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.

 

Can China innovate?

Yu Zhou
Professor of Geography, Vassar College
yuzhou@vassar.edu

Nowadays, it has become fashionable to talk about the technological potential of China. But unlike the case of the United States or other western countries, the question of China’s technological progress almost always revolves around the role of the Chinese state. Romo (2004), for example, credited the strategic emphasis of the Chinese state in innovation as the first of three theorems in his famous “Beijing Consensus.” China observers also routinely scrutinize Chinese governmental documents to foretell the changing directions of state industrial policy. Given China’s recent accomplishments on high speed rail and super computers, feats made through a centralized state-sponsored system, such discussion has a reasonable foundation. Within China, many intellectuals also see the role of the state as a decisive factor, although they disagree on the benefits and costs of state intervention. Some have argued that the Chinese state is at fault since it has not devoted sufficient resources to indigenous innovation so that China remains largely dependent on western technology, to the detriment of China’s long-term security. Others blame the Chinese political regime or governmental interference for creating a research culture that stifles creativity, diversity and dissidence (Shi and Rao 2010).

But is the role of the Chinese state really that decisive? After researching and writing my book Inside Story of China’s High-tech Industry: Making Silicon Valley in Beijing, I am convinced more than ever that the answer is no. To be sure, I do not believe that the state should be banished from the arena of business enterprise. Far from it, I feel that in China, as in other developing states, the question is never whether the state should play a role in technological development, but how. As I traced the emergence of China’s high-tech industry since the mid-1980s, examining the historical evolution of relationships among MNCs, domestic companies, research institutes, and the Chinese central and local states in Zhongguancun—China’s Silicon Valley— I concluded that the role of the state is essential, not as a leader, but as a reflective and flexible collaborator with multinational corporations (MNCs), indigenous companies and research institutes in the process of technological change. My findings can be summarized as follows:

The role of China’s state in technological change has been highly varied and experimental, and sometimes diametrically in opposition. There has not been a single unified model.

Since the founding of the PRC, the Chinese state initially tried defense-led technological development strategies, then changed to focus on the civilian sectors. It tried self-sufficiency and import substitution behind closed doors, only then to pursue the transfer of western technology by opening China’s markets. It established a science and technology system within a centrally planned economy, but then embraced the neo-liberal model by introducing market forces and engaging in technology commercialization. It increased the size and competitiveness of the largest state-owned enterprises, then recognized the need to support small innovative firms and encourage the participation of non-state agents in high-tech industries. It managed to lure considerable western investment while attempting to issue technological standards to assist innovation by domestic firms. None of these efforts can be judged an unequivocal success. China continues to rely greatly on external technology to this day, and Chinese enterprises continue to rely on cheap labor rather than technological prowess. While no one can accuse the Chinese state of not trying, it is clear that it has yet to find a workable model for technological development. So China has not had one single approach to state involvement. Whatever strategies it has today will undoubtedly undergo change in the future.

A State-centered approach for Science & Technology has been tried and failed in most civilian areas.

Since 2003, the Chinese government has paid growing attention to Science & Technological (S&T) sectors. China’s Eleventh Five-Year Plan and its Plan for Medium and Long-Term Science and Technology Development (2006–2020) call for building an innovative society with heavier investment in domestic R&D. The increased investment is necessary, but given that China’s central state has a powerful tradition and bureaucratic interest in favor of a centralized approach, it is worrisome that some officials advocate the revival of a state-directed R&D program. In 2005 the head of the Ministry of Science and Technology cited China’s success in producing nuclear bombs and a satellite in the 1960s, products of state-directed research programs, as examples of strategic technological breakthroughs that could be emulated in other technological areas. Unfortunately, this argument shows little understanding of the difference between military and civilian technology, or of the reality of the global marketplace in which Chinese companies must operate. Although defense technology is utilized in the civilian sectors in the United States and China, a nuclear bomb does not have to stand the rigorous test of open global competition. Thus, China’s success with bombs proves nothing about the effectiveness of state-directed research programs in commercialized technology. In fact, China’s state-directed S&T research prior to the mid-1980s had a very poor record in responding to market needs. So what about high speed rail and super computers? As many have noted, both are built based on existing foreign technology and collaborations with other companies. Given the intensity of globalization today, a state-centered approach to R&D would be counterproductive, if not simply unfeasible. There will be sectors, defense and railroad, among others in which the existence of a natural monopoly may give the centralized approach a better chance of success. But it would be a major mistake to imagine that, in the absence of business competition and wide spread knowledge diffusion, state investment would result in sustained competiveness.

The most important role of the state is to be an honest and responsible collaborating partner with other technological agents.

So what should be the roles of the state? The Zhongguancun experience shows us that these roles are necessarily multi-faceted. Zhongguancun is better characterized as a result of institutional evolution under globalization, in part tolerated and assisted but largely unanticipated by the state. The state’s crucial roles are not just providing specific policies or R&D capital but collaborating effectively with other technological agents and learning to reform regional institutions under changed circumstances. Institutional transformation is necessary for the growth of China’s high-tech industry, but such transformation is a learned process, as entrepreneurs, businesspeople, professionals, bureaucrats, scientists, and consumers learn to work with each other while the new rules of the game are being negotiated, established, and observed.

Simply put, the accomplishments of China’s Silicon Valley thus far cannot be attributed primarily to the Chinese government. Domestic companies and MNCs alike have spent considerable energy pushing the state to change its resource allocation, ease its restrictions, and alter its regulations. Over the years, the Chinese state has largely been responsive to and tolerant of the various experiments in the regions, setbacks notwithstanding. But the state has not gone far enough. In the long run, genuine innovation can only come from freedom of thought, experimentation, collective effort, and frequent exchanges with advanced technological parties and marketplaces. All that will require the Chinese government to continue to collaborate with—rather than supervise or direct—other parties. Only then can a fairer and more open institutional structure for fostering innovation can be built.

 

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.

Can China innovate?

Yu Zhou
Professor of Geography, Vassar College
yuzhou@vassar.edu

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.