The Myth Behind China's Miracle

George J. Gilboy

From Foreign Affairs, July/August 2004

Summary:  Washington need not worry about China's economic boom, much less respond with protectionism. Although China controls more of the world's exports than ever before, its high-return high-tech industries are dominated by foreign companies. And Chinese firms will not displace them any time soon: Beijing's one-party politics have bred a timid business culture that prevents domestic firms from developing key technologies and keeps them dependent on the West.

George J. Gilboy is a senior manager at a major multinational firm in Beijing, where he has been working since 1995, and a research affiliate at the Center for International Studies at the Massachusetts Institute of Technology.

NODES WITHOUT ROADS

This industrial strategic culture is rational and effective given the current structure of politics and business environment in China. (These features echo patterns of interaction between authoritarian officialdom and merchant enterprise that were established in China's first period of industrialization in the Qing dynasty 150 years ago.) But China's industrial strategic culture weakens the competitiveness of Chinese firms and it may have damaging economic repercussions down the road. Most Chinese industrial firms focus on short-term gains and, despite increasing operational efficiency, sales revenues, and profits, have not increased their commitment to developing new technologies. Their total spending on R&D as a percentage of sales revenue has remained below one percent for more than a decade. R&D intensity (R&D expenditure as a percentage of value added) at China's industrial firms is only about one percent, seven times less than the average in countries of the Organization for Economic Cooperation and Development (OECD).

Focusing on short-term returns has also guided China's imports of industrial technology. Chinese firms tend to import technology by purchasing foreign manufacturing equipment, often in complete sets such as assembly lines. Throughout the 1980s and 1990s, hardware accounted for more than 80 percent of China's technology imports, whereas licensing, "know-how" services, and consulting accounted for about 9 percent, 5 percent, and 3 percent, respectively.

Although China has recently begun importing more "soft technology" -- mainly in the form of licenses for the use of imported equipment -- the knowledge embodied in it must be absorbed and mastered (or, in technology parlance, "indigenized") before it can become an effective basis for domestic innovation. Chinese firms remain weak in this regard. Over the last decade, large and medium-sized Chinese industrial firms have spent less than 10 percent of the total cost of imported equipment on indigenizing technology. Indigenization spending at state firms in the sectors in which China is most often cited as a rising power (telecom equipment, electronics, and industrial machinery) is also low (at 8 percent, 6 percent, and 2 percent of the cost of imported equipment, respectively). This is far lower than the average for industrial firms in OECD countries, which amounts to about one-third of total technology import spending. The practice of Chinese firms also stands in contrast to spending patterns in Asian countries such as South Korea and Japan in the 1970s and 1980s, when they were trying to catch up with the West. Industrial firms in those countries spent between two and three times the purchase price of foreign equipment on absorbing and indigenizing the technology embodied in the hardware.

Chinese firms have also failed to develop strong domestic technology supply networks. In 2002, Chinese firms devoted less than one percent of their total science and technology budgets (which include technology imports, renovation of existing equipment, and R&D) to purchasing domestic technology. China's best firms are among the least connected to domestic suppliers: for every $100 that state-owned electronics and telecom firms spend on technology imports, they spend only $1.20 on similar domestic goods. Thus Chinese technology suppliers do not enjoy a strong "demand pull" from the best domestic firms to stimulate their own innovative capabilities; they are relegated primarily to serving rural enterprises and less competitive state-owned enterprises. And because FFEs use their investments in China as technology "snakeheads" (a Chinese term for portals), through which they bring product designs, advanced manufacturing equipment, and high-value components from foreign firms or their China subsidiaries, they too are poorly linked to Chinese domestic technology markets.

Industrial collaboration and horizontal networking are also rare, prompting Chinese firms to run their R&D projects in relative isolation. In the most recent national R&D census in 2000, Chinese industrial firms reported that they spent 93 percent of their $2.7 billion total R&D outlay in-house, but only 2 percent on collaborative activities with universities and less than 1 percent on projects with other domestic firms. China's research institutes are increasingly insular, too, especially since market reforms have forced them to commercialize their operations. In 2000, only 38 of China's 292 national industrial research institutes devoted more than one-third of total activities to collaborative projects, even though these institutes are specifically tasked with diffusing technology. Instead, many are becoming competitors of the firms they are supposed to serve. A 2003 World Bank report found that many Chinese engineering research centers have been mass-producing and marketing the products of their research for their own financial gain, rather than diffusing these technologies through patents.

Failed collaborations have also plagued China's attempts to commercialize domestic innovations. Julong Technologies, the firm that developed China's first digital telecom switching equipment, is no longer a major telecom-equipment player due to conflicts among its research, production, and marketing arms, which came under the influence of competing political officials. China's homegrown mobile telephone standard, TD-SCDMA, has received central government support, but thus far none of China's major telecommunications operators have agreed to commit to it, preferring a foreign standard, WCDMA, instead.

Given the political perils of challenging competitors and their local patrons, few Chinese firms develop alliances with or invest in companies in other provinces. One recent survey of 800 companies that have conducted domestic mergers and acquisitions found that 86 percent of them invested in firms within their own city and 91 percent invested in firms within their own province. Strong local political ties tend to isolate a region from the rest of the economy, which helps explain why Chinese firms are often small and the country's industries fragmented. For example, a recent study performed for the State Council (China's cabinet) revealed that Chinese managers regard the country's two most politically powerful technology and industrial hubs, Beijing and Shanghai, as leading centers of local protectionism in China. Among the industries most affected by such protectionism were pharmaceuticals, electrical machinery, electronics goods, and transport equipment. SOEs and private firms suffered the most, FFEs the least -- which suggests that the burden of particularism falls most heavily on Chinese firms.

To avoid the difficulties of developing interregional supply chains while securing short-term profits, Chinese firms tend to engage in excessive diversification -- also with damaging results. Many of China's most famous firms have made unsuccessful forays into ancillary businesses: Haier (from household appliances into computers, mobile phones, and televisions), Fangzheng (from computers into tea, steel, software, and financial services), and Shougang (from steel into banking, auto assembly, and semiconductors). Huawei, China's best technology firm and maker of network equipment, has recently made a questionable entry into the mobile-handset market, where sales prices and margins have fallen dramatically for the last five years and 37 licensed vendors produced excess inventories of 20 million phones last year.

Together, China's institutions and the industrial choices of local firms have restricted the ability of Chinese firms to develop new products and services. The share of total sales revenues accounted for by new products at Chinese industrial firms was flat, at about 10 percent, throughout the 1990s. (In contrast, new products account for 35 percent to 40 percent of sales revenue for industrial firms in OECD countries. Chinese firms lag behind firms in other developing countries as well: in 2000, for example, new products accounted for about 40 percent of total sales revenues in Brazil's electrical machinery industry.) And because of overlapping investments, fragmentation, and the weakness of industry associations, even those firms in China that make new products often find themselves engaged in vicious price competition, which prevents them from reaping high returns from their innovations.