Are Chinese firms paper tigers? There have been a number of naysayers (often China specialists) who point out that China is the factory to the world, but the factory owners are foreign and the core value-added activities are located abroad. Some of these pessimists go so far as to predict that the end is near, with scenarios from a simple halt in the country's rapid growth to a complete collapse of the state and economy. Pessimists look at China's reliance on foreign direct investment (FDI) and see nothing but weakness. China may be the 'world's factory', but it is the foreign-owned factories that have thrived in China, while the domestic firms are either crippled by mismanagement (in the case of state-owned firms) or systematically discriminated against (in the case of private firms).
However, if you read the popular business press, you get a very optimistic view. The optimists look at the raw data of China's growth and conclude that it is on a fast track to becoming an economic superpower, with world-class companies that combine cutting-edge technology with low-cost labour. They look at Chinese companies such as Lenovo and Shanghai Auto and see the world's next Samsung and Toyota, but on an unparalleled scale-Japan Inc. times 10. Both these viewpoints share a reference point: successful developers cultivate indigenous enterprises with independent technological capabilities in the tradition of a developmental state.
But China is developing in a new era with new opportunities and constraints. The mechanics of the global economy have changed. Improvements in transportation and communications technology have made it possible for multinational companies to divide up production chains and locate activities based on comparative advantage rather than geographic convenience. It is true that China depends more on FDI than its neighbours, but this is partly the product of changed circumstances and partly due to its quite different domestic institutional setting.
And yet predictions of the rapid emergence of globally competitive Chinese giants are also off the mark. The rise of China has coincided with the globalisation of production. It presents formidable challenges to the world's leading firms, but these are fundamentally different from those of Japan's rise, precisely because of China's global linkages. The intensity of these global linkages may preclude the rise of indigenous national champions, but in the new global economy a heavy reliance on FDI need not be a source of weakness.
The three primary drivers of China's new development path are FDI-related: the 'bamboo network'; the globalisation of research and development (R&D); and the multinational seeds of domestic innovation. The global network of ethnic Chinese engineers and technologists, what has been called the bamboo network, has been at the forefront of investment in Chinese technology firms, creating links to global technology centres and creating a pool of highly skilled labour.
Second, multinationals are showing more willingness to locate R&D activities in developing countries, and these investment projects become training centres for local engineers.
Finally, these seeds of innovation spread to the broader economy as Chinese engineers and technologists seek new opportunities in the rapidly growing domestic economy. In short, China is not running into a developmental dead-end because of foreign investment. On the contrary, it is just what is needed to break through its domestic difficulties.
The bamboo network
Taiwanese and Chinese returnees from global centres of innovation, such as Silicon Valley, are at the forefront of China's technological development. These bamboo networks depend not simply on fostering relationships (guanxi), but also on the technical skills of the participants. Nowhere is the impact of such networks more important than in the IT industry. As in all the high-performing east Asian economies, IT has been an outsized contributor to economic development; currently, it contributes close to a fifth of China's GNP.
In microelectronics - which includes the 'fabs' that make integrated circuits (ICs) and 'fabless' design houses (which design ICs, but outsource the manufacturing) - the number of chip designers in China has exploded in recent years from a mere 1,800 in 1998 to over 7,000 in 2003. Although the current number pales in comparison to the US figure of 40,000-50,000, it is close to the 11,000 chip designers in the world's second biggest centre of fabless design houses, Taiwan. Byron Wu of iSuppli, a semiconductor market research firm, predicts that with the growth of fabless design in China, greater China (the mainland plus Taiwan) will overtake North America by 2008.
Returnees from Silicon Valley and Taiwanese firms have been the force behind the explosive growth in the microelectronics industry. Over the last several years, about two-thirds of the designers trained in skills other than reverse engineering were working for firms run by Taiwanese or returnees from abroad. Until the recent investments by Samsung and Infineon, other foreign firms did very little chip design work in China. The truly local firms were even less impressive: the vast majority were doing reverse engineering, much of it as state procurement for the cell phone and ID card markets.
