first of its kind, offers a detailed profile of African consumers, including their demographics, behavior, and needs.

By now, most investors and businesses know about the tremendous potential of Africa—the world’s second-fastest-growing region, topped only by emerging Asia. But it may come as a surprise that Africa’s growth is fueled not by resources but rather by a rising consumer market.

The continent’s consumer-facing industries are expected to grow by $400 billion, representing its single-largest business opportunity, by 2020. But many companies don’t know how to translate this potential into action, because of a dearth of market research. That, however, is changing. In one of the first studies of its kind, McKinsey’s Africa Consumer Insights Center surveyed 13,000 consumers in ten African countries, with a focus on the largest cities. Five categories of consumption were covered: apparel, financial services, groceries, the Internet, and telecommunications.

Several factors are shaping this new consuming class. Africa’s population, the fastest growing and youngest in the world, is concentrated in urban areas. This new class of consumer has a smaller family, is better educated and higher earning, and is digitally savvy. Africans are exceptionally optimistic about their economic future: 84 percent say they will be better off in two years.

These new African consumers resemble their urban counterparts anywhere in the world: they are both brand and quality conscious, seek out the latest trends but watch the budget, and want a modern and attractive shopping environment.

But Africa is a complex, nuanced market of 53 countries and more than 2,000 dialects. Consumers in the north have preferences and needs very different from those in the sub-Saharan countries. The McKinsey study attempts to provide companies, whether new to the continent or expanding an existing footprint, with the insights they need to formulate a winning business model to reach this new consuming class. Here are some highlights from the research.

Focus where it matters. Cities offer the best opportunity: urban Africa is forecast to contribute nearly 40 percent of GDP growth. But companies may be wise to bypass high-profile megacities, such as Cairo, Johannesburg, and Lagos, for midtier cities, like Abidjan and Rabat, which are more accessible, have less competition, and offer better profit margins.

Develop locally relevant, quality products. Companies can better tailor products to local markets if they understand what quality means for African customers and know their preferences, lifestyles, and daily needs.

Hit the right price point. Since affordability is critical, companies may have to reengineer products to hit a specific price point. The necessary moves may include offering lower-cost versions, smaller sizes, or alternative payment models.

Download the full report, The rise of the African consumer (PDF−1.06 MB).

 

Protecting information in the cloud

IT and business executives need to apply a risk-management approach that balances economic value against risks.

The use of highly scaled, shared, and automated IT platforms—known as cloud computing—is growing rapidly. Adopters are driven by the prospects of increasing agility and gaining access to more computing resources for less money. Large institutions are building and managing private-cloud environments internally (and, in some cases, procuring access to external public clouds) for basic infrastructure services, development platforms, and whole applications. Smaller businesses are primarily buying public-cloud offerings, as they generally lack the scale to set up their own clouds.

As attractive as cloud environments can be, they also come with new types of risks. Executives are asking whether external providers can protect sensitive data and also ensure compliance with regulations about where certain data can be stored and who can access the data. CIOs and CROs are also asking whether building private clouds creates a single point of vulnerability by aggregating many different types of sensitive data onto a single platform.

Blanket refusals to make use of private- or public-cloud capabilities leave too much value on the table from savings and improved flexibility. Large institutions, which have many types of sensitive information to protect and many cloud solutions to choose from, must balance potential benefits against, for instance, risks of breaches of data confidentiality, identity and access integrity, and system availability.

Refusing to use cloud capabilities is not a viable option for most institutions. The combination of improved agility and a lower IT cost base is spurring large enterprises to launch concerted programs to use cloud environments. At the same time, departments, work groups, and individuals often take advantage of low-cost, easy-to-buy public-cloud services—even when corporate policies say they should not.

High growth and value expectations

Corporate spending on third-party-managed and public-cloud environments will grow from $28 billion in 2011 to more than $70 billion in 2015, according to IDC. However, total spending on the cloud is much larger than these estimates indicate because the figures do not reflect what enterprises spend on their private-cloud environments. Eighty percent of large North American institutions surveyed by McKinsey are planning or executing programs to make use of cloud environments to host critical applications—mostly by building private-cloud environments. At several of these institutions, executives predict that 70 to 75 percent of their applications will be hosted in cloud environments that will enable savings of 30 to 40 percent compared with current platforms.

Using external cloud offerings can yield even more pronounced savings. Some executives cite examples of 60 to 70 percent savings by replacing custom-developed internal applications with software-as-a-service alternatives sourced from the public cloud. In addition, according to recent McKinsey research, 63 percent of business leaders who responded agreed that the cloud can make their entire organization more business agile and responsive.

The rise of bottom-up adoption

Truly cloud-free organizations are extremely rare—and in fact may not exist at all. If you think you are the exception, you are probably wrong. Regardless of any “no cloud” policy, the democratized nature of cloud purchasing reduces the middleman role played by traditional IT departments and makes central control difficult. Users are subscribing directly to cloud services, from online storage and backup to media services and customer-relationship management solutions, paying via credit card. Developers are using infrastructure-as-a-service and platform-as-a-service solutions for testing code and sometimes for hosting applications.

Ironically, forbidding cloud offerings may lead to users subscribing to less secure solutions. An employee using a credit card may not be sufficiently security inclined or aware to purchase the enterprise-class version of cloud software. That same individual might have been perfectly willing to use cloud service providers endorsed by his or her organization had they been available.

Risks and opportunities

Using the cloud creates data-protection challenges in public-cloud services as well as private-cloud environments. However, traditional platforms at most organizations have significant information risks that actually can be mitigated by moving to a more highly scaled and automated environment.

Risk of contracting for public cloud

Decades of experience matured the practice of writing contracts for telecommunications network services and traditional outsourcing arrangements. Terms and conditions exist for allocating liability for security breaches, downtime, and noncompliance events between providers and enterprises. They may be unwieldy, but they are well understood by providers, law firms, and—in many cases—CIOs and CROs.

Contracting for the cloud is different in many ways. Highly scaled, shared, and automated IT platforms, for example, can obscure the geographic location of data from both the provider and customer. This is a problem for institutions dealing in personally identifiable information because often they must keep some customer data in certain jurisdictions and face regulatory action if they do not. At this point, banking CIOs and CROs that we have interviewed largely do not believe that most public-cloud providers can give them the guarantees they require to protect their institutions from this type of regulatory action. Another novel challenge presented by the cloud is how to conform to regulatory and industry standards that have not yet been updated to reflect cloud architectures.

At some level, for the cloud, we are simply in the early days of contracting for enterprise-class services. How to draft the required terms and conditions will remain an open question until litigation has identified the critical issues and legal precedent has been established for resolving those issues.

Risk of aggregation in private-cloud environments

The current state of data fragmentation at many enterprises provides a peculiar kind of risk-management benefit. Dispersing sensitive customer data across many platforms means that a problem in one platform will affect only a subset of a company’s information. Fragmentation may also limit the impact of a security breach, as different platforms often have varying security protocols.

In contrast, consolidating applications and data in shared, highly scaled private-cloud environments increases the honeypot for malevolent actors. There’s much more valuable data in one place, which raises the stakes for being able to protect data.

Risk-management advantages of the public and private cloud

Both public- and private-cloud solutions can provide data-protection advantages compared with traditional, subscale technology environments. Cloud solutions improve transparency—for example, the centralized and virtualized nature of the cloud can simplify log and event management, allowing IT managers to see emerging security or resiliency problems earlier than might otherwise be possible. Likewise, in cloud environments, operators can solve problems once and apply the solutions universally by using robust automation tools.

Perhaps more important, technology organizations can focus investments in security capabilities on a small number of highly scaled environments.

A risk-management approach to exploiting the cloud

In many large institutions, information security traditionally has been a control function that used policies limiting what IT managers and end users could do in order to reduce the likelihood of data loss, privacy breaches, or noncompliance with regulations. We believe that IT organizations must now adopt a business-focused risk-management approach that engages business leaders in making trade-offs between the economic gains that cloud solutions promise and the risks they entail. It is still the early days of cloud computing, and risk-management decisions are highly dependent on the specifics of the situation, so there are no hard-and-fast rules. However, some rough principles for managing cloud-information risk are emerging.

