/ 5 May 2011

Can China’s billions spur the next big idea?

If innovation is about dreaming up the next big idea, then the black box devised by Guangdong East Power probably doesn’t qualify.

The two-metre tall stack is a power supply system, a machine designed to ensure a smooth, uninterrupted flow of electricity to computer servers and medical equipment.

The design isn’t entirely original. The company’s engineers, working in stark white laboratories at the heart of China’s Pearl River Delta, spent three years pulling apart rivals’ products and imitating them.

But they made some important design changes, producing a machine that is more energy efficient and slimmer, allowing users to squeeze it into smaller spaces. And it is cheaper: the system sells for 30% to 40% less than comparable products from Western competitors.

The strategy is the brainchild of He Simo, an amiable former soldier who started the company in 1989 with just 3 000 yuan in capital, and once resorted to selling his own blood and bicycle to make ends meet.

Through imitation, tinkering and steady improvement, Guangdong East Power is now one of China’s leading producers of power supply systems and increasingly a competitor for the global market leaders, Schneider Electric’s APC and Emerson.

“The company I most admire is Apple,” said He, sitting in an office off of the factory’s humming production line. “God’s hand sometimes gives them an idea and they come up with a completely new product. I don’t think we are anywhere near that stage yet. But I always say a product is never perfect — it can always be improved.”

Innovation is an obsession for China’s central planners, who have showered billions on state-owned businesses and research institutes in an effort to make the country a creator of — rather than a mere user and copier of — intellectual property.

It’s an effort that has had Western multinationals up in arms, fearful that the policies favour local companies and force foreign companies to transfer their best technologies to China.

The government is seeking major breakthroughs — scientific discoveries and new technologies that will set the standard for companies around the world. The effort hasn’t been a success.

“You can’t really point to an individual firm or area where the Chinese are currently leading,” said Adam Segal, a senior fellow with the Council on Foreign Relations, and author of a book on innovation in Asia.

“Some people point to nanotechnology and some say nuclear. Otherwise, it’s hard to figure out if there’s going to be any breakthrough in China. I just don’t see it on the horizon.”

But seen another way, innovation is thriving in China. Thousands of companies in China’s lively and unruly private sector have built money-making businesses on their ability to take existing technology and products and make them better and cheaper.

“Chinese companies have been doing wonderfully by being on the cusp of the latest available technologies developed elsewhere and then being able to work on it,” said Dan Breznitz, a professor at the Georgia Institute of Technology.

“It’s a strategy that’s basically against the central government’s push. But those innovation capabilities are probably going to maintain Chinese growth for the next 15 years.”

That is, added Breznitz, if the Chinese government’s thirst for big, state-directed projects doesn’t undermine its privately owned companies.

Bold plans
In 2006, China’s Ministry of Industry and Information Technology came up with an answer to what it saw as a vexing problem: the millions of dollars in licensing fees Chinese companies would have to pay to foreign patent holders as the country rolled out its 3G network.

The solution was to mandate the use of a homegrown standard, TD-SCDMA, which Chinese engineers had developed jointly with Siemens.

The technology, developed with government money, had shortcomings. TD-SCDMA was slower than W-CDMA, the 3G standard developed in Japan. It was less stable. And it took a very long time to roll out. The trials finished two years later than planned.

China’s three state-owned carriers complained about the delay and at having to adopt a standard incompatible with the technologies being produced by the world’s major handset makers.

Beijing eventually relented, allowing China Telecom and China Unicom to have standard 3G licenses but required the biggest, China Mobile, to use TD-SCDMA. By the time it was implemented, the global telecoms industry was already looking ahead to 4G.

The effort wasn’t completely fruitless, says James McGregor, a senior counselor with consulting firm APCO Worldwide. While the 3G standard developed by China was probably 60% as good as the existing standard, Chinese engineers are applying what they learnt to their work on the 4G standard.

But the project fell far short of its goals.

“The government’s intentions are good in trying to create innovation,” said McGregor. “But its policies are just driven to getting state enterprises to build big industrial machines and borrow technology from around the world to do it.”

