About Yin Li

As a graduate student of economic development, my interest is in understanding innovation, which in my belief, the key dynamism of a modern economy. Through visionary strategy, mobilized organization, and committed resources, successful industrial enterprises generate innovations that have shaped national economy and the world we are living in. Since the beginning of 20th century, innovative enterprises have played the central role in the rise of the American, European and Japanese economy. Now a similar process is inevitably happening in China, which I am devoting this blog to.

New competitors from China’s hinterland

For a long time, the image of China’s high-tech exports has been linked with consumer electronics assembled in the country’s export processing zones. Within a global production network controlled by multinationals, components made by US, Japanese and Korean companies gathered in China’s coastal cities have been processed, assembled, and exported to the world market. This system is exemplified by the famous iPod model, “designed in California” and assembled in China. Today China continues to assemble iPods, but the overall pattern of China’s high-value-added export has vastly changed in the past few years.

According to a white paper produced by Economist Intelligence Unit (EIU), a consultancy, China is rapidly expanding the exports of technology- and capital-intensive products. In particular, the Chinese are invading the capital equipment export market, the traditional stronghold of US, Japanese and Korean multinationals. Between 2007 and 2010, China’s share of global export increased from 14.4% to 28.4% in shipbuilding, from 18.6% to 26.3% in motorcycles, and from 16.9% to 22.4% in derricks and cranes. As the Chinese export lower costs and higher quality products, they have become even more competitive in the markets of the developing world. In sectors like electric trains, tractors, and construction equipment, virtually all Chinese exports are going to non-OECD countries where the market shares of incumbent multinationals are shrinking rapidly.

While China’s share of world manufactured exports is steadily increasing, the share of China’s exports produced by foreign-invested manufacturers is declining after reaching its peak of around 60% in 2005. Thus, it is the indigenous Chinese companies that are making inroads into the mid- and high-end export market. More surprisingly, the new competitors are increasingly coming from China’s inland provinces instead of the developed coastlines. Take the construction equipment segment as an example. Formidable Chinese competition comes from three companies, Sany, Zoomlion, and Xugong. While the long-running national champion Xugong from coastal Jiangsu province was the first to enter the global top ten in 2009, the private company Sany and Zoomlion from inland Hunan province both leapfrogged Xugong to become the world’s 7th and 9 thlargest in 2010. The domestic leader, Sany is now not only ramping up its production bases in Brazil and India, but also tapping into the German engineering talent pool to produce in the heartland of Europe.

Compared with the electronic assembly lines in the coastal provinces, new competitors in the capital goods segments have developed entire supply chains. Their strong growth is rooted in abundant skills and industrial infrastructure developed in the Mao era. From the 1950s to the 1970s before the economic reform, China’s central planners overwhelmingly favored investment in heavy industry, particularly in inland China. Though most of the state-owned enterprises created at that time ran into difficulties with subsequent mass lay-offs in the 1990s, the significant improvement in business management and the abundant supply of machinists and metallurgists has transformed the industry. As inland China has gained access to the world market by the improvement of transportation infrastructure in the last decade, these indigenous firms quickly took advantage of the demand opportunities provided by first the booming domestic market, and now the whole developing world.

The rapid growth of these new competitive firms is now contributing to an economic boom in China’s hinterland. And indeed, the prosperity of the Chinese economy will be ultimately dependent on the innovativeness of these companies.

Going West and Climbing Higher?

Some recent evidence suggests that a profound transformation of the industrial landscape in China is under way. First of all, migration of mass manufacturing activities from traditional export centers in Southern and Eastern coastal cities to the inland is accelerating. The world’s largest PC makers and their contract manufacturers are establishing new factories in the Southwest: Hewlett-Packard (No.1 PC vendor by shipments), Acer (No. 2) and AsusTek (No. 6) have chosen Chongqing, while Dell (No. 2) and Lenovo (No. 4) have chosen Chengdu of Sichuan Province. When these new plants run at their full capacity, industrial analysts expect that Chongqing and Chengdu will become the world’s largest manufacturing base for notebook and tablet computers, respectively. China’s populous Chongqing and Sichuan Province, once characterized as poor and rural and the country’s major sources of migrant workers, are going to be transformed into immense industrial hubs.

The drivers of this large-scale industrial migration are a sharp rise in labor and land costs as well as labor shortages in established manufacturing centers in Eastern and Southern China. In addition, the new manufacturing locations are well-serviced by infrastructure after a decade of government investment under the campaign of “Developing the West”. This migration of mass manufacturing presents a new challenge of growth for the developed coastal cities. While shifting manufacturing to the inland, multinationals are also transferring more managerial and R&D functions to China, with some cities being better positioned than others to attract this high-end employment. Regional headquarters of multinationals in Shanghai rose to 305 in 2010, up from 224 in 2008, according to the Shanghai statistics bureau (Financial Times, May 25). Intel has just sent an executive vice-president to Beijing as chairman of its China operations, a clear sign of the expansion of higher-end activities in the country.

