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.

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.