Jason Dedrick
Senior Research Fellow
Center for Research on Information Technology and Organizations (CRITO)
University of California, Irvine
Kenneth L. Kraemer
Professor, Graduate School of Management
Director, Center for Research on Information Technology and Organizations (CRITO)
University of California, Irvine
China’s Emergence as a Computer Industry Power: Implications for the U.S.
Presented before the U.S.-China Economic and Security Review Commission
China as an Emerging Regional and Technology Power:
Implications for U.S. Economic and Security Interests
February 12, 2004
INTRODUCTION
China has emerged as both a major market and a leading producer of computer hardware, along with other electronics goods. PC sales grew from less than 1 million units in 1995 to over 12 million in 2003, as China passed Japan to become the world’s second-largest PC market. Much of this growth was captured by local PC makers, particularly Legend Computer, which now controls nearly 30% of the market. Meanwhile, in 2002, China became the world’s second-largest producer of computer hardware, mostly consisting of production for export by foreign and Taiwanese firms.
This spectacular growth has been driven by China’s rapid economic growth and large inflows of foreign investment into the computer and electronics industries. Underlying these trends was a shift in government policy that began in the 1980s from technological nationalism to a more pragmatic approach. This includes requiring foreign companies to transfer technology in return for market access, directing domestic R&D toward commercial purposes, and supporting local companies in high-technology markets. In the computer industry, government policy has focused on promoting production and export of PCs, peripherals and components by foreign and Taiwanese companies, and supporting local PC makers in the domestic market.
From the perspective of U.S. computer makers, Greater China (including Taiwan) has become the key hub in the global production network, as U.S. companies have steadily outsourced manufacturing to focus on product design, branding, marketing and customer relationships. This raises the question of whether U.S. PC makers risk nurturing their own competitors, as consumer electronics companies did when they outsourced production to Japanese suppliers. Another concern is whether U.S. and other foreign companies have a reasonable chance competing in the fast-growing China market against local firms who may benefit from favorable government treatment. A newer issue is whether knowledge activities such as product development and process engineering will follow manufacturing to China, particularly given its large pool of low-cost engineering talent.
We conclude that the chances of Chinese computer makers becoming strong competitors in the global marketplace are currently low, given their inexperience operating outside of China and the still sizable growth opportunities available in China. At the same time, we expect that U.S. companies will not achieve a large market share in China, due to their lack of local market knowledge and effective distribution channels as well as to unofficial policies that favor local vendors. Finally, the shift of knowledge work to China appears to be inevitable, although it will likely take place gradually as Chinese engineers and other professionals gain practical experience and specialized skills.
Starting with Japan in the 1960s and 1970s, and continuing with Singapore, Korea, and Taiwan in the 1980s, the Asia-Pacific region became the leading global producer of computer hardware and associated components such as semiconductors, storage, and displays. The success of these countries has involved a strong role for government policy. Strategies varied considerably across the countries, but commonly involved a combination of export promotion and efforts to develop national capabilities such as infrastructure and human resources (Anchordoguy, 1989; Dedrick and Kraemer, 1998).
China has emulated key parts of its neighbors’ strategies, often consciously, by promoting exports and investing heavily in its information infrastructure. On the other hand, China’s strategies are notable for the government’s desire to catch up technologically while maintaining central control over key htmects of the economy and reducing China’s dependence on foreign technologies. For instance, in a February 2000 editorial, the People's Liberation Army Daily, which speaks for China's military, argued that China must develop its own software. It wrote: "Without information security, there is no national security in politics, economics and military affairs. While learning from others, China should not be under their control" (Goad and Holland, 2000). This willingness to learn from outsiders without surrendering technological or economic control has been a guiding philosophy behind China’s computer policies.
China’s technology policies are similar to those of its neighbors, but have been adapted to fit China’s unique national environment. Three factors in particular have influenced the development of China’s computer industry, shaping the government’s policy options and affecting the decisions of domestic and foreign firms.
