Can China innovate?

Yu Zhou
Professor of Geography, Vassar College

We know that China can manufacture at low costs, but can Chinese companies innovate? With many of China’s exporting markets face prolonged recession, the question is becoming more urgent. For China to become a worthy global economic engine, it has to move beyond specializing in cheap-labor exports. Evidence is mounting on both sides. On the one hand, China claims the world’s largest number of engineering graduates and the second highest amount of R&D spending. Its registered patents exceeded those of Germany in 2007. On the other hand, China’s rigid political and educational systems are seen as crippling creativity. Chinese enterprises sit low in the global production chain so they have low profit margins with little room for long-term R&D investment. China’s weak intellectual property rights protection is another popular explanation for lack of innovation. Debates also rage on who will lead Chinese technological changes. Some believe that multinational corporations (MNCs) are the leaders. Others believe that China has become too dependent on Western technology. The Chinese government stresses “indigenous innovation” as a national priority.

I argue in my book, “Inside Story of China’s High-tech Industry: Making Silicon Valley in Beijing“, that Chinese domestic companies can become technology leaders, but only when they successfully collaborate with foreign MNCs. My research traces the emergence and development of China’s high-tech industry since the mid-1980s in Beijing’s Zhongguancun–the so-called China Silicon Valley. By detailing the stories of the region, collected over six years through interviews, I argue the following:

1. MNCs have limitations in bringing technological transformation to China. Chinese firms have a competitive edge in the home market, which may serve as a launching pad for their international ambitions in the long run.

Foreigners often assume that if a large multinational company, say HP or Google, is successful in the United States and elsewhere, it should also be successful in China. If it is not, the Chinese government is blamed for unfair treatment. But the reality is that China is a vast, regionally fragmented, rapidly evolving and largely low-income market. It is challenging for MNCs to reach beyond China’s affluent core. In contrast, Chinese domestic firms understand their home court better, and have greater commitment and flexibility. Successful Chinese companies have served the Chinese market with their access to competitive, reliable, and high-quality component suppliers—the same suppliers that MNCs use for exports. The Chinese companies then target the Chinese market with special designs, pricing and marketing that enable them to beat foreign-brand competition. This is the story of Lenovo, Huawei and many other successful Chinese high-tech companies. Though they are not at the cutting-edge of technology at the beginning, they have always been extraordinarily effective in bringing new technology to the Chinese market at an affordable price.

2. The key constraint for Chinese companies to produce cutting-edge innovation is the Chinese market, but this will change.

Many believe that the lack of innovation by Chinese companies has to do with their low R&D capacity. This is only partly true. It is worthwhile to remember that almost all Chinese technology companies were established after the mid 1980s, and also that most have emerged only in the 1990s. This short history sets them apart from business power houses in Japan, South Korea and even India.

But beyond their inexperience, capital capacity, and technological lag, the key constraint for the Chinese companies to innovate is the Chinese market. Michael Porter in his book The Competitiveness Advantage of Nations argues that it is the quality of the domestic market that is critical for national competitiveness. A technologically sophisticated market pushes innovation by forcing the companies to constantly upgrade their products. Yet Chinese consumers value low-price and lack experience with many products. Most have yet to attach the same importance to the quality, design, and newness of products that consumers in advanced economies do. This provides little incentive and reward for cutting-edge innovation by domestic companies. It is not surprising, indeed it should be expected, that most Chinese companies would concentrate on following the MNCs’ lead in making products cheaper and better suited to Chinese customers rather than blazing their own paths. But as the market evolves with sustained higher income and more sophisticated consumer tastes, one can bet that Chinese companies will evolve with it by offering more innovative products.

3. The competition between Chinese indigenous firms and MNCs is not a zero-sum game.

The growth of Chinese companies does not crowd out foreign companies. It is tempting to view the competition between MNCs and domestic firms as one side trying to eat the other’s lunch. But the prevailing pattern is actually a relationship of collaboration. Virtually none of the Chinese products are made without MNCs’ components. This is true for both hardware and software. China’s most popular enterprise management software by UFIDA, a domestic company, uses an Oracle database. As domestic companies cultivate and expand the market, MNCs have an enlarged consumer base for their products.

Some critics from China lament the lack of innovation in China, and imagine that if only Chinese scientists put their minds to innovation with ample state funding, innovation would take place. The truth is that domestic companies cannot generate globally significant technology unless they work with MNCs. Chinese companies are actively learning from MNCs how technologies, markets, and human resources are managed in the modern world.