In 2006, China launched policies designed to make it a technology leader. Among other things, they call for China to replace foreign technology in key sectors with locally developed intellectual property. Incentives to innovate include tax deductions for R&D expenses, government-backed loans and discounted interest rates for R&D investment.

The latest innovation push is a plan to dominate seven “strategic” sectors, ranging from alternative energy and green cars to advanced manufacturing. The government plans to devote $1,5-trillion to the sectors over the next five years. Some of this is likely to be direct government spending, and much of it will come off the balance sheets of large state-owned enterprises.

While that spending is bound to produce some benefits, it’s an open question whether it will result in the new, world-leading technologies China’s planners aspire to.

“Inevitably, a lot of that money is going to be wasted,” said Breznitz, who has co-authored a new book on innovation in China, Run of the Red Queen.

“A lot of it will be spent on big players that either don’t know the market or feel so secure that they won’t compete as hard.”

He points out that some of the companies picked by the government to be champions of the telecoms sector have faded into obscurity. “China’s great companies ZTE and Huawei were not supposed to be the national champions. Those who were just spent all that money.”

Similarly, while government efforts have helped produce a veritable flood of patents in recent years — China will surpass the United States and Japan as the world’s biggest issuer of patents by 2011, according to a Thomson Reuters report — there may be less there than meets the eye.

Nearly half of these patents are so-called “utility patents”, ones that offer a shorter period of protection and are easier to obtain than regular patents issued in the United States or Japan.

China’s innovation shortcomings are not merely the product of a preference for central planning over entrepreneurship, of course. Barriers include poor enforcement of intellectual property rules, an educational system that stresses rote learning, and a relative lack of independent organisations that can evaluate scientific projects and help police instances of plagiarism.

“There’s a political constraint, too,” said Arthur Kroeber, managing director of GaveKal-Dragonomics in Beijing. “In the long run, innovation arises in societies that are really open, where you can discuss anything. And China doesn’t have that kind of political culture yet.”

Second generation
One feature that sets the headquarters of TechFaith Wireless Technology apart from the other office buildings lining an industrial park south of Beijing is the $750 000 black Rolls Royce parked in front.

The car belongs to Dong Defu, the 39-year-old founder of the Nasdaq-listed cellphone designer and software company.

Dong, a former employee of Motorola, started his company in 2002 as an outsourced provider of design services to other cellphone makers, including Nokia, Philips, NEC and his former employer.

“Doing that kind of work, the margins are too low, and you are under constant pressure to cut your prices,” said Dong, a fast-talker with close-cropped hair. “Even if you have great technology, you have no pricing power.”

After the company’s IPO in 2005, he set off on a different course, designing and building white-label phones for other companies to brand as their own, and developing handsets under its own brand, tailored for different types of users.

Those include a phone with software to help soft drink makers keep track of what visits its promoters make to stores, water- and shock-proof phones for policemen and encrypted phones for use by government entities.

Not all of the company’s designs seem original — one model looks remarkably like the RIM Blackberry. But the company’s engineers — 600 out of a total staff of 1 100 — are constantly devising new features and applications, including a cellphone that doubles as a motion controller for video games and a Disney-branded phone equipped with GPS, so that parents can track their children’s whereabouts.

“We can do anything that the foreign handset makers can do,” said Dong. “But we have our core engineering team here in China. Our costs are lower.”

Broadly speaking, academics put innovation into two categories. One kind is typically associated with Silicon Valley — the bold new idea that creates a new market where one didn’t exist before. Think, for example, of Apple’s iPad, or Google’s business model for selling targeted online ads.

The other kind is incremental, or second-generation, innovation, where a company takes a design and improves upon it, typically through cost cutting or some redesign.

Chinese companies have done well with this second kind. Baidu, for instance, began as an imitator of Google, but differentiated itself with features like music downloads and search algorithms better suited to Chinese.