Consider the full range of cloud contracting models

“Public cloud” and “private cloud” are useful simplifications, but there are other models that may provide attractive combinations of control and opportunities to tap vendor capabilities:

  • One option is on-premises managed private-cloud services, in which third-party vendors provide a service that operates like an external cloud offering but is located in an enterprise’s own facility and is dedicated to the organization.
  • Some flavors of virtual private clouds can be used; these are similar to public clouds in that the solution is externally managed, but like private clouds, they offer dedicated capacity, such as resource pools, that are reserved for each client.
  • Community clouds feature infrastructure that is shared by several organizations and meets the needs of a specific community of users. Community clouds may, for example, provide industry-specific solutions that ensure compliance with relevant regulations.

To complicate things further, the maturity of technological and organizational solutions varies by deployment type and by application, vendor, and specific configuration.

Pursue a mixed-cloud strategy

Different workloads and data sets have vastly different stakes when it comes to data protection, depending on the nature of the application and which phase of the software life cycle it supports—for instance, development and test versus live production. The public cloud can be a good option for developing and testing software, since this usually does not involve sensitive data. Any workload that includes personally identifiable customer information will require careful consideration before it could be hosted in a public-cloud environment. Control of data access is also important in order to protect confidential business information and intellectual property. Essentially, any data that has business value or is covered by regulation needs appropriate management and protection (for more on the types of information to manage.

In addition, benefits from cloud migration can vary widely by workload. For example, consumer-commerce sites, where capacity demand spikes during major promotions or at certain times of the year, will benefit from taking advantage of the variable pricing available through highly scalable public clouds.

Sophisticated IT shops are developing tools to map workloads to cloud-based hosting options using criteria like mission criticality, sensitivity of data, migration complexity, and peak processing requirements. This will make it possible for IT staff to pursue a mixed-cloud strategy and drive workloads to the hosting options that best balance risk and economic value.

Implement a business-focused approach

Organizations that have mature risk-management functions—for example, large companies in heavily regulated industries such as banking—should establish a comprehensive risk-management approach for cloud computing that extends beyond technology solutions and the IT department. Design and implementation should cover the policies, skills, capabilities, and mind-sets required of the IT and risk-management organizations, as well as the operating units. The risk-management methodology should address several elements, including transparency, risk appetite and strategy, risk-enabled business processes and decisions, risk organization and governance, and risk culture.

Transparency about the risks of breaches of confidential business information, intellectual property, and regulated information is essential to protecting sensitive data. Fortunately, centralized cloud platforms and expanded operational data available from these platforms allow managers to assess risks, discover breaches, design guidelines based on trade-offs between risk and value, and in many cases automate the enforcement of these guidelines.

To a large extent, the rules for the data that certain groups of employees are authorized to access and the data that must remain in the private cloud can be enforced by the cloud platform itself. Data on the company’s quarterly financial results, for instance, can be automatically blocked from leaving the secure environment of its private cloud until results have been officially released.

For organizations engaged in wholesale cloud migrations, roles and responsibilities will require significant changes—moving from specialized roles, such as server or network managers, to broader roles for integrated service managers. These service managers will be well positioned to steward business risks because their perspective is more comprehensive than that of specialized managers, for example, when making judgments on when to use private- or public-cloud resources.

Nonetheless, the democratized nature of cloud purchasing and usage constitutes risks that automated guidelines cannot fully address. The proliferation of wireless devices that can access cloud computing anytime and anywhere, for instance, extends the reach of the company’s information infrastructure, but by doing so, the information also becomes more vulnerable to breaches. Among the risks: lost or stolen devices with sensitive data stored on them. This means that the mind-sets and behaviors of line staff and managers can have great impact on cybersecurity. As a result, companies must drive risk awareness across the organization and provide risk orientation for new and lateral hires. Linking compliance to compensation through clear metrics reinforces the culture shift.

The cloud in its many forms is an exciting development for enterprise IT, but it also creates new types of challenges in protecting sensitive information assets. A business-focused risk-management approach enables large institutions to strike the right balance between protecting data and taking advantage of more efficient and flexible technology environments.

Printed with permission from McKinsey Quarterly.

What’s in store for China in 2013?

The year ahead could be a time of significant change for everything from banks, retailers, and infrastructure projects to pork prices, soccer, and “compulsory” vacation time.

How might China surprise us in 2013? Read the ten predictions of Gordon Orr, a McKinsey director based in Shanghai, and tell us what you would add.

1. Banks underperform

Mainland banks have undergone a remarkable financial recovery over the past decade, thanks to the sector’s initial recapitalization and China’s rapid economic growth. As the economy slows, however, two issues are of immediate concern: the scale of nonperforming loans left behind after the 2009 economic stimulus and the volume of wealth-management products recently snapped up by retail investors in search of decent returns. The latter may come back to haunt Chinese banks in the same way that structured products plagued Western ones in the early stages of the global financial crisis.

This year could mark the start of a more fundamental transformation that will last several years. Most banks, after all, realize they need to find a different economic and business model, given growth rates that comfortably exceed returns on equity and unsustainable rates of capital consumption. In view of current trends, banks must find 1.3 trillion renminbi ($208 billion) in additional capital over the coming five years.

The challenge, which many banks are ill-equipped to manage, will be to shift from customer-acquisition and “growth at all costs” strategies to more differentiated ones focused on profits. The winners will be institutions that serve the customer well and improve their operational capabilities—among other things, by taking a more robust approach to risk. Complying with decisions of the China Banking Regulatory Commission, for example, must become a much more strategic exercise in future.

2. Pork or chicken prices rise 100 percent

China’s domestic food supply has been strained for years. The country consumes 50 percent of all pork globally, and rising demand for protein, especially pork, is pushing the system beyond its limits. In July 2011, pork prices surged 57 percent for a number of reasons, including the steady exit of swine farmers from the market beginning in 2010 and an outbreak of disease among pigs in late 2010 and early 2011. That could easily happen again, and on a much larger scale, because of failures in farms or in the extremely rudimentary cold supply chain. Imports could not increase on a scale sufficient to fill the gap. The psychological scars from recent food-safety scandals could lead to panic hoarding of substitute products and drive up their prices, too. Although a better food chain will develop over time, this may take several years.

3. Local protests intensify—and succeed more often

In June 2007, local protesters successfully forced the authorities to withdraw plans to build a chemical plant in Xiamen. Since then, a growing number of planned incineration and chemical projects have been withdrawn, postponed, or modified following protests, whose number doubled in the second half of 2012. A “not in my backyard” mentality is becoming common. Since there is no formal process for legitimizing proposed investments in a community, people are willing to protest noisily for an extended period, harnessing the power of social media. They realize that the government has little choice but to intervene with force or to compromise or back down.

In 2013, local protests against both new construction of polluting facilities and the operation of existing ones are likely to intensify. The fear of further damage to health and the environment will increasingly trump the desire for economic growth. Local governments will back down more often.

4. China spends more on infrastructure

Beijing’s airport welcomed more than 80 million passengers last year, and China has the world’s largest network of toll roads and high-speed trains, as well as six of the ten busiest container ports. Yet the high cost of logistics is just one indicator that China needs to build a much more extensive transport infrastructure. Many in government not only recognize this reality but also believe profoundly that it is better to build sooner rather than later.

China lags furthest behind other nations in the number of airports with paved runways: the world’s most populous country has 452 airports, Brazil 713 and the United States 5,194. Forty-four Chinese cities with more than a million people still have no mass-transit system other than buses. The supply chain for agricultural products remains rudimentary.

Most significantly, much of the urban population in all but the top-tier cities lacks modern accommodations, and the rehousing of China’s existing urban residents is considerably less than half complete. The scale of the construction task is all the greater, since many of the residential buildings China put up in the 1980s were of relatively poor quality and will reach the end of their useful lives much sooner than might have been expected at the time.

