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.

China’s High-Speed Railways: A Work of the Ministry?

Earlier this year, in newspapers, on TV, and over the Internet, China’s state media triumphantly announced the country’s breakthrough in high-speed trains. According to reports from Xinhua, China’s state news agency, China now has the world’s “longest high-speed railway tracks, fastest high-speed trains (running at 380 km/h), and largest scale of high-speed railway under construction”.

How have foreigners responded to these announcements? In March, soon after the Chinese media blitz, Japanese business executives criticized the Chinese for “steal(ing) technology and compromis(ing) safety (in speedup)”. In April, newspapers like The New York Times worried about IP issues as China was expected to export its high-speed trains. In October, when the California governor Arnold Schwarzenegger was on a shopping tour to buy low-costs Chinese bullet trains, The Financial Times wrote a long editorial piece on “how China digests (or steals?) the technology” (October 8). However, none of these responses questioned the content of the Chinese claims. Indeed, China’s leadership in high-speed railway systems seems to be well-founded.

The fear is that the Chinese will take over one industry after another by implementing similar “digesting” strategies, defined by China’s Ministry of Railway as improving and innovating on the basis of imported foreign technologies. Those who are familiar with China’s history of technology development over the past thirty years would cast doubts on such a quick conclusion. From the late 1980s, Chinese officials began to talk about the so-called digesting strategies, based on imitating the successes of Japan and South Korea. Yet, from automobiles to pharmaceuticals to semiconductor chips, many of China’s expensive state projects have failed.

It is rare for the technology import and digest projects to be conducted by a strong arm of the government. In the case of rail transport, however, the Ministry of Railway owned the country’s entire railway system, plus dozens of super-large state-owned train makers with annual sales of billions of RMB. The railway system is essentially a national monopoly, which enabled it to act like a business group in collectively and aggressively bargaining with foreign partners, Germany’s Siemens, France’s Alstom, Japan’s Kawasaki Heavy Industries, and Canada’s Bombardier. Lured by the world’s largest high-speed railway market, the four foreign companies compete with each other so fiercely that they are all suspected of transferring to the Chinese more of the advanced technologies than they had agreed to provide.

In many other technology-digest projects conducted by weaker ministries, China’s decentralized development pattern gave enormous incentives to local governments to foster growth, but it also created too much governmental competition, manifested in greater concessions to attract multinationals. Such competition generally undermined the state’s ability to leverage China’s big market in bargaining with the powerful multinationals. Before the success of high-speed railways, the norm of the Chinese state technology-digest projects was to pay a lot and only get a little.

The other difference in railways is the technological sophistication of the Chinese firms involved. Historically most Chinese state-owned enterprises (SOEs) were badly managed, at least before the major restructuring of SOEs in 1998. Many of the SOEs involved in state projects had little capability to learn new skills or engage in technology upgrading. But railways were different because of a history of attempts to learn from abroad. As early as 1990 the Ministry of Railway began sending engineers to France and Japan to learn the high-speed technology. The first Chinese home-grown high-speed model was a system called “Spring City” developed in 1998 in a state lab located in a ministry-owned SOE. The “Spring City” engineering team was subsequently involved in developing the China Star of 2002 and in later technology transfer programs. As a result, a few of the SOEs in railways were technologically quite sophisticated before entering the digest project.

In sum, the main reason for China’s success in high-speed trains is the Ministry of Railway’s system of innovation.

China’s technology standard strategy: more than a standard war?

As a component of its development strategy, China has been creating its own indigenous technological standards. One of the most high profile examples is TD-SCDMA, the Chinese home-brewed 3G wireless network standard, implemented in 2007. Although there were plenty of skeptics, both within China and abroad, of the commercial viability of TD-SCDMA, the Chinese state has demonstrated its strong determination to construct the network based on this standard. China Mobile, the world’s largest wireless carrier in terms of user subscriptions, has been charged with the construction of the TD-SCDMA network. To ensure TD-SCDMA chip fabrication, in 2009, Datang Holding, the primary technology company that is developing this standard, injected USD 171.8 million into financially constrained SMIC, China’s largest pure-play chip fabrication company.