First is the scale of China’s domestic market, with its 1.3 billion potential consumers, nearly unlimited supply of low-cost labor, and continued rapid economic growth. This makes China uniquely attractive to foreign firms as both a market and a production platform. The government has negotiated with foreign investors over access to this market, requiring local production, local partnerships or technology transfer in return. The size of the market also makes it possible for local firms to enter the PC industry and achieve economies of scale without venturing abroad.
Second is the development of China’s computer industry within the context of its transformation from a centrally planned to a mixed economy. While the other Asian economies have pursued their industry development strategies within a capitalist market context, China has done so in a transitional economy, leading to unusual ownership structures that include both private capital and state ownership. This intertwining of government and markets makes it difficult to make the usual distinctions between market forces and government policy.
Third is the fact that China built its computer industry on the foundation of a large science and technology complex with technological capacities well beyond those of most developing countries. This S&T complex was created partly in response to U.S. technology export restrictions which have limited China’s access to the most advanced computer and semiconductor technologies. As part of its economic transition, China transformed its science and technology system to spur growth and development (Lu, 2000). This was done in part by creating state-owned but market-oriented enterprises linked to state research institutions in order to commercialize the technologies developed in those institutions.
COMPUTER INDUSTRY POLICY
Computer technologies have been a priority of the Chinese government since the first long-term science and technology development plan in 1955. The first computers developed for industrial and commercial uses were produced in the 1970s, and the first microcomputers in 1977. China’s drive to create a commercially-oriented computer and electronics industry began in 1986 with the Seventh Development Plan. In that and subsequent plans, China’s electronics industry was given special emphasis and support as a “pillar” industry that leads the development of the entire economy.
China invited foreign computer makers to help develop its industry, often requiring them to transfer technology and form alliances with domestic companies in return for production licenses and market access. Multinational companies such as IBM, Hewlett-Packard, Toshiba, and Compaq formed joint ventures with local companies in order to market their own products and gain access to local distribution channels.
In the past, China discouraged direct import of computers by maintaining high tariffs and taxes, but reduced tariffs from 82% in 1992 to 35% in 1993 and has since removed them. The government also regulated foreign vendors’ access to its markets by limiting the production of foreign firms for the domestic market to a certain percentage of their export production. In order to encourage exports, the government created “export processing zones” where imported materials used in production would be free from duties and taxes when they were directly exported.
The most important “foreign” investors in China’s computer and electronics industry have been Taiwanese firms. Interestingly, China has welcomed this investment, while the Taiwanese government has attempted to slow it down through various restrictions. These restrictions, along with restrictions on direct flights and shipments between Taiwan and China had the effect of routing people, money and goods through Hong Kong.
The government has promoted domestic enterprises, but does not directly intervene in the management of these firms. Rather, it has dealt with them as part of enterprise reform, which involved separating politics from enterprise management, combining research with industry and trade, and forming joint ventures with foreign firms. Many domestic computer makers who had operated on a small scale became favorites of their supervising government departments and quickly expanded their operations by partnering with foreign companies.
The ownership structure of the Chinese PC makers is quite unusual from a western capitalist perspective, but is a reminder that there is still socialism in “market socialism.” Market leader Legend is closely affiliated with the Chinese Academy of Sciences (CAS), the leading government research institution. Founder Group is affiliated with Beijing University, and Great Wall is a spin-off of the Ministry of Electronics Industry (MEI). Each of the enterprises was restructured into joint-stock companies, and went public on either the Hong Kong or a local stock exchange. Yet each is controlled by a holding company that is owned by the affiliated government institution (Lu, 2000). In spite of their status as state-owned or collective enterprises, each is clearly managed in an entrepreneurial, market-oriented manner, and the Chinese PC market is highly competitive.
A key resource provided by the government was access to technologies developed by state R&D institutions. For instance, Great Wall’s initial PC was developed inside MEI research institutions, and Legend commercialized various technologies developed in CAS labs. These technologies enabled the companies to develop successful commercial products that sustained their growth and expansion into new industries, including PC manufacturing (Lu, 2000).