In turn, MNCs have learned from local firms’ marketing expertise to enhance their market performance. For example, when Nokia and Motorola suffered setbacks in marketing cell phones in China in 2002-2004, they managed to regain the market by adjusting marketing strategies in part modeled after local competitors’ regional distribution channels. Overall, the increased involvement of MNCs in China in the past 20 years has been accompanied by, and indeed dependent upon, the growing competence of local Chinese companies. By partnering with Chinese companies, MNCs can penetrate far larger markets than would be possible relying on their own work force. The interdependence of Chinese and foreign firms can be seen regionally. The regions with more advanced development of indigenous companies are the same regions where one can find a greater presence of MNCs in more diverse fields, not the other way around. It is uncommon to find foreign technology firms work alone very successfully in the Chinese market without major Chinese business partners.

Innovation is a long term process, and can only be approached step by step, not just by a few strong companies in China but by succeeding generations of them, collaborating with foreign companies. My research in Beijing’s Zhongguancun has found that there have been rapid generational successions in the region, from a first generation of competitive Chinese personal computer makers in the 1980s, to an entrepreneurial Internet generation in the 1990s to current overseas returnee-founded high-tech companies in the 2000s. In the last two decades, Chinese indigenous companies have moved a long way in capital capacity, management expertise and technological sophistication. In the end, it is the development of these indigenous companies, not MNCs or the Chinese government, that will ultimately determine the extent to which China controls its technological destiny, and how much China can contribute to the world economy.

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.

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.

Does China Need Billionaires to Spur Innovation?

It is often asserted that a high level of income inequality is necessary to induce innovation. One can point to the billionaires connected to successful companies like Intel, Microsoft, Cisco, Yahoo!, and Google whose fortunes have been made through their ownership of large shareholdings and the gains from exercising stock options. The existence of NASDAQ, as a highly liquid stock market for high-tech companies, has made these fortunes possible, but it is not clear that the creation of billionaires was necessary for the innovation process to occur. It must be remembered, moreover, that in the boom of the 1998-2000, many promoters of Internet companies made hundreds of millions of dollars by cashing in on the speculative stock market, even when the companies themselves turned out to be total failures.

China is now on the way to embracing this type of financialized business model, as the country seeks to transform into an innovation-based economy. Approximately six months ago, China launched ChiNext, the long-awaited NASDAQ-style board for high-tech start-ups. Due to the “extraordinary enthusiasm of investors” (Caijing, Nov 2, 2009), the first day of trading created 13 paper billionaires based on their declared stakes in the 28 IPO companies. The biggest winners of that day were Pu Zhongjie, CEO of Lepu, a pharmaceutical company, and Wang Zhongjun, Chairman of Huayi Brothers, a film company. Both Pu and Wang saw the value of their holdings exceed RMB3 billion. A total of 116 shareholders became instant tycoons with a combined value on paper of over RMB100 million. Yet such wealth still cannot compare to the gains of the husband-and-wife team of Li Li and Tan Li from the recent initial public offering of Hepalink Pharmaceutical. After the company sold 10 percent of its shares on the Shenzhen SME Board last month, the 80 percent pre-sale stake owned by Mr. and Mrs. Li was worth RMB42.6 billion (US$6.2 billion). Overnight, this low-profile couple became the richest people in China. Meanwhile Goldman Sachs’ original US$4.9 million investment in Hepalink in 2007 is now worth US$975 million (RMB6.7 billion).

While the new stock markets are creating enormous wealth for entrepreneurs and financiers, are they providing the financial foundations for the transformation of new ventures into innovative businesses? In the six-month experiment of ChiNext, 87 companies raised US$8.5 billion, according to the Wall Street Journal. Many of these companies have relatively long operating histories (in some cases as long as ten years) developing technology for niche markets. But, given their narrow niches, even the most outstanding companies seem to be overvalued in terms of their growth potential For example, Hepalink, which recorded the highest IPO price-earnings ratio – 73 – in the history of the Chinese stock market, relies almost exclusively on the export of heparin, a pharmaceutical ingredient for blood thinner extracted from pigs’ intestines, to three US pharmaceutical producers as the only Chinese exporter accredited by the US Food and Drug Administration. In the case of Hangwang, which raised RMB1.1 billion last month in its Shenzhen-based IPO, the company leads China’s e-reader market and has a growth potential as the technology provider to multinational companies of Chinese/Asian language handwriting recognition on touchscreen handsets. Even then, however, Hangwang’s key value generator, the e-reader, possesses little in the way of distinctive technology, and is gradually losing its price advantage to new low-cost competitors.

