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.

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.