Internet & Tech

China is innovating…

The question just has to be reframed, says veteran fund manager

China is innovating…

In response to our Talking Point last week ‘Can China innovate?’, we received the response below from WiC reader, James Cheng, a fund manager with Morgan Stanley Investment Management. With his practical experience of visiting Chinese firms, Cheng’s analysis takes the debate a stage further. He writes:

If the question is whether China is ready to take the lead in the innovation stakes, I think that the answer is still a resounding no, or at least not yet.

However, I think this question does not address the real issue, because if a country at less than $4,000 per capita can innovate faster than the rest of the world, then either the size of the Chinese economy is massively undervalued or the developed world will soon see its $40,000 GDP per capita deflate rapidly! As usual, the truth lies somewhere in between.

There is plenty of evidence that the rate of innovation within the Chinese economy is accelerating. They are now able to produce goods first made in developed companies at much lower cost on a quality-adjusted basis. China has turned the binary outcome of the past (you either master the technology or you don’t) into a gradation of outcomes – you can buy Chinese cars that work, but not at the quality of developed world cars. But the price-quality point enables it to tap into the ‘other 5 billion consumers in the world’ where per capita GDP is at $4,000.

The key is to bring costs and average selling prices down. In other words, China is not “innovating” by creating new products technologically. They are just making them a lot cheaper (and increasingly, owning the intellectual property rights to do so).

A prime example is the telecommunication equipment industry. Of the top five global equipment suppliers today, two are Chinese and the most profitable as measured by net margins despite selling at a lower price to their developed world competitors. In fact, apart from Ericsson, both Alcatel-Lucent and Nokia-Siemens are loss-making!

Without the low cost of equipment of Huawei and ZTE, there would not be a 1.5 billion mobile subscribers today in China and India! This is not innovation, but it is critically important in making products available to the 5 billion people who have not been part of the “global” economy in the past.

In my 25 years in emerging markets, I have not witnessed another country as capable of producing goods that can replace developed countries capital equipment, let alone do it cheaper! Japan was a developed economy 25 years ago but in 2009, China overtook both it and Germany to become the largest producer of machine tools, the foundation of an industrial economy.

So, it is not about leapfrogging the developed countries technologically, it’s about doing the same thing at a much cheaper cost and on a much larger scale. The most competitive companies we see all share the same secret – their scale allows them to innovate their own capital equipment (from BYD to Shenguan). Yet many still think it’s all about cheap assembly line labour!

So why is China able to produce companies like Huawei and ZTE at such a low per capita GDP? On closer analysis, the real competitive advantage of Huawei is not cheap manufacturing labour, but its 44,000 strong R&D team. This is double the size of Ericsson’s R&D team. But Huawei’s total R&D cost is still only 40% of Ericsson’s!

In 2005, China had about 1.2 million researchers and ranked number three globally, just behind the US and EU25. With the global financial crisis, I will not be surprised if China outpaces both the US and EU25. In 2009, Ericsson cut its R&D personnel from 20,000 to 18,000 whereas Huawei increased R&D personnel from 37,000 to 44,000. China has also witnessed a 64-fold increase in peer reviewed scientific papers and is now only behind the US. On a per dollar billion GDP basis, in 2007 the World Intellectual Property Organisation ranked China number three after South Korea and Japan, ahead of the US.

These numbers perhaps explain why, when visiting companies on the ground, I sense acceleration in the rate of technological upgrading. Again, this is not about making new leading-edge products. It’s about making existing products cheaper and better. As an example, a leading manufacturer of coal-fired power plant equipment confided that it took them 25 years to upgrade from 125MW plants to 300MW plants, but only 7-8 years to upgrade to 600MW and 2-3 years to upgrade to 1,000MW plants.

So, many critics miss the point – they are right, China is not “innovating” in the eyes of the developed world. But in the eyes of the developing world, China is innovating by making existing things cheaper and faster.

In the green energy space, the focus on China’s production of solar panels and wind turbines is somewhat misleading. Solar panel production is not really technological innovation. But I have seen companies innovating in the production of capital equipment for the manufacture of solar panels. Likewise I’ve seen the willingness of entrepreneurs in China to fund application R&D by harnessing existing technology and combining it with the scale available in the domestic market to make unviable technology viable. Again, this is not leading edge innovation, but practical innovation, which may be more efficient economically. Part of this investment in R&D is driven by generous policies that allow for a 150% deduction for tax purposes.

As to why China stopped innovating for 500 years, I am sure there are some truths to all the arguments presented [in the WiC article]. However, the most important event is probably the decision during the Ming Dynasty to ban all maritime activity in 1371. The susbsequent 500 years of looking inward blocked the cross pollination of ideas and led to autarkic development. Perhaps one should not be surprised that the current economic miracle traces its origin to Deng Xiaoping’s “Open Door” policy which makes China one of the most open economies in the world (measured as a percentage of trade to GDP).

Furthermore, the last 200 years of Chinese history was marked by extreme poverty and political upheaval. The last hundred years of the Qing Dynasty saw the de facto occupation of China by foreign forces and like all dynastic endings, the years before 1911 were marked by mass starvation and social upheavals. Then China suffered two world wars (with Japanese occupation in between), and then experienced communism for another 40 years. Maybe the extreme entrepreneurialism that is driving the innovation that I have witnessed is just a very human reaction. Perhaps, after being deprived of it for 200 years, the Chinese have been given back their right to “dream and hope”?

If other readers have experiences or views on this theme and would like to add their voice to the debate on China’s capacity to innovate, please email the editor at [email protected] Our thanks to James for contributing this response.

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