There is now a critical mass of experienced returnees (defined as engineers with over 10 years' experience) and this has created a snowball effect. These highly experienced returnees start their own China-based technology firms, train local engineers and transplant the networking associations (such as the Chinese American Semiconductor Professionals Association) that were critical to spurring entrepreneurship among the Chinese in US centres of innovation.
The same pattern is found in microelectronics fabrication, an area of manufacturing that requires large numbers of skilled engineers. In 1998, a visit to Wuxi, one of the traditional bases of China's state-planned IC industry, found that the massive technology transfer from Lucent and others to the state-owned domestic champion Huajing had gone awry. Huajing had been unable to use the technology effectively because it suffered from the mismanagement typical of the state-owned sector. In 2001, a return trip revealed a remarkably different situation. A Taiwanese-invested firm had rented the plant and, under Taiwanese management, the plant was transformed into a viable commercial venture called CSMC.
CSMC is typical of the 'foreign' firms created by the bamboo networks: it is foreign-invested and yet all its core operations are located in China and it relies heavily on China's high quality human resources. As the Semiconductor Manufacturing International Corporation (SMIC) shows (see p39), the impact of the Taiwanese has been even more dramatic in Shanghai.
In the broader IT sector, Taiwanese firms have a strategy of using mainland China as the foundation of their core competencies and are building up their R&D capabilities in China. Some large technology firms have proclaimed their intention to become 'Greater China' firms rather than simply Taiwanese firms. Inventec, a manufacturer of notebook computers, calls this a 'dual axis' strategy and this isn't just talk: the firm's software teach is entirely in China (several thousand engineers).
In 2001, Inventec had more US utility patents, the gold standard of patents, than all its Taiwanese computer counterparts, save Compal, and almost 40% of these were from China. Hon Hai Precision Industry, one of the largest Taiwanese holders of US patents, invested in a new large R&D centre in China even before it decided to build a second one in Taiwan under the blandishments of the Taiwanese government. Just under 14% of Hon Hai's patents are from China. In total, Taiwanese firms operating on the mainland contributed 42% of all China's corporate US utility patents from 1997 to 2001.
Similarly, the start-ups founded by returnees from other regions have become increasingly active. Between 1997 and 2004, firms from the ethnic Chinese economies (ECEs), combined with those founded by returnees, created 503 of China's 616 IT corporate US utility patents. In contrast, the domestic firms contributed only 11 and the major Chinese champions that get so much press in the West have little R&D activity as measured by patents. Huawei has only six and Lenovo none.
It has long been assumed that the Chinese auto industry will be dominated by joint ventures (JVs) with foreign firms. These firms have the latest technology, they are rich in capital and they have the strong support of the Chinese government. Although JVs continue to dominate the market, they now compete with local firms that are capturing market share with vehicles that are of far inferior quality but sell at a fraction of the price.
Anhui-based Chery, the most successful of these firms, began producing cars in 1999 and only four years later it had achieved annual sales of 80,000 vehicles. Earlier this year it made headlines when it announced that it would begin exporting cars to the US in 2007. It is easy to dismiss this sort of achievement as the result of intellectual property rights violations, but this would miss a broader trend: early success is now being leveraged into investment in R&D, and these efforts revolve around returnees with significant automotive experience abroad.
There is a general trend towards the globalisation of R&D, as multinational corporations (MNCs) begin to locate design centres according to local competencies rather than regulatory requirements. China has a particularly strong hand to play, partly because the government can use the lure of the domestic market to force multinationals to transfer technology and establish design centres in the country - and frequently did so during the 1990s. However, MNCs are quite skilled at placating the Chinese governments with R&D centres that are little more than empty shells. What will probably prove to be more important over the long run are the internal incentives for MNCs to locate research and design activities in China.
The combination of a low-cost manufacturing base with an enormous potential market is a potent one; indeed, firms have woken up to how much China has to offer in terms of cheap, trainable science and engineering talent. The sheer numbers are impressive: in 2000, China had 220,000 graduate engineers - 21% of the world's total. In comparison, the US and the EU together had less than 240,000 engineering graduates (fewer than 60,000 of which were in the US). India, often held up as China's chief rival, had only 82,000 such graduates.