Other cities may not be so lucky. According to recent Chinese reports, eighty percent of the Shanzhai cell phone manufacturers in the Shenzhen area have gone bankrupt since the beginning of the financial crisis. Although started as local-made lookalikes of foreign brands as the Chinese characters suggested, some scholars of industry have characterized the Shanzhai cell phone makers as a “Chinese way of innovation”. Based on turnkey solutions for combined chip, platform and third-party apps (provided by Taiwanese company MTK), clusters of small cell phone suppliers had been very successful in making cheap phones with gaudy features and shiny looks that pleased low-income Chinese and foreign consumers. Some 200 million unbranded Shanzhai cell phones were sold in 2010, and a large portion went abroad. Yet the faster than expected conversion to 3G-capable smart phones has destroyed the Shanzhai business model; at this stage at least, it is difficult for chip suppliers to commoditize the sophisticated smart phone platforms. The small Shanzhai manufacturers that used to implement incremental innovations on less advanced technologies in the 2G era now have neither the capability nor the financial resources to develop 3G smart phones.

 

The BYD Way of Production, Emerging but Incomplete

In history, innovative ways of manufacturing have underpinned the rise of great carmakers. Such is the story of Ford’s assembly lines, and such is the story of the Toyota production system. When China’s BYD launched its commercial plug-in hybrid electric cars in December 2009, a year ahead of Toyota and two years ahead of GM, the world witnessed the unfolding of a new production system. Only a year later, BYD demonstrated its innovative capabilities, again, by deploying its electric technologies to a new line of buses in order to penetrate the U.S. market. What gives BYD the capability to generate these innovative products?

At a glance, what distinguishes BYD from today’s conventional carmakers seems to be a rare vertically integrated business model. Many researchers highlight the effectiveness of integrating battery production and car manufacturing in applying the company’s advanced battery technologies to the development of electric cars. But BYD’s level of vertical integration is well beyond integrating two business segments. Unlike most carmakers that rely on a contract network of component suppliers, BYD produces almost all parts of its cars in-house, from engines, transmission systems, steering systems, and braking systems, to wipers, indicator mirrors, and even CD and DVD players. The only exceptions are tires, windshields, and a few of the most generic components.

What are the innovative capabilities that BYD derives from this unusual integrated structure? Like any newcomer to the car industry, the technology barriers faced by BYD in making a modern vehicle were enormous. Though BYD acquired a bankrupted state-owned carmaker in 2003, the deal provided BVD with the state sanction to enter the business rather than useful industrial expertise. Instead of adopting the easy strategy of licensing technology from multinationals, BYD chose to develop its proprietary technologies through reverse engineering – a strategy shared by many indigenous carmakers. The army of young engineers employed by BYD, nearly 10,000 today, learnt to make cars essentially by imitating designs from Japanese carmakers, aiming to follow the Japanese low-cost, high-quality manufacturing techniques. In its R&D centers, BYD disassembles a targeted car model, and then modifies it, replacing patented components with customized ones, to form a new design. This radical learning methodology has enabled BYD to generate its proprietary technologies rapidly, with an accumulation of more than 2,000 patents in 2007 after only four years of entering the industry.

A reliance on customized components produced in relatively small volumes, as a result of indigenous learning, may cause significant cost problems for conventional carmakers. But by drawing on its capabilities in process innovation developed from manufacturing batteries, BYD has used its in-house production model to transform such disadvantages into advantages. In the battery business, BYD is well known for outcompeting the Japanese manufacturers by reaping a significant cost advantage from its labor-intensive manufacturing process. It is less known that BYD’s engineers developed this manufacturing process. By redesigning the workflow and deploying in-house produced machinery, BYD’s workers are able to produce batteries by hand with quality comparable to those made by automated machines, but at a much lower cost. Similar innovation strategies have been extended to car manufacturing. Semi-automated processes are developed to replace automated machines, with workers aided by tools produced in-house to ensure consistent quality. In the case of BYD’s own plug-in hybrid, all the manufacturing equipment is produced in house. The ability to deploy in-house produced equipment of newer technology and lower costs at a faster pace than its competitors has significantly contributed to BYD’s early breakthrough in the production of electric cars.

BYD’s vertically integrated structure provides the context, not the source, of the competitive advantage of the company’s emerging production system. The real source of BYD’s advantage is an engineering force that engages in learning and develops unique productive capabilities. Such a system is built upon long-term investments in a learning organization, with BYD situating R&D divisions in every workshop, and spending two-thirds of its R&D budget on process innovation.