PERFORMANCE OF CHINA’S COMPUTER INDUSTRY
Total computer hardware production has grown so fast that China became the world’s second largest hardware producer in 2002 (Table 1), with production reaching $45 billion. Computer exports increased dramatically between 1992-2000 from $227 million to over $16 billion (Table 2). Moreover, China has an overall trade surplus in computers—totaling $6.7 billion in 2000, compared to a deficit of $524 million in 1992 (Table 2). More recent complete data is not available, but the rapid growth of notebook PC exports alone would mean that China’s computer exports were much higher by 2003.
China’s production exports are mainly a result of production by foreign (including Taiwanese) companies. China’s domestic vendors are primarily concentrated on the domestic market, although a few such as Legend have begun exporting to other countries in the Asia-Pacific region. Major products include desktop and notebook PCs, monitors, motherboards, add-on cards, disk drives, printers and other components and peripherals. Local content is increasing as more components are produced in China, although data on local content is not available.
Beginning in the 1990s, foreign companies set up PC production in China. In the early years, they had as much as 60% of the market, but their share has subsequently declined as local manufacturers have come to the fore. High tariffs along with regulations prohibited foreign companies from trading directly with the Chinese companies. Consequently, foreign PC makers began to set up production in China and work with local distributors. Most have formed joint ventures with domestic companies, allied with domestic enterprises favored by the government, made use of their partners’ sales channels to sell their own products, and/or aligned themselves with particular local governments seeking high-tech companies.
For the overseas vendors, the benefits of setting up local manufacturing sites in China are especially significant. During the negotiations over tariffs and domestic sales quotas, “they can argue that they earn foreign exchange, build up local industry, and relieve unemployment.” Furthermore, these vendors also allow the local government of China to make arrangements and selections for their partners for joint ventures because these Chinese partners “often have strategic locations and a reserve of local good will” (MIC, 1999c, p.22).
Currently, U.S. companies make up the bulk of the 30% market share of foreign PC vendors, led by Dell, IBM and HP. More important to the U.S. industry is China’s role as a production platform and supply base. IBM produces most of its ThinkPad notebooks for the global market in its IIPC joint venture in Shenzhen (it has increased its share of equity from 51% to 80%). Dell assembles PCs and notebooks for the China market and for export to Japan from Xiamen. In addition, the major PC vendors have pushed their Taiwanese suppliers to move production to China, partly to reduce costs, but also to provide a supply base that will enable them to achieve higher local content for products sold in China.
Role of Taiwanese companies
Taiwanese firms play a leading role in China’s computer industry. They first entered China in search of low-cost labor and production sites for components and peripherals, but have since expanded the scale and level of operations to include PC production. They have also expanded their role to doing contract manufacturing for foreign and Chinese firms, and trying to penetrate China’s computer market.
Taiwanese PC makers initially entered China in the early nineties with low-end, shoestring operations intended to hold costs and risks to a minimum. Investments often were routed through Hong Kong to circumvent Taiwanese government restrictions on direct investment in China. Taiwanese companies have markedly increased their investment in response to price pressures from the U.S. PC companies and fierce competition among Taiwanese suppliers and manufacturers. Consequently, major Taiwanese firms such as Acer, Quanta, Arima, Hon Hai, FIC, GVC, and Compal have built production facilities in China in the past several years. Hon Hai alone employs around 70,000 workers at its massive campus near Shenzhen, with entire buildings dedicated to customers such as HP, Apple, Sony and Dell.
Taiwanese firms have been prevented from producing certain high-end products on the mainland by Taiwan government restrictions. However, restrictions on notebook PC production ended in 2002, and major Taiwanese notebook manufacturers (who make the majority of the world’s notebook PCs) have set up large manufacturing facilities in China since then. There is also significant Taiwanese investment behind manufacturing of key components such as semiconductors in China.
The combination of Taiwan’s management and design skills and relationships with leading global computer companies, China’s low-cost labor (from factory workers up to engineers) and its potentially huge market, make Greater China a formidable competitor in the global computer industry. An important question is what will happen to Taiwanese companies as China’s own manufacturers improve their capabilities. Will China’s domestic firms continue to rely on Taiwanese companies as suppliers, or will they replace them? Will the foreign vendors continue to rely on Taiwanese companies producing in China or turn to Chinese companies? From Taiwan’s point of view, an equally big issue is whether Taiwanese companies will succeed by abandoning Taiwan and moving most of their production to China. If so, can Taiwan thrive by focusing on design, development and other knowledge activities, or will those activities eventually follow manufacturing to China, leaving Taiwan with a hollowed-out computer industry?