In the IT sector, 33 foreign firms with R&D activities in China, including eight ECE firms, had trained more than 20,000 Chinese engineers by 2004. This number far exceeded the 3,000 engineers doing actual R&D in domestic firms. Moreover, many of these R&D engineers had moved from final design work (design for manufacture) to much more technologically sophisticated applied research.
Similarly, in the automotive sector, global firms are exploiting design capabilities. In 2004, a total of 55 foreign-funded automotive technical centres existed in China - half of them in the Shanghai area. All but one of these was created since 1997. Visteon has invested about $20 million in the design centre of its Shanghai JV; Bosch has invested close to $20 million in a Shanghai engine management research centre and Delphi has invested $50 million in a Shanghai development centre.
The Pan Asia Technical Automotive Centre (PATAC), a JV between General Motors and the Shanghai Auto Industry Corporation, is the most advanced automotive design centre in the country. It represents an initial investment of $50 million (and a recent commitment for new investment of $250 million over the next four years), and has played an important role in Shanghai General Motors' (SGM) success in China.
It should not be assumed that all these technical centres do cutting-edge design work - they are sometimes referred to as PR&D centres due to the public relations benefits they bring - but their potential integration into global design networks also should not be ignored. Delphi, for instance, uses its 34 technical centres around the globe to implement '24/7 engineering'. Diesel engine technology is a speciality of the European centre, and it collaborates on projects with design centres in the US and Asia that have complementary skills.
There is evidence that multinational firms are using the design capabilities of their China operations. Between 2002 and 2004, foreign IT firms in China received four times as many utility patents from R&D in China as they had in the previous two decades combined: 21 patents before 2002 and 81 between 2002 and 2004. Although this is a small percentage of the total number of patents held by foreign firms, it is an indication of the manner in which they are leaning towards genuine capabilities.
Although sceptics have argued that Chinese domestic enterprises have had relatively low aggregate investment levels in R&D, particularly in comparison with India and the West, its performance in historical perspective is not too bad. It has about the same level of utility patents in the US as Taiwan did at a similar level of development. In 2000, China invested 1% of GDP in research and development, well below that of the advanced industrial world, which averaged 2%-2.5%, but in line both with other rapidly growing countries in the developing world and with US R&D expenditures in the early 1950s.
Sowing the seeds
The multinational firms that invest in China not only create capabilities that can support their own operations, they also create capabilities that can be drawn on by indigenous Chinese firms. The foreign-invested firms provide a training ground for local engineers and managers, and these skills spill over into the local economy as employees move on.
The clearest manifestation of this trend is in flows of human capital. In the auto sector, for instance, relatively few firms have the resources to lure many returnees home from abroad, but all the major independent firms have the capability to lure personnel away from JV projects. Geely, one of the most successful private auto firms in China, is staffed at all levels with personnel from JVs. At the highest level are former general managers from both Shanghai Volkswagen and FAW-Volkswagen.
At Great Wall Auto, a private firm in Hebei Province, the design centre is stocked with former JV employees, and because the management would like to implement the Toyota production system, the majority of the supervisors on the production line come from the FAW-Toyota JV. The next best thing to a returnee from abroad is foreign experience within China.
Even in the short term, the presence of foreign-invested firms is valuable because they provide immediate solutions as suppliers of key components. Rather than creating capabilities across the board, these new indigenous firms can choose which capabilities they will focus on and outsource the remainder to foreign firms with strong technical capabilities. This approach allows the domestic firms to rapidly increase volumes, create brand awareness and (if sales are strong) reinvest in their internal design capabilities. This is the strategy of many of the largest indigenous auto firms, such as Chery and Geely.