Nevertheless, BYD’s model of innovation has a serious limitation, i.e. learning is confined to the managerial structure. Process engineers break down work into simple tasks to ensure consistent quality and fast pace, leaving high workloads, long working hours and tedious task assignments on shop floor. The BYD model is yet to be tested by major labor unrest. But its failure to extend learning to the shop-floor casts doubt on whether BYD can eventually outperform the Toyota production system, which long ago included shop-floor workers into the processes of organizational learning.

Chuanfu Wang, Founder and CEO of BYD, has a famous saying: “the manufacturing of cars starts with manufacturing of talents, then tools, and then cars”. Indeed, Mr. Wang has done far better than most of his fellow entrepreneurs in China in fostering growth through investing in employees. Yet the BYD way of production will only become a formidable force when Mr. Wang and his techno managers can integrate their some 100,000 workers into a unified learning system.

 

Government Policy and the Growth of the Chinese IC Industry

On February 9th, the first workday after the Chinese New Year, the State Council of China released the country’s first industrial policy of this year: “policies on further encouraging the development of software and integrated circuit (IC) industry”. Known as New Document No. 18 by the Chinese IC industry community, this policy replaces the one expired that at the end of the year 2010. The continued commitment of the Chinese government to supporting the IC industry meant that all major Chinese IC companies, including foundries and fabless design houses, saw a rise in their stock prices on the day after the policy announcement.

Released in 2000, the original Document No. 18 was one of China’s most influential industrial policies. Adopting an import substitution strategy, Document No. 18 offered a series of favorable tax treatments to domestically produced IC chips, in addition to heavy government investment in infrastructure, education and basic research. The United States, the world’s largest IC chip exporter, has viewed Document No. 18 as a threat to the competitiveness of its semiconductor industry. In 2005, by complaining to the WTO for China’s violation of trade rules, the United States forced China to drop most of Document No. 18’s value-added-tax (VAT) rebate for IC producers located in China. But other industry-promoting policies besides the VAT rebate in Document No. 18 remained effective until the end of 2010.

For the Chinese IC industry, Document No. 18 launched a decade of fast growth. During this time, China’s share of world IC chip production rose sharply from less than 1% in 2000 to almost 9% in 2009. Today, China produces 60,000 million semiconductor chips annually. The chip industry’s export revenue increased from US$1,690 million in 2000 to US$23,300 million in 2009, according to CCIDnet. Since the implementation of Document No. 18, large-scale semiconductor clusters not only have consolidated in China’s costal manufacturing centers, such as Yangtze River Delta, Pearl River Delta, Beijing, and Tianjin, but also are emerging in inland Wuhan and Sichuan Province. During this time, giant semiconductor multinationals accelerated the relocation of their productive capabilities, from back-end packaging and testing to chip design and manufacturing, to China. But most of all, the spectacular growth is driven by indigenous Chinese competitors. A Shanghai-based startup in 2000, SMIC( 中芯国际) has already become the world’s fourth largest chip contract manufacturer, operating the largest and most advanced chip fabrication facility in China.

Yet even after ten years of fast growth, China still needs to import roughly 80 percent of the chips it consumes today. In 2010, China spent more money on importing IC chips (US$156,990 million as the largest category of imports) than on crude oil (US$135,150 million) and iron ore (US$79,430 million), according to trade data from China Customs. Even though the trade deficit in semiconductors is primarily the result of the country’s re-export processing business, it nevertheless lays the background for the government’s continued involvement in industry promotion.

Indeed, as early as 2005, the Chinese IC industry was seeking new forms of subsidies from the government when the VAT rebate was terminated. Regional governments, from the high-income metropolitan areas of Shanghai and Beijing to relatively poor Wuhan and Chengdu, have all invested heavily in the construction of extremely expensive semiconductor fabs in their municipalities. The New Document No. 18 legitimizes such subsidies, allowing budget money from central and regional governments to be allocated to subsidize technological upgrading. Moreover, the new policy plans to contract government R&D projects to these IC firms, aiming at nurturing R&D capabilities at the firm level.

With the implementation of the New Document No. 18, the growth of the Chinese IC industry is likely to accelerate again. But will the policy promote the emergence of more innovative firms? As this column pointed out earlier, the social conditions of innovative enterprise require strategic control, organizational integration and financial commitment. Even with the intensive involvement of the Chinese government, the decision-making process has remained inside the firms, so the strategic control over the allocation of resources by executives of chip companies has stayed intact. The investment from the government is likely to be long-term, low-cost financial commitment. What remains in questions is whether these Chinese firms will be able to build learning organizations to engage in the uncertain, collective and cumulative process of innovation. The New Document No. 18 calls for using stock-based compensation to place incentives for the managers and engineers in these high-tech firms, following the paradigm of the Silicon Valley model. It could be a good idea, as long as the Chinese policy makers can prevent the companies from being “financialized”, with key people in these companies becoming more interested in making money for themselves than in generating high quality, low cost products for their companies.