CHINA’S DOMESTIC COMPUTER MARKET
China’s IT market grew to $27 billion during 2002 from $1 billion in 1990 (IDC, 2003). PC sales reached 12 million units in 2002 from only several hundred thousand in the early 1990s. Market share in PCs changed dramatically in the late 1990s. In 1995, the leaders in market share were Compaq, AST, IBM and Legend, each with 5-7% of the market, while much of the market consisted of locally assembled clones, known as “white boxes” or “grey market” imports. By 2000, the government had cracked down on grey market imports, and created minimum standards for PCs sold locally. At the same time, Legend was in the process of building an extensive national distribution network, with hundreds of exclusive distributors and thousands of retail franchises. The result was that Legend captured nearly 30% of the market at its peak.
Overall, domestic firms account for about 70% of the market, with Legend most recently at about 27%. Among foreign firms, Dell has 6% and HP about 4%, with IBM, Toshiba, Samsung and others active in the market (note that PC sales and market share data for China are difficult to obtain and have been the subject of serious debate in the past). On the other hand, Dell is said to be the leading seller of PC servers, IBM the leader in commercial computers, and foreign firms such as IBM and Toshiba have a strong position in notebooks. The question is whether they will hold onto those positions as Legend and others gain capabilities, or whether they will fall behind as they did in desktop PCs.
Another interesting issue now arising in China is the government’s efforts to promote open source software, and in particular the Linux operating system as alternatives to proprietary foreign software. Given the high rates of software piracy in China, Microsoft and other software vendors have mainly had to compete with pirated versions of their own software in the past. However, if China does begin to reduce piracy, the benefits might go to the open source community and local firms making products on open source platforms, rather than U.S. software companies.
SHIFTING KNOWLEDGE WORK TO CHINA
Up to now, China has developed into a manufacturing powerhouse, but has had little involvement in knowledge activities such as product design and development, process engineering, marketing or brand management. China likewise has been a minor player in the global software industry, mainly producing software for the domestic market. However, given China’s large pool of science and engineering talent, there is a growing expectation that it will begin to play a more important role in knowledge work as well as manufacturing. In order to test this proposition, we looked at one type of knowledge activity in which China might be expected to play a role—notebook PC design and development. China is now home to a large and growing share of global notebook PC manufacturing, mostly through the investment of Taiwanese original design manufacturers (ODMs, who both design and manufacture notebooks for branded PC vendors such as Dell, HP and Apple). Therefore,one might expect design and development to follow manufacturing to China.
What we found was a mixed picture, with different phases of the design and development process divided among the U.S., Japan, Taiwan and China.
· Design, which includes concept creation, industrial design and product specification remains in the vendor’s home market, and is carried out internally by the branded PC makers, because of the strategic importance of branding and the need to be close to the market. This means that design is still done in the U.S. and Japan for the most part.
· Development, including mechanical and electrical designs, prototype development and testing, product verification and pilot production, is largely outsourced to Taiwanese ODMs, and is carried out mostly in Taiwan (the exceptions are IBM and the Japanese vendors who still have development teams in Japan). The key is the highly specialized skills available in Taiwan and Japan.
· Process engineering, including manufacturing ramp-up and taking out cost, is shifting to China along with manufacturing. This takes advantage of proximity to manufacturing as well as using low-cost Chinese engineers.
· Sustaining engineering, which involves supporting products throughout their lifecycle with upgrades and maintenance, traditionally was performed by engineers in the development organization, is now performed increasingly by engineers in the manufacturing organization. Thus this function is also moving to China.
Some hypothesize that once production moves to a low cost location, it will pull development activities with it. We found some support for this view. As manufacturing engineers in production sites upgrade their capabilities, they are set up to pull other activities from the development organization if there are labor cost advantages. Given that production is increasingly in China, sustaining engineering was first to move, and is now being followed by pilot production. Not all vendors or ODMs have created test facilities or transferred know-how to engineers in China, but the upgrading process is underway and expected to move further up the product life cycle. One source estimates that the entire development process (but not design) could potentially move to China by 2006.