Manufacturing investment will be strong this year. Capital-intensive Chinese manufacturing continues to earn good returns, and investment in technology across all sectors is boosting productivity, although this is perhaps not such good news for employment.

Infrastructure spending will continue to drive economic growth in 2013, and the vast majority of it will be put to good use. Yet the capital efficiency of many projects lags behind that of global leaders.

5. Online competition bankrupts a major main-street retailer

Online competition has yet to put major retailers in China out of business. Historically, economic growth has been sufficient to support all players, but that is about to change. In third- and fourth-tier Chinese cities, where modern retailing still isn’t well established, online retailers have the biggest edge in product range and prices. But thanks to low-cost distribution and very small markups on consumer-electronics products such as mobile phones, China’s e-retailers are increasingly penetrating “time poor” middle-income households in all cities. The appeal of these players lies not just in low prices but also in convenient home delivery, a trusted payment system, and the ability to return goods quickly and without administrative barriers. Physical retailers are moving online as fast as they can, but for most of them this is a very different business model and one that requires execution skills and a sophisticated online presence they currently lack.

The scale of the Alibaba companies—with $150 billion-plus 2012 sales, up by more than 60 percent—is overwhelming. This year will represent a tipping point for growth in the share of online sales of clothes and electronics. Many Chinese physical retailers, as owners of their own real estate and part of broader conglomerates, may be able to hide their underperformance for a while. But further exits from China by multinationals (following the path of Home Depot, Mattel, and OBI) seem likely.

6. Even the middle classes hedge their bets

It has long been common knowledge that many of the offspring of China’s leaders study outside the country. More and more upwardly mobile people are now following suit. In the past four years, the number of Chinese students applying to boarding schools in the United Kingdom and the United States appears to have tripled; many of these institutions could fill their classes entirely with students from mainland China. Parents are not motivated only by a desire to give their children an alternative to the rote learning that still characterizes much of Chinese education; they are also creating additional options for their children should there be a discontinuity in China.

Private-business owners have an opportunity to give themselves such options by making international investments and acquisitions outside China. With permanent residence on offer in countries such as Australia, Canada, and Singapore in return for an investment of up to a few million dollars, many are taking advantage. Vancouver, in particular, has had a new influx of the kind it experienced from Hong Kong in 1997. Individuals may have fewer options for diversifying their asset base outside the country, but buying real estate is one of them: by some reckonings, the Chinese are now the second-largest acquirers of luxury property in London. Like other forms of “groupthink,” this wave will probably get a lot larger before it subsides.

7. European soccer teams invest in the Chinese Super League

The government-owned Chinese Super League of soccer became a lot more glamorous last year when the star player Didier Drogba joined Nicolas Anelka at Shanghai Shenhua, an ambitious but underperforming team. Yet the Chinese Super League will never fulfill its potential until fans have confidence that the games are clean and that coaches and players are improving. In many other (generally Olympic) sports, China has imported the best coaches and operating models. But not in soccer.

A new leadership intends to privatize the Chinese Super League and welcome international investment as part of an ongoing program of reform. This will allow team owners to develop and retain the full range of revenue streams at a modern sports club’s disposal. International teams from many European countries will invest in leading Chinese teams and rotate players between Europe and China.

8. Investment in overseas agriculture is the “next big thing”

In China, a trend that starts as a trickle often becomes an overnight flood. Outbound investment in commodities and premium agricultural products, for instance, will reach a tipping point in 2013: China has shifted rapidly from a trade balance on agricultural goods to a deficit that’s currently around $40 billion and growing at 50 percent a year. This transformation reflects increased demand in China for basic cereals to feed its expanding livestock populations and a slow-to-restructure domestic industry that can’t supply the need. China is now the second-largest importer of rice and barley and a top-ten buyer of corn. Chinese companies lease hundreds of thousands of hectares from Argentina to Kazakhstan to grow soybeans.

Outbound investors also eye a growing opportunity for premium fruits and vegetables of the kind sorely lacking in China. I don’t mean only state-owned enterprises spending their spare cash. Many private Chinese entrepreneurs, who have been wildly successful in areas from real estate to technology, have identified the food chain as their next big thing. Investing outside rather than inside China is attractive not only for the reasons already mentioned but also to diversify assets geographically and to avoid the high prices paid recently for assets in the domestic food chain. In the last few months, for example, the Shanghai Zhongfu Group diversified from real estate in Shanghai by investing around $728 million in a sugar-cane project in Western Australia. And at a major conference in Beijing in December, Chinese private-equity firms met with senior executives of US food companies and representatives of US state agricultural bureaus to discuss ways of increasing China’s investment in US agriculture.

9. A third-tier city goes bankrupt

Chinese cities still depend on land sales—in many cases, for 30 percent of gross revenue and, in some, for more than 50 percent. However, the supply of attractively located land for sale to developers is not inexhaustible. Some cities, especially those located in areas where manufacturing is in decline, now find that land values are on the slide. The financing vehicles these cities have been using to build projects will no longer work. Recent cases of trust companies bailing out troubled local real-estate concerns represent warning signals that municipalities are in difficulty. Without a bailout from the central government, they will no longer be able to meet their bills. Continuing to roll over loans to state-owned enterprises just pushes the problem a short way into the future.

10. National holiday weeks are abolished (please)

Perhaps this is more a hope than an expectation. Fifteen years ago, when the current structure of mandated vacation weeks was put in place, China’s economy was very different. There was a real belief that, without mandated vacations, most workers would never get a holiday or have an opportunity to spend the income they were saving. Yes, many hundreds of millions did travel during the Chinese New Year period, but far fewer people had migrated from their home towns to new urban environments than have done so today, and far fewer could afford to travel. In this respect, China was not that different from those European countries that mandated vacation weeks in the 1970s.

Today, these compulsory holiday weeks merely serve to saturate and overload the country’s infrastructure—if anything, reducing the amount of money that people spend on travel and related services as more and more choose to stay at home. The growing middle classes can schedule their own vacations when they want to much more readily than they could in the past. Formerly, large numbers of state-owned and private-sector enterprises did not meet the legal requirements for vacations. But in the age of social media, even factory workers can now name and shame offending employers.

Mandated vacation weeks will either gradually decline into irrelevance—starting in first-tier cities—or, better still, they will be formally abolished as an idea that has outlived its purpose.

Printed with permission from McKinsey Quarterly.

Investing in growth: Europe’s next challenge

Although the decline in Europe’s level of private investment from 2007 to 2011 is rarely highlighted as a feature of the region’s financial crisis, it was unprecedented. In fact, during that period, private investment in the European Union’s 27 member states (the EU-27) plunged by a combined total of €354 billion—20 and 4 times the fall in private consumption and real GDP, respectively.

Investment in European Union

Research by the McKinsey Global Institute (MGI) finds that while private investment was the hardest-hit component of GDP, it is also vital for recovery. Even in the face of weak demand and high uncertainty, some investors would start spending again if governments took bold measures to remove barriers that now stand in the way. And companies need not rely exclusively on regulatory changes to take a more fine-grained look at their own investment approaches.

In the past, private consumption has been the driving force behind most economic recoveries. But high rates of unemployment and personal debt have made consumers cautious about spending. Governments are feeling the weight of large debts and pressure to deleverage, so they cannot fill Europe’s private-investment hole themselves by investing or consuming. And while exports have played a significant role in the recovery thus far, they now face headwinds, not least because Europe is its own biggest export market and its overall growth has been anemic.

In contrast, publicly traded European companies had excess cash holdings of €750 billion in 2011, close to their highest real level in two decades. By removing regulatory barriers, European governments could, at a relatively low cost, unlock short-term private investment that would contribute to growth—and inspire confidence in firms that have hesitated to launch their own dormant investment plans.

Skeptics might argue that governments can make a difference only at the margins of the private sector’s investment decisions. But the largest investment potential for private companies lies in capital-intensive sectors such as energy and transportation, where government policy has a significant impact. MGI’s latest research finds that closing only 10 percent of the current subsector variation between countries in capital stock per worker would involve more than €360 billion in additional investment—more than what was lost during the financial crisis.