In recent research, Dan Breznitz and Michael Murphree of Georgia Institute of Technology have found that there are thousands of standards being proposed every year in China, and the state enforces hundreds of new standards annually. They argue that the Chinese state has induced domestic corporations and research institutes to join the innovation arms race of technological standard-making with enhanced social visibility, abundant financial support, and lucrative monopoly rents. It seems that the world’s industrial juggernaut is waging a total war on the battleground of technology standards.

Yet some observers have raised doubts about the actual contribution of indigenous innovation to the technology standards war. In several high profile cases of China’s “own” technology standards, foreign technology partners controlled the majority of the patents embedded in these standards. Three global telecommunications leaders contributed up to 66% of all patents used in TD-SCDMA, while Datang, the state appointed national champion, holds only 7.3%. In the case of CHBD, China’s own high-definition blue-ray videodisc technology, the technology alliance formed by Chinese companies purchased 90% of the patents from foreign technology partners, mostly Toshiba, the Japanese consumer electronics giant. Despite the question of whether the Chinese standard is really made in China, researchers like Breznitz and Murphree have also pointed out that competing standards may force Chinese companies to hedge the risk of being marginalized in the market by spreading their already thin R&D expenditure over the development of several lines of incompatible products, which in turn diminishes the possibilities of major breakthroughs.

Does this mean that China’s standard-making efforts are a waste of money? Probably not. The Chinese state and Chinese industry have benefited from this strategy in two ways. The first is the reduced royalties that Chinese industry has to pay to foreign standard owners. Chinese exporters are well known for relying on foreign standardized technology for production, and royalty payments burden their thin profit margins from assembling imported components. A classic example is the Chinese video compact disc (VCD) player industry, which exploded in the mid-1990s, but went into a crash when foreigners tightened their revenue-collecting efforts in the late 1990s. After the introduction of indigenous technology standards, dramatic changes occurred. With the emergence of a credible threat that they would be cut off from the Chinese market, foreign standard owners significantly lowered the royalty payments that they demanded. In some extreme cases such as WCDMA handsets, Chinese manufacturers paid lower royalties than anywhere else. Indeed in most sectors, China does not seek to replace the global standard with the domestic one; instead, it uses the development of an indigenous standard as a source of bargaining power.

The other benefit is the opportunity of engaging in technological learning and technological leverage. The lucrative rewards of holding a state-selected standard have drawn Chinese corporations into the innovation race. For many of these companies, it is necessary for the first time to have a formal structure supporting R&D activities. For fear of losing a large market like China, multinational corporations are also compelled to engage in China’s standard making projects. Local firms thus are provided with ample opportunities to learn from foreign partners by working with them and forming partnerships. A proven example is Huawei, which greatly accelerated its pace of technology development by forming partnerships with global leaders in all three competing 3G-network technologies.

Can Money Buy China Innovative Capabilities?

The Financial Crisis has accelerated the shift of economic power from West to East in many ways: one of them is that more and more cash-strained American and European companies have been looking for buyers from their counterparts in emerging economies, particularly China. Last month, Geely, a Chinese car manufacturer, set a new record by completing the acquisition of Volvo, the Swedish premium car maker, from Ford for $1.5bn. Meanwhile, the largest foreign investment in Germany’s engineering sector for years came from Sany, a Chinese industrial conglomerate. Sany will build a machinery plant near Cologne to gain access to Germany’s rich engineering skills.

For years Western media have been talking about Chinese state-owned enterprises, backed by Chinese state banks, buying strategic assets, such as minerals, oil, and gas, all over the globe. But the newest players in the merger & acquisition game come from more competitive sectors with diversified ownership. Profits from China’s booming domestic market certainly helped companies like Geely and Sany to be in the position to do the acquisitions mentioned above. Remember that not that long ago, in 2006, Sany failed in its bid for Xugong, a state-owned heavy machinery maker, in competition with Carlyle Group, the US private equity firm. This year, Sany is already the market leader in sectors such as concrete pumps, with enough confidence – and cash – to “push into Germany’s heart and soul” (Financial Times, August 11). Indeed, aided by the Chinese state’s “walking out” strategy, which plans to utilize the country’s inexhaustible foreign reserves to help make Chinese companies global players, Chinese companies are increasingly adept at obtaining technological knowledge, managerial experience, and, more recently, global brands through overseas acquisitions.