At the same time, for all the ultrarich people who have emerged from these IPOs, how many will continue to lead their companies to generate innovative products? Among these new tycoons, Li Li of Hepalink stands out as a technological innovator for perfecting the process of extracting heparin. Yet even in his case, it is difficult to see why his contributions to innovation warrant his ranking as the richest person in China. It is the highly speculative stock market rather than the value of his contributions to technological innovation that has accorded him this lofty position.

The danger now exists that the Chinese will adopt the ideology, widespread in the United States, that only the promise of enormous riches can spur smart people to provide their skills and efforts to the innovation process. In an advanced economy such as the United States, the creation of high-tech billionaires is the result of the emergence of successful companies in a highly financialized economy rather than a necessary inducement for entrepreneurs and managers to supply their skills and efforts to build these successful companies (see the research of the European Commission project on Finance, Innovation and Growth: ChiNext may be creating instant billionaires but will it support continued investment in innovation, which is an uncertain, collective, and cumulative process?

This article has aslo been published on the ChinaAnalysis Monthly Newsletter Issue 23, June 2010.

Evaluating SOE Performance: Do Top Executives Deserve Their Bonuses?

This year, China’s largest state-owned enterprises (SOEs), including China Petro, China Mobile, Sinosteel, State Grid, and other industrial giants, are facing a new 3-year Performance Evaluation policy from the Chinese state. Effective Jan. 1, 2010, this new policy requires the SOEs governed by SASAC (State-owned Assets Supervision and Administration Commission of the State Council) to calculate their net profit by taking into account the opportunity cost of capital, both debt and equity. The initial cost of capital is set as 5.5%. In essence, the concept of EVA (economic value added) is being used to evaluate the performance of the SOE top executives.  SASAC now governs 128 central SOEs, with US$3 trillion in assets, US$3 trillion in sales, and 12 million employees, concentrated in sectors of national priority, such as energy, transportation, communication, and heavy machinery (the 30 national financial companies are not governed by SASAC).

The new evaluation policy represents an attempt to constrain executive compensation at SOEs.  With the transformation of SOEs into huge profit centers over the last decade, SOE executive compensation has grown rapidly. Government officials disclosed that in 2007 senior managers earned 18 times the average pay of workers in China’s SOEs.  Although this number is well below the US ratio (360 in 2007), the official survey may well underestimate the gap. In Beijing, the annual salary of a fresh graduate is 40 to 80 thousand RMB annually, and of a middle manager in SOEs 200 to 400 thousand RMB. There are many news reports of SOE top executives who are paid more 2 million RMB. In 2006 Jiafu Wei, CEO of COSCO (HKSE 0517), was reportedly paid 18 million RMB, making him the highest paid SOE executive in China. In 2007 China Ping An Insurance Co. (HKSE 2318), an ex-SOE and publicly traded company, paid Mingze Ma, the CEO, 66 million RMB, which is 1,000 times more than an entry-level position. Executive pay in SOEs is becoming a highly controversial issue in the Chinese society, particularly with regards to companies that enjoy a position of regulated monopoly.

The new policy may restrain the compensation of top executives, as it is estimated that half of the SOEs being affected currently produced a negative EVA. But if the experience of executive pay in the United States is a guide, Chinese executives will counter with financial behavior and accounting tricks that will produce positive EVA, and justify their pay increases, even if the sustainable growth of the companies they oversee is compromised. More generally, a focus on “bottom-line” measures such as EVA is a poor way to evaluate the performance of a company. Rather, the state should provide “patient capital” to encourage sustainable growth and investment in innovation, and evaluate company performance in terms of the actual development and utilization of productive resources.

Background: Currently, there are approximately 113000 state-owned or state-controlled enterprises in China. The 128 central SOEs governed by central SASAC are among the largest corporations in China, and many of them enjoyed monopoly position or shared market with a few SOEs, as these sectors are considered of strategic importance in the national economy. Data from Ministry of Finance shows that in 2009, the total profit of SOEs (excluding the financial sector) in China was RMB1.34 trillion (approximately US$0.2 trillion) in 2009, among which RMB0.7 trillion was generated by central SOEs. Not long ago in 1998, the total profit of SOEs national wide was only RMB21.3 billion, with 2/3 of all SOEs having deficit.

The newsletter issue 21, April 2010 is a compact version of this article.