Such government intervention has a poor track record. “Picking winners” has too often been ineffective and a drain on public money. Instead, governments should consider a new policy for investment: prioritizing sectors in which it is most likely to help renew GDP growth, identifying barriers in those sectors, executing cost–benefit analyses, and building the skills necessary to implement these new policies effectively.

Regulatory change often involves difficult, time-consuming political trade-offs, so businesses looking to invest shouldn’t rely exclusively on regulatory changes, however great the imperative and opportunity. Companies need to examine their own approaches to investment. That might mean taking a more granular perspective on market opportunities (for example, by focusing on “micromarkets,” at the city rather than country level), engineering a step change in capital productivity, or ensuring that the bitter experience of recent years does not screen out potentially attractive opportunities by creating a bias against risk.

Download the entire report.

The global gender agenda

Women continue to be underrepresented at senior-management levels in Asia, Europe, and North America. McKinsey research suggests some answers.

The progress of women toward the upper echelons of business, government, and academia continues to provoke media attention and lively debate. Look, for instance, at the coverage of Marissa Mayer’s July appointment as CEO of Yahoo! and the diverse reactions to an article (“Why women still can’t have it all”) published in the July/August issue of the Atlantic magazine.

Coincidentally, this summer also marked the moment when we released the latest phase of a global research initiative on women in senior management across Asia, Europe, and North America. This effort involved assembling fresh data on the gender composition of boards, executive committees, and talent pipelines, as well as detailed surveys of leading businesses in each region.

Encouragingly, the research shows that a growing number of women, both in senior roles and among the rank and file, are finding their voices and inspiring others to achieve progress. It also demonstrates that more companies are enjoying the benefits of gender diversity and that some have found ways to boost the representation of women at the highest levels of their organizations. From an admittedly low base, for instance, more women sit on European corporate boards (though not executive committees) than did so five years ago. Countries with a clear political commitment to change, in the form of specific quotas or targets, are achieving significant results. Several major corporations are emerging as inspirational role models.

Yet while the vast majority of organizations in developed economies are striving to unlock the potential of women in the workforce, many executives remain frustrated that they have not made more immediate and substantial progress. Firmly entrenched barriers continue to hinder the progress of high-potential women: many of those who start out with high ambitions, for instance, leave for greener pastures, settle for less demanding staff roles, or simply opt out of the workforce. In Asia, cultural attitudes toward child care and household tasks further complicate the challenges for corporate pioneers. And everywhere we look, despite numerous gender diversity initiatives, too few women reach the executive committee, and too few boards have more than a token number of women.

Our research also offered some clues about the characteristics of companies that make the greatest advances in gender diversity. Much depends on the stage of the journey companies have reached. The regional and cultural context matters, too. Still, we were struck by the global applicability of some core principles. Across geographies, we find that a wholly committed senior leadership, active talent management, and more effective efforts to shift mind-sets and change behavior can transform the gender agenda (see sidebar, ‘We’re at a tipping point’).

Global challenges

Women hold 15 percent of the seats on corporate boards and 14 percent of those on executive committees in the United States; 16 percent and 3 percent, respectively, in Germany; 20 percent and 8 percent, respectively, in France; and less than 10 percent on both boards and executive committees in China, India, and Japan. In Scandinavia, the numbers are higher: Norway’s representation is currently at 35 percent and 15 percent, respectively; Sweden’s at 25 percent and 21 percent, respectively.

The representation of women in all regions, moreover, diminishes markedly at each higher management level. Some female executives, of course, leak out of the talent pipeline because they are headed for other or better jobs; others voluntarily draw back from promotions as part of conscious work–life decisions. But a significant number run into a succession of seemingly immovable barriers at key career intersections.

We have long noted the combination of structural obstacles, lifestyle choices, and institutional and individual mind-sets that hinder the advancement of women. But only recently have we started to understand how deeply entwined they are. Men and women tend to be evenly distributed across line and staff roles early in their careers, for example, but women begin a steady and disproportionate shift into staff roles by the time they reach the director level. Lacking the sorts of networks that come more easily to men, many women miss out on discussions with sponsors who might encourage them to stay in the line. Line jobs tend to involve more pressure and less flexibility—less appealing to women forming families or opting for greater control over their lives. Some male executives, with good intent, do not even ask mothers to consider line assignments that involve travel and long hours.

Natural advantages or disadvantages do characterize some sectors, but the situation varies markedly even within them, and contradictions abound. In European financial services, for instance, the rate of attrition is particularly severe by the time women reach middle management. In contrast, our research indicated that some of the top US gender diversity performers were in financial services.

Finally, Asia stands out. The relatively low overall rate of female labor force participation in many Asian countries—though not all of them, for China is a notable exception—means that it is harder to fill the pipeline at the outset. Next, the double burden of Asia’s working women, who must juggle families and jobs, is not only reinforced by cultural factors but also compounded by a lack of government support in areas such as childcare. In many markets, women wait until their children are older before returning to work or (in Taiwan, for example) drop out in their late 20s never to return. Exacerbating matters in much of Asia is an absence of urgency to change the equation. In our recent survey of the region’s senior executives, just 30 percent of respondents said that gender diversity was currently a top priority for their corporations, and only a third saw it as being one of the top ten priorities on the corporate agenda in coming years.

From good to great

These challenges persist at a time when many companies, particularly in North America and Europe, are pursuing an arsenal of measures aimed at easing women’s progress through the organization. Such measures include efforts to make appraisals objective and unbiased; the adoption of diversity targets; greater flexibility in remote working; smoother transitions before, during, and after maternity leave; and executive coaching for high-potential vice presidents. Of the 235 European companies we surveyed recently, for instance, more than 60 percent told us they have at least 20 gender diversity initiatives in place.

Motivations vary. A number of studies find a correlation between high-performing companies and those with strong female representation at the top,3 though correlation does not prove causality. Many CEOs are convinced that mixed boards and mixed executive teams perform better than those dominated by men. As one corporate leader put it, just about every company wants to “get the best brains to work on the problem.” That said, successfully transforming gender attitudes and performance requires much greater leadership attention and dedication than even committed CEOs and top teams are currently giving to it. These goals also call for integrated management and monitoring of women in the talent pipeline from early on to the point when they become eligible to join the C-suite and for intervention to shift widely held beliefs holding back talented women.

Leadership ‘obsession’

Every major cultural, operational, or strategic change in a business requires personal passion, “skin in the game,” and role modeling from senior leaders, and gender diversity is no exception. When a CEO is the chief advocate and “storyteller,” more people (including the often less committed male middle managers) believe that the story matters and begin to adopt the CEO’s mind-set and behavior. Intensely committed CEOs make their goals clear and specific, tell everyone about them, get other leaders involved, and manage talent to help make things happen. CEOs who do not see gender diversity as a top issue fold “gender” into “diversity” and “diversity” into “talent,” thereby losing focus as leadership of initiatives is delegated to others further down the line. CEOs who champion gender diversity, for example, participate in women’s events and multiday talent discussions; less committed CEOs introduce them and leave, inadvertently signaling that other priorities take precedence.

In Europe, many executives tell us that the momentum for change took hold only when the top team made its commitment visible—for example, by appointing women to senior positions or taking measures to ensure that they were considered for certain jobs. Sponsorship is (and always has been) a critical part of an executive’s path to the top. HR leaders tell us that these relationships are hard to institutionalize and that formal programs have mixed success. But we find it significant that one company did much better when the CEO and the diversity leader personally took charge of the sponsorship program, selected a group of high-potential women, and invited them to spend significant time with the top team. Women in the program really got to know the CEO and senior-team members, and vice versa, and most have since moved up the management ladder.

Managing—and cultivating—the pipeline

McKinsey’s more general work on transforming the performance of companies shows that those with a clear understanding of their starting point are more than twice as likely to succeed as those that are less well prepared.4 In a gender diversity context, this understanding means knowing the gender balance at every level of the organization; comprehending the numbers by level, function, business unit, and region; and then monitoring metrics such as pay levels, attrition rates, reasons women drop out, and the ratio between women promoted and women eligible for promotion.