Never before in world history has a country in the process of development been so deeply involved in offshore acquisitions. East Asian economies such as Japan, Korea, and Taiwan rarely engaged in outward investment at a similar stage in their development. Instead these economies confined themselves to establishing public institutions to help domestic firms to identify, import and absorb foreign technologies, as well as to nurture domestic innovative capabilities. With “walking out” through outward investment, has China discovered a new way, or even a shortcut, to technological advancement and capabilities accumulation?

So far, China’s record of using overseas acquisitions to strengthen its capabilities remains a mixed outcome. Successful stories include Lenovo’s successful integration of IBM’s personal computer business, which not only consolidated Lenovo’s position in the domestic market, but also helped the company leapfrog into being a competitive player in both US and EU market. But there are failures. The high-profile acquisition in 2006 of France’s Thomson by TCL, the world’s largest television maker at that time, turned out to be a waste of time and money. By the time TCL closed most of its facilities in Europe, it lagged behind its aggressive domestic rivals in next-generation flat screen products. Overseas acquisitions of strategic assets can accelerate enterprise growth, but these foreign acquisitions may be at the expense of investments in indigenous innovation.

Last month, China surpassed Japan as the second largest economy in the world in terms of nominal gross domestic product. But it is still too early to say that China has outperformed other East Asian developmental states in building innovative capabilities, through various policy options it experimented including outward investment. China’s GDP per capita is only 1/30 that of Japan. And more critically, when Japan achieved the position of the number two economy in the world in the late 1960s, a group of world-class companies like Toyota, Sony and Toshiba had already emerged. In climbing the technological ladder, corporate China has a long way to go.

Innovative Enterprise and the Historical Transformation of China

In his Economic Manuscripts of 1861-63, Karl Marx wrote, “Gunpowder, the compass, and the printing press were the three great inventions which ushered in bourgeois society.” But Karl Marx might have not well realized that the origins of these great inventions can be traced back to Ancient China, which in his eyes is a stagnant peasant society. Indeed, despite generating numerous inventions of historical significance, Ancient China failed, as a society, to evolve into a dynamic socioeconomic system. To this day, scholars ponder the “Needham Puzzle”: the question of why capitalism ceased to advent amid the economic prosperity of ancient Chinese empires.

But the sentimental age of craftsmen’s ingenuity is gone forever. After centuries of decline and impoverishment, China has emerged (again) in last decade as a budding economic superpower. However, much of China’s current growth is built upon exploiting its large population base and consuming scare natural resources. The Chinese economy is steaming forward, but the risk of such growth model increases even faster. If the ongoing Dalian oil spill is just another warning of the huge environmental costs of China’s stunning GDP growth, the recent widespread labor unrest (see my last entry) is seriously questioning the sustainability of its inequitable growth. Once again, the country is facing an old problem: how to transform the economy so that it generates sustainable prosperity?

The only way out is innovation, as I had been advocating in this blog. Innovation, by definition, generates more and better goods and services with fewer costs of resources; by increasing productivity it creates more value, value that could be distributed among a larger population. Then the question is how to engage in innovation in the age of information?

As elsewhere, China relies business enterprises to house most of its innovative activities, either inside large industrial conglomerates or clusters of smaller, specialized firms. It is rarely the case today that a small company, not to mention an isolated individual, is capable of innovation. Modem innovation is a collective, cumulative and lengthy process. Its complexity requires the integration of a wide range of capabilities over a long period of time, with an uncertain chance of success. Even a slightly improvement on a single industrial product may requires teams of specialists from different areas to work together for months. An example is the recent “Antenna gate”, in which it takes approximately three months for Apple, one of the most innovative companies on this planet, to fix a small design flaw of its latest iPhone 4.