Chinese PC makers have grown by focusing on the middle and lower end of the market and taking market share from foreign vendors and clone makers. However, price competition among domestic vendors has reportedly driven margins to near zero and brought about reorganizations, acquisitions, and changes in top management at some Chinese PC companies.
Chinese PC makers also lack economies of scale enjoyed by large foreign vendors such as Dell, HP, and IBM. In contrast, a fragmented domestic market is leading to low production by individual Chinese PC makers, with the exception of market leader, Legend. Local and regional government incentives to domestic PC makers may encourage expanded production by smaller vendors, leading to further market fragmentation and excess capacity.
A major challenge for China’s computer industry will be to move beyond production of standard PCs for the domestic market and low-value peripherals and components for the global market. With China’s strong base of technical skills and its ability to attract foreign investment and technology, the country has a reasonable chance to do so. Legend already is moving into software, Internet services, and information appliances, and other hardware makers are expanding their scope. However, developing a more knowledge-intensive industry will require a relaxing of controls on information and greater protection of intellectual property by the government.
For U.S. companies, China remains a large but often difficult market in which to do business. Not only are local firms favored by the government, they also benefit from their intimate knowledge of the market.
Success for U.S. companies may require partnering with domestic Chinese companies in order to gain access to distribution channels and markets. The IBM/Great Wall partnership has been the most successful example. However, many partnerships have led to disappointment, as the two sides were unable to collaborate effectively. In some cases Chinese distributors have defaulted on credit extended to them by foreign vendors.
While there are many potential pitfalls in dealing with traditional distribution channels, it is not easy to bypass these channels by selling direct. Dell’s direct sales model does not work well with individual consumers or small businesses in China because they lack experience in PC use, and also are not comfortable with ordering a product they cannot touch or see in advance. There are also problems with the financial infrastructure, such as lack of credit card use, and the transportation infrastructure, where there is no nationwide equivalent to a UPS or FedEx. Dell has built an assembly plant in China to support its direct model there, but also has had to develop relationships with local distributors and resellers who can give it access to large corporate accounts. In spite of these problems, Dell has been able to grow its sales and market share in China to enter the top five in market share. However, some of those sales are to the Chinese subsidiaries of Dell’s U.S. multinational customers.
China has targeted the software and IT services sectors of the computer industry for growth in the latest five year plan. It is increasing the number of IT professionals produced each year, fostering the establishment of software and services companies, giving preferential treatment in awarding of government contracts, and once again encouraging partnerships with foreign companies. Chinese officials intend to compete with India and others for the growing offshore outsourcing business in the U.S. That effort, along with the promotion of open source software, could have implications for the U.S. software and IT services industries, and for software professionals in the U.S.
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Appendix: Tables
|
|
1985 |
1990 |
1995 |
2002 |
|
US |
49.2% |
27.0% |
26.5% |
20.8
|
|
Japan |
18.9% |
29.2% |
25.2% |
13.4 |
|
Singapore |
1.2% |
3.9% |
7.3% |
5.7 |
|
Taiwan |
1.0% |
3.3% |
5.6% |
7.6 |
|
China |
0.0% |
0.4% |
1.9% |
14.4 |
Source: Calculated from Reed Electronics, Yearbook of World Electronics Data, 2003.
Table 2. China’s computer hardware trade, 1992-2000(US$ millions)
|
|
1992 |
1993 |
1994 |
1995 |
1996 |
1997 |
1998 |
1999 |
2000 |
|
Exports |
820 |
1,258 |
2,006 |
3,750 |
5,315 |
7,543 |
10,169 |
11,698 |
16,577 |
|
Imports |
1,344 |
1,344 |
1,763 |
2,403 |
2,876 |
3,868 |
5,300 |
6,969 |
9,883 |
|
Trade balance |
-524 |
-86 |
233 |
1,347 |
2,439 |
3,675 |
4,869 |
4,729 |
6,694 |
Source: Reed Electronics, Yearbook of World Electronics Data, 2003.