And then there are China’s famous pirate cellphone manufacturers, known as Shanzhai, or “mountain bandits” in Chinese. Concentrated in southern China’s manufacturing hub, the Shanzhai have engineered their own versions of iPhones and iPads, often with extra features like double SIM-card slots or ultraviolet lights that help users check for counterfeit money, a common problem in China.

Such resourcefulness is apparent in industrial sectors, too.

“German and American engineers can never design like Indian and Chinese engineers can design,” said David Lee, a China-based partner with Boston Consulting Group, who specialises in sourcing and industrial goods.

“Because those engineers are exposed to the standard components in China, they are fully aware of how to design something that can go to a low-cost market or a low-price point market.”

That’s a key advantage in emerging markets, where customers are usually more cost conscious.

“In China’s domestic market, you see a lot of people who are tinkering and localising,” said Segal. “These companies not only do well in the local market, but also have a leg up in developing markets, since those are more similar to the Chinese market than the US market.”

That’s how TechFaith sees it. The company is looking to expand overseas, particularly in Latin America, where it sells its GSM and CDM mobile phones and other gadgets. Jay Ji, the company’s senior vice-president, argues that the company has an advantage over foreign cellphone providers such as Samsung Electronics , Nokia , and Motorola Mobility.

“They are more expensive than us,” says Ji, who adds that TechFaith can more readily customise its phones, a skill honed in China’s cutthroat mobile phone market.

“For US companies the cost of customisation is very high — you can’t always have an order that is more than a million units. But we can do it easily.”

Some western companies have taken notice.

One is GM, which has worked with its Chinese partner SAIC Motor to produce simpler, cheaper car models for the Chinese market to help it compete with homegrown rivals.

That includes the Chevy Sail, which sells for as little as $8 640 in China and has been a hit with local consumers. The partners plan to export the cars to Latin America.

Over protective parent?
China may have a leg up in incremental innovation, but some experts worry that Beijing’s state-led innovation push could actually set back the cause.

A central worry are the policies foreign businesses contend require them to transfer technology to Chinese companies to gain access to the government procurement market. Such rules could eventually drive away some of the foreign partners Chinese companies need, said Breznitz.

“The real risk from China’s policies is that they will make multinationals nervous and make them hedge and build supply networks outside of China. Do that for five years and it will diminish China’s power,” he said.

“In China you have a system that is already extremely good at incremental innovation, that has allowed the economy to grow rapidly, has created jobs and is sustainable. And in that system [such policies] create a lot of noise and fear.”

A broader concern is that the Chinese government’s current focus on the state-owned sector steers capital away from the country’s entrepreneurs. State-controlled firms dominate many industries — for example, banking, telecoms — and account for an increasingly big slice of the economy.

They also receive most of the bank loans.

As Beijing tries to cool lending to hold down inflation, the big banks have responded by funneling more of their capital to less risky state firms.

Smaller enterprises, starved of capital, often turn instead to “underground” banks, which charge about five times the official lending rate.

Liao Li, a professor at Tsinghua university, said China needs to develop better ways of directing money to the brightest ideas. The launch in 2009 of the country’s Nasdaq-style enterprise board was a step in the right direction, he said, but even the government’s push to spur development of the “strategic” industries could benefit from a more market-oriented approach.

“For very early-stage industries like electric vehicles some government support is necessary,” said Liao. “But the most effective way is to use market mechanisms that will give a return to investors for taking the risk of investing early on.”

But a more basic question is this: Is China ready for an innovation push?

After all, many companies in China are doing just fine churning out existing products faster and cheaper than others — they may have no real need to innovate.

“For most Chinese companies the aim is to provide 80% of global best quality but at 50% of the cost,” said Kroeber. “If you can make money doing that — and many do — you really have no incentive to invest in high-risk innovation.”

Back at the headquarters of Guangdong East Power, such concerns seem distant. Having struck success with power systems, He Simo is driving the company into new fields, including green energy systems such as solar power, opening up potentially new markets, markets far bigger than that for power supply systems.

“We try all the time and we implement things quickly and keep things simple,” said He. “I don’t think there’s anything I can’t do.” – Reuters