Why go to this expense? Establishing the facts is the first step toward awareness, understanding, and dedication to improvement. Using a diagnostic tool, one company simulated how much hiring, promoting, and retaining of women it would require to increase the number of senior women managers. That approach helped it set an achievable and, just as important, sustainable target that would not compromise a highly meritocratic corporate culture. With an overall target—that 25 percent of managing directors and directors should be women by 2018—and a clear understanding that the bar for promotion could not be lowered, managers now look harder for high-potential women and start working with them earlier to develop that potential.

Incentives tied to managers’ bonuses can help, though some companies fear that targets may undermine the credibility of women at the top. Those in favor of such targets believe that a radical mandate is required for substantial change and worth the backlash from women who ascended “the hard way.” Where targets are rejected, other mechanisms “with teeth” are necessary—almost all the top US performers on gender diversity have goals, if not targets. In Europe, we identified a gap between the measures companies now have in place and how carefully these companies apply and monitor them. Some have targets for women in senior positions, for example, but no plans for implementation; others have targets and plans but fail to communicate them. Companies with cultures inimical to top-down diktats should consider adopting a regular report that candidly evaluates progress and prompts senior management to brainstorm for new ideas.

Shifting mind-sets and behavior

Leaders with the best of intentions may still fall short unless they can change the way they and their organizations think. So if, for example, the prevailing view is that truly committed executives work 24/7 and travel at the drop of a hat, many talented women will turn their backs on further advancement. Such prevailing attitudes are hard to shift: in our experience, that can be done only by role models who challenge them through their actions and by a learning environment that cultivates self-awareness. More women at the top should help, though of course women can be as responsible as men for promoting a culture of nonstop work.

The top performers on gender diversity value and promote inclusiveness. Their leaders firmly believe that mutual respect drives better customer service and hence sales. When such beliefs take hold, they are powerful. One global cosmetics company we know, which operates in 88 countries and has a customer base that’s 90 percent female, now cites gender diversity as one of its key strengths. Another consumer-based business, headquartered in Europe, makes mostly products for men but learned through research that women usually make the buying decision. Increasingly, the company looks to female employees to refine its marketing and product-development approach.

Certain institutional biases are subtle—for example, a reluctance on the part of men to give women the tough feedback everyone needs on their way to the top. Many men, fearing that sponsoring women might seem inappropriate, find it difficult to do so. Most people feel more comfortable promoting those who behave and think as they do. A willingness to question can make a difference. When one company discovered, through an audit of its recruiting processes, that recruiters were more critical of female than male candidates, it devised a training course for the critics. One of them was asked to lead a session and has since become among the company’s most vocal supporters of diversity and inclusion.

The mind-sets—and aspirations—of women themselves are as important as those of the companies that employ them. Interviews with 200 successful middle-management and more senior women in 60 large companies across the United States highlighted some common threads: early career acceleration coupled with significant sponsorship, a willingness to change employers to gain greater opportunities, and a propensity to stay in line jobs for much of their advancement. These women remained optimistic even in the face of significant challenges.

Early-tenure women want to move to the next level as much as men do. Yet we found that only 18 percent of entry- and midlevel women have a long-term eye on the C suite, against 36 percent of men. That finding reinforces our belief that inspirational leaders should intervene with talented female middle managers to discuss their aspirations, build their confidence, embolden them to aim higher, and seek ways to make line roles more palatable for them. In particular, we would emphasize the need for women’s leadership-development programs to focus on personal mastery of thoughts, feelings, and actions and thus to make women accountable for their own future.5 In the average Fortune 500 company, a 10 percent boost in the odds that women will advance from manager to director and then to vice president would yield an additional 90 female executives, including five senior vice presidents and one member of the executive committee.

Four priorities for committed leaders

The widespread applicability of the principles above suggests a short list of actions that should be on every committed leader’s priority list:

1. Treat gender diversity like any other strategic business initiative, with a goal and a plan that your company monitors and follows up at the highest levels over many years. Build in a “report or explain” process and articulate a well-supported point of view on the value women bring to your organization and the case for or against explicit targets. If greater representation of women in the talent pipeline promises a competitive advantage, successful leaders will work hard to include them. If greater female representation better serves the company’s customers, those leaders will make that happen.

2. Ask for—and talk about—the data, sliced and diced to identify ‘pain points’ in the pipeline by business, geography, and function. Go well beyond measuring success by the number of women at the top. Discuss the percentage of talented women at each stage of the pipeline, their odds of advancement versus men’s, and the mix of women between line and staff jobs compared with that of their male counterparts. Make sure your entire top team and those who report to its members are accountable for the numbers, and brainstorm about what it will take to improve them.

3. Establish a culture of sponsorship, encouraging each top executive to sponsor two to three future leaders, including women. Instill a mind-set of “paying it forward,” so that every woman sponsored will in turn sponsor two or three others. Embed effective sponsorship of women into the profile of successful leaders at your company and raise the issue in performance dialogues with your own direct reports. Show your wider commitment by talking with top female talent when you visit regional divisions and business units or participate in external events.

4. Raise awareness of what a diverse work environment looks like, celebrating successes to reinforce the mind-set shifts you desire. Use frequent personal blogs, top-team meetings, and town hall gatherings to communicate what you are doing to drive change. To increase awareness of the new mind-sets, question your own personnel choices, and think about whom you tend to work with and why. Top executives who work hard to encourage diversity of thought across a company will increase everyone’s determination to bring the best to work—ending up not only with what they set out to achieve but with even more: an engaged community that corrects itself when things go off track.

A wide range of global companies made real advances in gender diversity over the past five years. They know that this is hard work—a journey measured in years rather than months. But they also know that improving the pipeline of female talent is possible, with rewards that include tapping the best brains, improving customer service, increasing employee engagement, and everything that comes with these benefits.

Linking jobs and education in the Arab world

The region’s future prosperity depends on its youth. Governments must ensure that young people have the right skills for the jobs being created.

The Arab world is experiencing unprecedented turmoil. Any evaluation of its root causes would include unemployment for youth between the ages of 15 and 24. More than 25 percent of youth in the Middle East are unemployed, the highest such rate in the world, while North Africa reports about 24 percent. Unemployment among young females is even higher, reaching and exceeding 30 percent across the region.

There is wide recognition that if nothing is done, unemployment levels are likely to rise further as a result of a demographic bubble: about one-third of the population is below age 15. As a result, millions of young people will enter the region’s workforce over the next ten years.

So far, the region’s governments haven’t focused sufficiently on a vital component of the employment picture: how to ensure that the region’s young people have the right skills for the jobs being created. To do so, it will be necessary to orient education directly to work opportunities—full- or part-time or even self-employment. There is even less focus on how to encourage the private sector (both employers and education providers) to play a role complementary to that of the government in addressing the region’s pressing needs. A new report based on research by McKinsey,Education for employment: Realizing Arab youth potential, highlights the dramatic gaps in education and employment across the region and provides a private sector–based road map for closing them. The report was commissioned by the International Finance Corporation and the Islamic Development Bank. We base our findings on more than 200 interviews with government officials, employers, education providers, investors, and nonprofit organizations in nine countries and on proprietary surveys of 1,500 employers and 1,500 young people in Egypt, Jordan, Morocco, Saudi Arabia, and Yemen.

Elsewhere in the world, the private sector, both education providers and employers, has played a critical role in providing opportunities for young people. Given the right conditions, it can play the same part in the Arab world as well. The report therefore highlights these messages: demand is substantial for private-sector involvement but supply is limited; vocational education and training, private universities, and work-readiness programs are the major categories of private investment opportunities; and several critical enablers of private participation are missing, such as rigorous standards to ensure that students are taught the right skills. Surveyed private employers tell us that only one third of new graduate employees are ready for the workplace when hired. Consequently, more than half of all employers provide substantial training for their new hires, to ensure work readiness. On the other side, only one-third of the surveyed young people believed that their education prepared them adequately for the job market, expressing strong doubts about the quality and relevance of their programs.