The Companies that Build the Chinese Auto Dreams

Although it was expected that China would become the next major competitor in the world auto market after Japan and South Korea, that day seems to be coming much earlier than anticipated, particularly with the implementation of clean technology. The State of California, America’s leader in enforcing environmental regulation, has recently selected a low-cost Chinese auto manufacturer to supply green technology for its public transportation system. According to The Financial Times, China’s BYD is going to build electric buses for California’s public projects by the end of 2011. Moreover, BYD’s hybrid electric cars will be running on the roads of the Golden State even sooner. On December 17, 2010, the Housing Authority of the City of Los Angeles announced that it would deploy a fleet of BYD’s F3DM (Dual Mode) cars at its office in downtown Los Angeles. These hybrid vehicles will be able to run on electricity for 40 to 60 miles after one charge, but may also switch to plug-in-hybrid electric mode for traveling more than 60 miles within a day.

BYD, whose initials stand for Build Your Dreams, is another example of China’s growing manufacturing capabilities. Founded in 1995 as a cellphone components producer, the company had its first success in China’s exploding domestic demand for cellphones in the late 1990s. By the early 2000s, BYD had already established itself as the world’s largest producer of handset batteries, supplying major cellphone vendors such as Motorola, Nokia, and later Apple’s iPhone. In 2003 the company entered car manufacturing one year after acquiring a bankrupted Chinese state-owned carmaker. It was said that in making this decision, Chuanfu Wang, BYD’s founder and CEO, had confronted fierce opposition from shareholders, some of whom even threatened to commit suicide. Yet Wang’s strategic vision soon justified his iron-fisted resolve. The fast expanding urban middle class of China in the late 2000s ignited the low-cost car market. While acclaiming the potential value of its capability in batteries for building electric cars, BYD heavily exploited the traditional compact car market by producing cheap cars priced for less than US$10,000. By the seventh year after its establishment, the carmaker had already built one million cars for Chinese consumers. This year, BYD’s annual sales are expected to increase from 400,000 in 2009 to somewhere between 600,000 and 800,000, making it China’s fastest-growing carmaker. In 2009, BYD launched its first all-electric vehicle, and one year later, it transferred its electric car technology into a new line of instantly marketable electric buses. By penetrating the US market with the low-cost green technology, Chuanfu Wang’s stated ambition for BYD to become the world’s largest car company by 2025 must be taken seriously.

The battery-turned-electric car company is among several innovative Chinese carmakers that have emerged within the last decade. Today, many of these companies, such as BYD, Chery, and Geely have already become international players. Starting as low-cost competitors in the domestic market, these indigenous companies, however, were not expected to lead the Chinese auto industry. China’s industrial policy from the 1990s was encouraging its giant state-owned carmakers to form joint ventures with leading multinationals, hoping to leverage their access to foreign technology. Yet most of the joint ventures became almost subsidiaries of the multinationals, relying on foreign partners to supply new models and brands so as to generate quick revenues and profits. While China’s mainstream media often criticized the new non-state-owned companies for producing inexpensive but low-quality cars and for infringing copyrights in their car designs, companies like BYD, Chery and Geely have been actually engaged in indigenous innovation. Chery, for example, is the first Chinese carmaker to implement Toyota’s lean production system. Rather than being captured by foreign technology partners, Geely is expected to leapfrog its technological capabilities through its acquisition of Sweden’s Volvo from Ford. After receiving a capital injection of US$231 million from Warren Buffet’s Berkshire Hathaway in 2008, BYD is pushing electric cars and new energy development in China with a rare vertically integrated model.

Why have these non-state-owned companies succeeded where giant national champions have failed? A report written by Feng Lu and Kaidong Feng of Peking University in the mid-2000s concluded that indigenous innovation is these carmakers’ source of growth. If these companies had only been interested in making quick money, as has been the case with many Chinese joint ventures, they would not have had the incentive to invest heavily in an R&D workforce. In setting their sights on generating higher-quality and lower-cost products, these new indigenous companies have built powerful learning organizations that have enabled them constantly to climb the technological ladder. In fact, as Lu and Feng observed, these new competitors have been able to assemble teams of high-quality engineers from state-owned enterprises that have eschewed an indigenous innovation strategy. Today, the divide between two types of companies, resulting from two different investment strategies, is increasingly obvious.