It is critical that the world's multinationals understand the implications of China's new, global path to development. The first step is to understand the nature of the competitive threat emerging from the country, and it is imperative for firms to locate the sources of competition and innovation in China. Domestic Chinese firms are not yet set to take over the planet or even ready to re-order industries in the manner of Japan's world-class firms in the 1970s and 1980s.
The competitive challenge in China is unlikely to come from the large state-owned firms, which are often supported by central government. They tend to move beyond the rapidly growing markets in China either because the intensity of the competition makes profits a rarity, or their generous state financial support gives them a distorted incentive to make dubious investments abroad. Outside of household consumables, those Chinese firms more often than not simply slap labels on low-margin products dependent on foreign technologies.
The most promising firms are likely to be smaller companies that draw heavily on the capabilities of the overseas Chinese. These firms are faster and more flexible, and have benefited greatly from the presence of foreign-invested firms in the economy. Firms of this sort will be heavily staffed with technologists trained abroad (or with multinationals) and now making their career in China. The good news for foreign firms is that these small, foreign-oriented firms are more likely to be partners with than adversaries to today's global firms.
It is important for MNCs to think carefully about what technologies they introduce in China - and how to protect them. The presence of design capabilities allows a firm to be more responsive to the domestic Chinese market. Local design also helps to lower costs: there is the potential for savings on the salaries of the engineers, but potentially more important are the savings in purchasing that are possible with local suppliers.
In many respects, China represents globalisation in its purest form. Manufacturing and technology networks are in large part the result of the massive levels of foreign investment and they consequently combine the resources of many nations. The challenge for both foreign and domestic firms is to capture the benefits of this industrial melting pot.
SEMICONDUCTOR MANUFACTURING INTERNATIONAL CORPORATION
In 2000, Richard Chang, a veteran of Texas Instruments and Taiwan's semiconductor industry, decided that China was ready for its own fabrication plant. The Shanghai-based firm he founded, Semiconductor Manufacturing International Corporation (SMIC), has led China's rapid rise to near the technological frontier in process technology. Moreover, SMIC now competes with Singapore's Chartered as the third largest pureplay foundry (firms that make chips based on customers' designs). The core of SMIC's engineering management team comprises Taiwanese and returnee engineers with decades of experience in Taiwan, Singapore and the US. These engineers, in turn, have trained hundreds of educated, if inexperienced, local engineers. SMIC's advanced fabrication operations in Shanghai have also forced the two largest foundry operators in the world, Taiwan's TSMC and UMC, to set up plants in China. SMIC already has one 300mm generation (the leading generation) plant in Beijing and is building another in Shanghai.
Vimicro, a Beijing-based company founded in 1999 by John Deng, is a classic example of the impact returnees can have on China's high-tech sector. A native of Beijing, Deng studied at UC Berkeley, worked for IBM at the TJ Watson Research Center, and then co-founded Pixim, a digital-imaging technology firm based in Silicon Valley. But Deng wanted to make his contribution in China and he began looking for seed capital for a business to design multimedia processors for computers, digital cameras and mobile phones. The seed money ($1.25 million) for Vimicro came from an unlikely source - China's Ministry of Information.
While Silicon Valley venture capital was pouring into the internet at the end of the 1990s, the Chinese government was eager to promote the development of independent technical capabilities. This enthusiasm, combined with foreign-trained expertise, proved to be a potent force. Today Vimicro owns more than 500 patents and its customers include Microsoft (Vimicro is one of only five firms authorised by Microsoft to use Windows XP for digital imaging chips), Samsung, Fujitsu, Logitech, Siemens and Lenovo. In November 2005, the firm raised $87 million on Nasdaq.
Douglas B Fuller is a postdoctoral fellow at Stanford University's Stanford Project on Regions of Innovation and Entrepreneurship (SPRIE); he will be an assistant professor at American University's School of International Service, Washington DC, in September. He is currently writing a book on the political economy of technological upgrading in China.
Eric Thun is the Peter Moores University Lecturer in Chinese business studies at the Said Business School, Oxford University. His book, Changing Lanes in China: foreign direct investment, local governments and auto sector development, is published by Cambridge University Press.