The analysis of the innovatin process requires, as Professor William Lazonick has shown, a theory of innovative enterprise. The transformation of China into an innovative economy depends on how its business enterprisess develop capabilities to overcome the uncertain, collective, and cumulative process of innovation. For example, it has been a “puzzle” of why some China’s companies become efficient and innovative players even in the most competitive sectors without being privatized, as advocated by many economists. The theory of innovative enterprises would argue that it is the control over the allocation of resources, and not necessarily the form of ownership, that determines successful industrial performance. Groups of professional managers with the incentives and abilities to allocate resources to innovation gained strategic control of these enterprises. They implemented incentives to ensure organizational integration so that people engaged in the enterprise’s hierarchal and functional division of labor would expend their efforts and apply their skills to the collective processes of transforming technology and accessing markets. They also ensured that the enterprise would have the financial commitment required to sustain the cumulative innovation process until it could generate financial returns. As Qiwen Lu showed in his pioneering book, China’s Leap into the Information Age (Oxford University Press 2000), strategic control, organizational integration, and financial commitment underpinned the innovative success of minying (people-run) companies such as Legend (Lenovo). On the other hand, the story of Foxcom’s suicidal workers tells that the building of innovative organization of production is far from complete. In addition, to encourage more companies invest in innovation, China also need its financial sector to actively aid companies to endure the high fixed costs of lengthy innovation, which till today lacks the financial commitments to most of the country’s private sector.

Ancient Chinese demonstrated how a nation could lose its wealth and status when it failed to transform the ingenuity of invention into the collective and cumulative process of innovation. It will not be difficult to predict that, the success or failure of the modern China’s innovative transformation will have a similar impact to the world and history.

Managing Labor Relations for Innovative China

Over the past month, labor unrest has beset China, now the world’s factory. The problem has flared up particularly in South China, where a large proportion of the nation’s manufacturing is concentrated. Strikes against Honda and then Toyota closed the car makers’ assembly lines as workers demanded wage increases. Foxconn, the world’s largest contract manufacturer, has been haunted by a spate of much-publicized suicides by factory workers, apparently in protest against excessive workloads and limited pay. As strikes have spread across the country, China seems to be entering a turning point of its labor-capital relations.

Have these strikes and suicides marked the end of the cheap labor era? Probably not. China has a considerable way to go to reach the so-called “Lewis turning point”, a term that economists use to refer to the exhaustion of surplus agricultural labor in the process of industrialization. Last year China’s urban population was less than 55% of the total; there are still huge numbers of Chinese workers in the countryside who can be attracted to urban manufacturing centers, thus placing downward pressure on wages. Meanwhile, for decades productivity has been growing much faster than wages, so that Chinese workers will still be considered cheap labor even after years of wage increases.

The labor unrest will not diminish the attractiveness of China to foreign investors, either. Other than cheap labor, the accumulated investment in productivity, infrastructure, and industrial clusters will still make China a critical link in the global supply chain. The vast and growing domestic market, pumped up further by the higher incomes of the working class, will continue to lure multinational companies to China. Multinationals that have already invested heavily in China will not be chased away by labor unrest, the purpose of which is to secure a larger slice of the growing economic pie.

The real challenge for Chinese industry is whether, before its competitive advantage in cheap labor is gone, it can develop “high-road” labor practices that stress both rising productivity and rising real wages. To obtain higher living standards for its citizens, Chinese industry must generate higher quality, lower cost products even as it pays its workers higher real wages. Put differently, Chinese industry must engage in innovation that supports economic development. China will be doing nothing new. Ever since the Industrial Revolution, in nations such as Great Britain, Germany, United States, and Japan, the foundations of economic development have been the same: innovative business enterprises have accumulated the productive capabilities that have made higher wages consistent with sustained competitive advantage.

China is on its way to becoming an innovative economy; an obvious sign is its innovative enterprises, such as the global telecommunication leader Huawei, fast learning car manufacturer Chery, global leading solar energy provider Yingli, state-owned but very innovative steel producer Baosteel, and many more. But the innovative transformation is not inevitable, particularly when a business model stresses cheap labor practices instead of an equitable distribution of the gains from productivity growth. For example, a leading company like Foxconn maintains an outdated Taylorist management style on the shop floor, where strict managerial rule forces workers to maintain high levels of throughput but segments them from the learning processes through which they could contribute to real productivity growth. The recent suicide scandal demonstrates the limits of such practices. The danger is that a company such as Foxconn will choose to shift production to global locations with lower wages and a more malleable labor force instead of investing in a more innovative organization of production in China.

This article has aslo been published on the ChinaAnalysis Monthly Newsletter Issue 24, July 2010.