The challenge is big, significant, and urgent. Action is required now: unless all stakeholders come together and embark on ambitious plans to address the employment gaps jointly, the Arab world’s young people face potentially dire consequences.

You can download the entire report from here: http://www.e4earabyouth.com/downloads/IFCBook_A4_Online_Complete.pdf

Talent tensions ahead: A CEO briefing

Looming imbalances in global labor pools could make it harder for some companies to find enough skilled workers and for some less-skilled workers to find jobs.

Technological advances, industrialization, and liberalized trade have created a staggering 900 million nonfarm jobs in developing countries since 1980, lifting hundreds of millions of people out of poverty. As global companies have tapped (and helped fuel the growth of) low-cost labor sources, they also have created high-wage jobs for more than 50 million high-skill workers, while boosting productivity in developed and emerging markets alike.

This virtuous cycle appears to be reaching its limits, however, and there is a growing sense that something has gone wrong with the machinery that, for decades, delivered GDP growth, higher productivity, rising wages, and better standards of living. Indeed, new research from the McKinsey Global Institute (MGI) suggests that by 2020, the world could have 40 million too few college-educated workers and that developing economies may face a shortfall of 45 million workers with secondary-school educations and vocational training. In advanced economies, up to 95 million workers could lack the skills needed for employment.

The projected gaps we identified are notional, and global labor markets will adjust in response to them. But their consequences would be serious: higher levels of unemployment (even as companies struggle to fill select vacancies), rising income inequality, and heightened social tensions testing political stability in countries around the world.

Senior executives and policy makers should study these imbalances closely because together they outline where dangers and opportunities will arise, and they provide a framework that business leaders and policy makers can use to guide their decisions. In this article, we’ll look at the most significant labor imbalances by geography and then discuss the moves companies can begin making now to prepare for the talent tensions to come.

A new world for work

To better understand the evolving global labor market, we analyzed 70 countries, representing 87 percent of global population and 96 percent of GDP. Segmenting these countries by educational achievement (a rough proxy for skill), median age, and GDP per capita highlighted clusters of countries sharing similar attributes (Exhibit 1). Using these clusters as a starting-off point, we modeled a “momentum” base case that combines current trajectories in demographics, GDP, educational attainment, and the supply of and demand for labor by skill level, all with the intention of highlighting potential labor imbalances that companies around the world might soon face. Four areas deserve close scrutiny from senior executives.

China’s high-skill gap

In recent decades, China’s industrialization has moved hundreds of millions of workers from farms into urban manufacturing and services. These changes boosted the country’s GDP per capita and productivity, while providing the developed world with a massive source of low-cost labor. More recently, China has expanded beyond its role as “workshop to the world” and become a vital growth market for global companies operating there.

Yet a confluence of factors—including China’s aging population, the rapid growth of the country’s service sectors, and the move into more skill-intensive manufacturing—means that by 2020 the economy will probably need 23 million more college-educated workers than it can supply (Exhibit 2). This gap, equivalent to 16 percent of estimated labor demand, will probably emerge despite massive investments, already made or planned, in education. (China, for example, is already on track to add more than 50 million workers with a college education by 2020.) The implications of the gap are huge, as an adequate supply of highly educated workers will be critical to securing the growth of higher-value-added industries and the productivity gains needed to sustain China’s GDP trajectory, not to mention realizing the growth aspirations of companies around the world.

Boosting the share of college graduates in the labor force would help—it currently stands at 11 percent—but that will be tough. Getting to 17 percent by 2020 would require more than 85 percent of China’s secondary-school graduates to complete a college education, compared with about 50 percent at present.

What’s more, the country already has one of the world’s highest female labor-participation rates, at 82 percent; increasing that level won’t be easy.

India’s missing middle

India is a much younger country than China, and its shift out of agriculture and up the value curve is proceeding more slowly. From 2000 to 2010, India created just enough nonfarm jobs (about 67 million) to keep pace with the growth of its labor force, but not enough to move workers out of agriculture in substantial numbers. Consequently, India faces a unique set of labor market imbalances. In fact, it could be among the few countries with a surplus of highly skilled workers: in our momentum case, 36 million college graduates will join its labor force in the coming decade, about 6 million more than its domestic industries can employ.

Nonetheless, the share of India’s working-age population with a secondary education is less than half that of China and many other developing economies. Further, India’s relatively low secondary-school graduation rate could mean a shortage of medium-skill workers, such as plumbers and welders, to fill the jobs created by the country’s burgeoning construction, manufacturing, retail- and wholesale-trade, and service sectors. All told, we project a gap in medium-skill workers of 13 million, or about 10 percent of demand in 2020 (Exhibit 3). India already faces a shortage of medium-skill workers, a fact reflected in high wage growth for vocationally trained people in sectors such as construction and mining.

Finally, if current population and education trends persist, India could have 27 million too many low-skill workers by 2020. This growing surplus of low-skill workers implies adverse social outcomes: millions of people trapped in low-productivity, low-income jobs. India would need an unprecedented increase in job creation and education levels (including vocational education) to address these labor market challenges.

From surplus to shortage

As China’s labor force growth slows in coming decades, the young developing countries we studied, a group that includes Bangladesh, Kenya, Morocco, and Nigeria,3 will contribute about one-third of the growth in the global labor force. Today, these countries have ample numbers of college-educated workers—often more than their industries are ready to employ. In North African countries, for example, unemployment among highly educated workers is 20 percent, which is worse than the 8 percent rate for workers with only a primary education. (This difference reflects the fact that lower-skill workers engage in subsistence activities to survive in the absence of social safety nets.)

The labor surplus many of these countries have won’t last forever, because their economies are growing much faster than those of the developed world and represent important markets for multinational companies. African countries, in particular, have garnered significant attention in recent years as destinations for investment, and new research from MGI finds the continent has large untapped job potential in agriculture, manufacturing, and the retail and hospitality industries.4

Nonetheless, if current growth, population, and education trends persist, we conservatively project that the countries of sub-Saharan Africa and South Asia (excluding India) could have a shortage of 31 million workers with a secondary education by 2030 (Exhibit 4). Furthermore, young developing countries will need to find work for about 30 million low-skill workers with no education or only primary schooling. By 2020, the surpluses will represent 14 percent of the supply of such workers in these countries.

Addressing such imbalances will require young developing economies to more than double the growth of educational attainment and to raise their secondary-enrollment and -completion rates.

High-skill shortage, low-skill surplus

Advanced economies, including those in Europe and North America, face daunting challenges, too. Trends in educational attainment and projected employment needs indicate that employers there will require 16 million to 18 million more college-educated workers than will be available in 2020, a gap representing 11 percent of demand.

The skill gap will be widest in Southern Europe, where educational attainment is lowest and populations are relatively old. These countries could have 3.5 million too few college graduates in 2020. Other advanced economies with high median ages—such as Germany—could face a shortage of college-educated workers equivalent to 10 to 11 percent of demand, despite relatively high college completion rates. In the United States, a demographically younger economy, the gaps will be less severe: perhaps 1.5 million too few workers with college or graduate degrees by 2020.

Meanwhile, the advanced economies are likely to face an excess supply of low- and medium-skill workers. Our analysis of demand patterns indicates that in 2020, there could be 32 million to 35 million more workers without post secondary education than employers will need—a surplus equivalent to 10 percent of the supply of these workers. That surplus implies a range of adverse social and economic outcomes: higher unemployment rates (even during periods of economic expansion), rising numbers of discouraged workers who opt out of the labor force permanently, and more workers forced to accept marginal jobs, resulting in downward pressure on wages.

The oversupply of low-skill labor will be most acute where educational attainment is lowest. Current demand trends suggest that in 2020, as many as 16 percent of Southern Europe’s roughly 50 million workers without a post secondary education could be unable to find employment.

Bridging the high-skill-worker gap would require raising young people’s rate of college completion by 2.5 times the historical rate of increase, and simultaneously raising participation rates of college-educated women and older workers at over twice the historical rate of increase. Even this won’t suffice to deal with the surplus of low-skill workers: the rate of job creation for them would need to be at least five times higher than it was in the past to create enough job opportunities.

What business can do

As we’ve said, labor markets are dynamic: wages will adjust in the face of imbalances; workers will relocate; and the nature of work itself will continue to evolve. Technology has a critical role to play—both helping workers perform higher-skill jobs than they otherwise could and serving as a powerful aggregator of skills. (Consider how 20,000 low-skill workers in southern India are using smartcards, mobile phones, and kiosks to disburse microloans or how Amazon’s Internet marketplace, Mechanical Turk, enables businesses to outsource simple tasks, such as writing product descriptions.)

The uneven distribution of skills and needs means that business leaders must develop a finer-grained view of shifting labor dynamics. By anticipating trends in education, aging, and incomes, executives can better tune their recruitment, offshoring, and investment strategies. In addition to sizing pools of appropriately skilled workers, companies will need to assess the quality of educational systems and the market forces that determine—often at the level of individual cities—the wage differentials among employees.

And then companies will need to take action. For those competing at the high end of the labor market, a deficit of high-skill workers implies an intensifying global war for talent. Companies worried about losing the skills and institutional knowledge of older employees as they retire may need to provide them with more flexible options. In Japan, for example, Toyota Motor aggressively recruits among its retiring employees to bring workers back in half-time roles at the company or its affiliates.

Of course, business leaders will be establishing their labor strategies in an environment set by policy makers, who should focus on raising the output of educational systems and eliminating barriers to creating jobs for less-skilled workers. Looming labor market tensions suggest it would be unwise to take that context for granted. Particularly in high-demand STEM (science, technology, engineering, and math) disciplines, companies can play a larger role in shaping the educational content of colleges. The Great Minds in STEM initiative, for example, is committed to increasing attainment in these subjects among Hispanic students through an extensive community and school outreach program facilitated by corporate partners such as Boeing, Lockheed Martin, and Northrup Grumman. Some companies may even want to participate directly in the large and fast-growing market for education and training.

Companies also can influence the context by focusing their corporate-social-responsibility efforts on youth unemployment and helping to bring the long-term unemployed back into the workforce. Beverage-maker Diageo, for instance, set up Tomorrow’s People, a UK-based charity that has helped more than 400,000 of the long-term unemployed find jobs, education, or training. Three-quarters of the people it helps to place remain employed after a year. Diageo supported the charity, now an independent entity, with operational and financial help, as well as access to jobs in businesses it owns.

By taking decisive action now, companies and policy makers can help ensure that over the next two decades a growing global labor market continues to provide the opportunities and benefits it did over the past 30 years. Companies would continue to access the talent they need to sustain growth and create opportunities. Workers, in advanced and developing economies alike, would enjoy clearer paths out of poverty, along with improved—and improving—living standards.

Printed with permission from McKinsey Global Institute

A CEO’s guide to innovation in China

Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; here’s a road map for navigating it.

China is innovating. Some of its achievements are visible: a doubling of the global percentage of patents granted to Chinese inventors since 2005, for example, and the growing role of Chinese companies in the wind- and solar-power industries. Other developments—such as advances by local companies in domestically oriented consumer electronics, instant messaging, and online gaming—may well be escaping the notice of executives who aren’t on the ground in China.

As innovation gains steam there, the stakes are rising for domestic and multinational companies alike. Prowess in innovation will not only become an increasingly important differentiator inside China but should also yield ideas and products that become serious competitors on the international stage.

Chinese companies and multinationals bring different strengths and weaknesses to this competition. The Chinese have traditionally had a bias toward innovation through commercialization—they are more comfortable than many Western companies are with putting a new product or service into the market quickly and improving its performance through subsequent generations. It is common for products to launch in a fraction of the time that it would take in more developed markets. While the quality of these early versions may be variable, subsequent ones improve rapidly.1

Chinese companies also benefit from their government’s emphasis on indigenous innovation, underlined in the latest five-year plan. Chinese authorities view innovation as critical both to the domestic economy’s long-term health and to the global competitiveness of Chinese companies. China has already created the seeds of 22 Silicon Valley–like innovation hubs within the life sciences and biotech industries. In semiconductors, the government has been consolidating innovation clusters to create centers of manufacturing excellence.

But progress isn’t uniform across industries, and innovation capabilities vary significantly: several basic skills are at best nascent within a typical Chinese enterprise. Pain points include an absence of advanced techniques for understanding—analytically, not just intuitively—what customers really want, corporate cultures that don’t support risk taking, and a scarcity of the sort of internal collaboration that’s essential for developing new ideas.

Multinationals are far stronger in these areas but face other challenges, such as high attrition among talented Chinese nationals that can slow efforts to create local innovation centers. Indeed, the contrasting capabilities of domestic and multinational players, along with the still-unsettled state of intellectual-property protection (see sidebar, “Improving the patent process”), create the potential for topsy-turvy competition, creative partnerships, and rapid change. This article seeks to lay out the current landscape for would-be innovators and to describe some of the priorities for domestic and multinational companies that hope to thrive in it.

China’s innovation landscape

Considerable innovation is occurring in China in both the business-to-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as communications equipment and alternative energy. Interestingly, even as multinationals struggle to cope with Chinese innovation in some areas, they seem to be holding their own in others.

The business-to-consumer visibility gap

When European and US consumers think about what China makes, they reflexively turn to basic items such as textiles and toys, not necessarily the most innovative products and rarely associated with brand names.

In fact, though, much product innovation in China stays there. A visit to a shop of the Suning Appliance chain, the large Chinese consumer electronics retailer, is telling. There, you might find an Android-enabled television complete with an integrated Internet-browsing capability and preloaded apps that take users straight to some of the most popular Chinese Web sites and digital movie-streaming services. Even the picture quality and industrial design are comparable to those of high-end televisions from South Korean competitors.

We observe the same home-grown innovation in business models. Look, for example, at the online sector, especially Tencent’s QQ instant-messaging service and the Sina Corporation’s microblog, Weibo. These models, unique to China, are generating revenue and growing in ways that have not been duplicated anywhere in the world. QQ’s low, flat-rate pricing and active marketplace for online games generate tremendous value from hundreds of millions of Chinese users.

What’s keeping innovative products and business models confined to China? In general, its market is so large that domestic companies have little incentive to adapt successful products for sale abroad. In many cases, the skills and capabilities of these companies are oriented toward the domestic market, so even if they want to expand globally, they face high hurdles. Many senior executives, for example, are uncomfortable doing business outside their own geography and language. Furthermore, the success of many Chinese models depends on local resources—for example, lower-cost labor, inexpensive land, and access to capital or intellectual property—that are difficult to replicate elsewhere. Take the case of mobile handsets: most Chinese manufacturers would be subject to significant intellectual property–driven licensing fees if they sold their products outside China.

Successes in business to business

Several Chinese B2B sectors are establishing a track record of innovation domestically and globally. The Chinese communications equipment industry, for instance, is a peer of developed-world companies in quality. Market acceptance has expanded well beyond the historical presence in emerging markets to include Europe’s most demanding customers, such as France Télécom and Vodafone.

Pharmaceuticals are another area where China has made big strides. In the 1980s and 1990s, the country was a bit player in the discovery of new chemical entities. By the next decade, however, China’s sophistication had grown dramatically. More than 20 chemical compounds discovered and developed in China are currently undergoing clinical trials.

China’s solar- and wind-power industries are also taking center stage. The country will become the world’s largest market for renewable-energy technology, and it already has some of the sector’s biggest companies, providing critical components for the industry globally. Chinese companies not only enjoy scale advantages but also, in the case of solar, use new manufacturing techniques to improve the efficiency of solar panels.

Success in B2B innovation has benefited greatly from friendly government policies, such as establishing market access barriers; influencing the nature of cross-border collaborations by setting intellectual-property requirements in electric vehicles, high-speed trains, and other segments; and creating domestic-purchasing policies that favor Chinese-made goods and services. Many view these policies as loading the dice in favor of Chinese companies, but multinationals should be prepared for their continued enforcement.

Despite recent setbacks, an interesting example of how the Chinese government has moved to build an industry comes from high-speed rail. Before 2004, China’s efforts to develop it had limited success. Since then, a mix of two policies—encouraging technology transfer from multinationals (in return for market access) and a coordinated R&D-investment effort—has helped China Railways’ high-speed trains to dominate the local industry. The multinationals’ revenue in this sector has remained largely unchanged since the early 2000s.

But it is too simplistic to claim that government support is the only reason China has had some B2B success. The strength of the country’s scientific and technical talent is growing, and local companies increasingly bring real capabilities to the table. What’s more, a number of government-supported innovation efforts have not been successful. Some notable examples include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

Advantage, multinationals?

Simultaneously, multinationals have been shaping China’s innovation landscape by leveraging global assets. Consider, for example, the joint venture between General Motors and the Shanghai Automotive Industry Corporation, which adapted a US minivan (Buick’s GL8) for use in the Chinese market and more recently introduced a version developed in China, for China. The model has proved hugely popular among executives.

In fact, the market for vehicles powered by internal-combustion engines remains dominated by multinationals, despite significant incentives and encouragement from the Chinese government, which had hoped that some domestic automakers would emerge as leaders by now. The continued strength of multinationals indicates how hard it is to break through in industries with 40 or 50 years of intellectual capital. Transferring the skills needed to design and manufacture complex engineering systems has proved a significant challenge requiring mentorship, the right culture, and time.

We are seeing the emergence of similar challenges in electric vehicles, where early indications suggest that the balance is swinging toward the multinationals because of superior product quality. By relying less on purely indigenous innovation, China is trying to make sure the electric-vehicle story has an ending different from that of its telecommunications protocol efforts. The government’s stated aspiration of having more than five million plug-in hybrid and battery electric vehicles on the road by 2020 is heavily supported by a mix of extensive subsidies and tax incentives for local companies, combined with strict market access rules for foreign companies and the creation of new revenue pools through government and public fleet-purchase programs. But the subsidies and incentives may not be enough to overcome the technical challenges of learning to build these vehicles, particularly if multinationals decline to invest with local companies.

Four priorities for innovators in China

There’s no magic formula for innovation—and that goes doubly for China, where the challenges and opportunities facing domestic and multinational players are so different. Some of the priorities we describe here, such as instilling a culture of risk taking and learning, are more pressing for Chinese companies. Others, such as retaining local talent, may be harder for multinationals. Collectively, these priorities include some of the critical variables that will influence which companies lead China’s innovation revolution and how far it goes.

Deeply understanding Chinese customers

Alibaba’s Web-based trading platform, Taobao, is a great example of a product that emerged from deep insights into how customers were underserved and their inability to connect with suppliers, as well as a sophisticated understanding of the Chinese banking system. This dominant marketplace enables thousands of Chinese manufacturers to find and transact with potential customers directly. What looks like a straightforward eBay-like trading platform actually embeds numerous significant innovations to support these transactions, such as an ability to facilitate electronic fund transfers and to account for idiosyncrasies in the national banking system. Taobao wouldn’t have happened without Alibaba’s deep, analytically driven understanding of customers.

Few Chinese companies have the systematic ability to develop a deep understanding of customers’ problems. Domestic players have traditionally had a manufacturing-led focus on reapplying existing business models to deliver products for fast-growing markets. These “push” models will find it increasingly hard to unlock pockets of profitable growth. Shifting from delivery to creation requires more local research and development, as well as the nurturing of more market-driven organizations that can combine insights into detailed Chinese customer preferences with a clear sense of how the local business environment is evolving. Requirements include both research techniques relevant to China and people with the experience to draw out actionable customer insights.

Many multinationals have these capabilities, but unless they have been operating in China for some years, they may well lack the domestic-market knowledge or relationships needed to apply them effectively. The solution—building a true domestic Chinese presence rather than an outpost—sounds obvious, but it’s difficult to carry out without commitment from the top. Too many companies fail by using “fly over” management. But some multinationals appear to be investing the necessary resources; for example, we recently met (separately) with top executives of two big industrial companies who were being transferred from the West to run global R&D organizations from Shanghai. The idea is to be closer to Chinese customers and the network of institutions and universities from which multinationals source talent.

Retaining local talent

China’s universities graduate more than 10,000 science PhDs each year, and increasing numbers of Chinese scientists working overseas are returning home. Multinationals in particular are struggling to tap this inflow of researchers and managers. A recent survey by the executive-recruiting firm Heidrick & Struggles found that 77 percent of the senior executives from multinational companies responding say they have difficulty attracting managers in China, while 91 percent regard employee turnover as their top talent challenge.

Retention is more of an issue for multinationals than for domestic companies, but as big foreign players raise their game, so must local ones. Chinese companies, for example, excel at creating a community-like environment to build loyalty to the institution. That helps keep some employees in place when competing offers arise, but it may not always be enough.

Talented Chinese employees increasingly recognize the benefits of being associated with a well-known foreign brand and like the mentorship and training that foreign companies can provide. So multinationals that commit themselves to developing meaningful career paths for Chinese employees should have a chance in the growing fight with their Chinese competitors for R&D talent. Initiatives might include in-house training courses or apprenticeship programs, perhaps with local universities. General Motors sponsors projects in which professors and engineering departments at leading universities research issues of interest to the automaker. That helps it to develop closer relations with the institutions from which it recruits and to train students before they graduate.

Some multinationals energize Chinese engineers by shifting their roles from serving as capacity in a support of existing global programs to contributing significantly to new innovation thrusts, often aimed at the local market. This approach, increasingly common in the pharma industry, may hold lessons for other kinds of multinationals that have established R&D or innovation centers in China in recent years. The keys to success include a clear objective— for instance, will activity support global programs or develop China-for-China innovations?—and a clear plan for attracting and retaining the talent needed to staff such centers. Too often, we visit impressive R&D facilities, stocked with the latest equipment, that are almost empty because staffing them has proved difficult.

Instilling a culture of risk taking

Failure is a required element of innovation, but it isn’t the norm in China, where a culture of obedience and adherence to rules prevails in most companies. Breaking or even bending them is not expected and rarely tolerated. To combat these attitudes, companies must find ways to make initiative taking more acceptable and better rewarded.

One approach we found, in a leading solar company, was to transfer risk from individual innovators to teams. Shared accountability and community support made increased risk taking and experimentation safer. The company has used these “innovation work groups” to develop everything from more efficient battery technology to new manufacturing processes. Team-based approaches also have proved effective for some multinationals trying to stimulate initiative taking.

How fast a culture of innovation takes off varies by industry. We see a much more rapid evolution toward the approach of Western companies in the way Chinese high-tech enterprises learn from their customers and how they apply that learning to create new products made for China. That approach is much less common at state-owned enterprises, since they are held back by hierarchical, benchmark-driven cultures.

Promoting collaboration

One area where multinationals currently have an edge is promoting collaboration and the internal collision of ideas, which can yield surprising new insights and business opportunities. In many Chinese companies, traditional organizational and cultural barriers inhibit such exchanges.

Although a lot of these companies have become more professional and adept at delivering products in large volumes, their ability to scale up an organization that can work collaboratively has not kept pace. Their rigorous, linear processes for bringing new products to market ensure rapid commercialization but create too many hand-offs where insights are lost and trade-offs for efficiency are promoted.

One Chinese consumer electronics company has repeatedly tried to improve the way it innovates. Senior management has called for new ideas and sponsored efforts to create new best-in-class processes, while junior engineers have designed high-quality prototypes. Yet the end result continues to be largely undifferentiated, incremental improvements. The biggest reason appears to be a lack of cross-company collaboration and a reliance on processes designed to build and reinforce scale in manufacturing. In effect, the technical and commercial sides of the business don’t cooperate in a way that would allow some potentially winning ideas to reach the market. As Chinese organizations mature, stories like this one may become rarer.

China hasn’t yet experienced a true innovation revolution. It will need time to evolve from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common. The government will play a powerful role in that process, but ultimately it will be the actions of domestic companies and multinationals that dictate the pace of change—and determine who leads it.

Printed with permission from McKinsey Global Institute