Absorbing Foreign Innovation

Recently, growth and development trends show technological innovation emerging as a major driving force. Through most of the 1990s, Chinese research and development (R & D) was an estimated 0.6 to 0.7 percent of GDP. Since the late 1990s, Chinese research and development has rapidly increased to an estimated 1.5 percent in 2005. In terms of its absolute level of R & D expenditure, China will rank in the top ten worldwide. In relative terms, its current proportion is still half that of Japan or the United States. On the other hand, many of the foreign multinationals are world leaders in information and communication technology (ICT). Indeed, China's trade in ICT goods (imports and exports) more than doubled from just over 12 percent of total trade in 1996 to more than 27 percent in 2003. More than half of these stem from the Chinese affiliates of the FIEs.

As the momentum shifted toward high technology, increasing economic regionalization and foreign trade protection has encouraged Chinese multinationals to develop offshore plants to avoid the quotas imposed on Chinese goods by importing countries. Meanwhile, the policy of "grasp the large, release the small", defined by the 15th Party Congress in 1998, endorsed the sale of all but the largest state enterprises, seeking to consolidate the most thriving state enterprises into organizations mirroring Germany's large multinationals and South Korea's business groups (chaebols).

Unlike overseas Chinese in mainland China, few U.S. companies used China as an export platform. The bulk of the investment was drawn by local market opportunities. Until the early 1990s, overseas Chinese investment had focused on low-tech industries to create cheap manufactured goods for export. After the mid-1990s, two-thirds of U.S. investment in China was directed at the manufacturing sector, especially industrial machinery and electronic equipment--the very same sectors that the Chinese government was now promoting in overseas investment.

Initially, the FIEs regarded China mainly as a low-cost processing and assembling base, relying on imports of component parts. Upgrading their investments and asset quality, foreign multinationals began to shape the new technology infrastructure in China, particularly in the prosperous coastal provinces, by contracting and sub-contracting, and by pioneering retailing networks and distribution channels. In the process, the "spillovers" nurtured the rise of indigenous suppliers, which provided components. By the late 1990s, foreign multinationals had become increasingly "localized", giving rise to a growing ecosystem of indigenous firms.

Today, foreign multinationals are increasing investment in R & D, marketing and services, while intensifying penetration and integrating management. The consolidation of FIEs in China is mirrored by the increasing boldness of Chinese multinationals. Typically, companies go abroad seeking resources, markets, efficiencies and strategic assets. In competitive high-tech industries, Chinese companies often internationalize to acquire strategic assets (brands, sales channels, technology, managerial competencies) in order to respond to the challenge of foreign multinationals at home.

Since the early 1990s, computers and mobile communications have been the two high-tech industries with the highest growth rates in exports from China. Last December, Lenovo--a bold electronics manufacturer that today provides inspiration to Chinese challengers and new attackers worldwide--acquired IBM's pc business for $1.75 billion. The goal was not to devour the U.S. market but to support Lenovo at home, where it is being squeezed by the likes of Dell and Hewlett-Packard.

In the past, China has been "the workshop of Asia." Now it is growing into the "innovation center of Asia."

The Rise of Chinese Challengers

If the computer industry exemplifies ambitious internationalization, mobile communications illustrates the high drama of FDI-driven challengers. Five years after the first orders from China--at the peak of U.S. trade conflicts and catch-up efforts with Japan--Motorola's chairman, Robert Galvin, made a long-term commitment to the market. Trading new technology for market access, foreign multinationals such as Motorola transferred technology, provided training and exchange programs, and set up retail training centers in a number of cities. However, resource commitments were still low and, after Tiananmen, significantly reduced, while European firms such as Ericsson, Nokia and Vodafone were only happy to fill the vacuum.

Following in the footprints of the likes of Motorola, Nokia and Ericsson, Chinese tech giants are gradually maturing into world-class high-tech players. With modernization, the reliance on contacts, or guanxi, is being augmented with the global business culture based on contractual obligations. Concurrently, bold new attackers are challenging their idols.

In the 1990s Chinese equipment manufacturers had no market share in China's mobile marketplace; in 2001 it was less than 10 percent; in 2003 an extraordinary 55 percent! Focused on building distribution networks that took them even into small cities, local handset brands like Ningbo Bird, Amoi, Panda and TCL were able to beat foreign MNCs and their global brands on prices and features that Chinese users appreciated the most, while pushing clever ad campaigns and developing product designs that appealed to local consumers. Rapid growth allowed Chinese firms to expand their presence in neighboring economies, which in turn has enabled the overseas Chinese to rejoin the changing production networks through market expansion, capability outsourcing and financial services. The rise of the Chinese mobile brands, for instance, was facilitated by outsourcing production from Taiwanese and South Korean electronics manufacturers, while gradually building in-house manufacturing capabilities.³

Once the technology-manufacturing infrastructure was in place, Chinese firms excelled because, knowing the marketplace intimately, they were better able to deploy the right marketing channels to offer the right products, the right campaigns, and the right advertising and promotion. It was a critical turning point. But that is not where the story ends.

After the rise of the indigenous challengers, the foreign multinationals mounted their own counter-attack. As Chinese challengers rarely spend more than 5 percent of revenues on R & D, the spending gap provides a substantial competitive advantage to the FIEs, which now imitated their challengers, flooding the market with me-too products, aggressive marketing campaigns, comparable distribution channels and slashed prices. In 2004 the market share of the indigenous producers declined to 37 percent. But in the meantime China had become the world's largest mobile manufacturer.

During the past decade or so, similar dramas have been seen in industries as different as car manufacturing, detergents, oil, petroleum and petrochemicals. In the first act, foreign multinationals pioneer the high-volume markets. Then, indigenous challengers respond with imitation and low-cost strategies. In the third act, innovation and more sustainable quality strategies emerge as the keys to success. In this drama, low-cost strategies offer short-term benefits, but sustained leadership is inconceivable without innovation. This requires global scale capabilities that only global multinationals possess--but the boldest Chinese challengers are determined to catch up the "resource gap."

Fierce Dragons or Cute Pandas?

At the first congressional hearing on the bid by CNOOC to purchase Unocal, the chairman of the House Armed Services Committee described the effort as "a strategic acquisition, just like the acquisition by the Chinese of these Sovremenny-class missile cruisers that they purchased from the Soviet Union, which have just one role, that is, to kill American aircraft carriers."

Are the emerging Chinese multinationals truly such fierce dragons, as many presume on Capitol Hill, or cute pandas, as others argue? After all, Chinese investments have gone hand-in-hand with high-profile state visits around the world by President Hu Jintao and Premier Wen Jiabao. Hoping to offset huge capital inflows into China by supporting the indigenous multinationals, Beijing has been keen to reinforce economic interest with diplomatic and political influence.

But let's look at the actual numbers. In 2004 the Global 1000 list by Business Week featured 423 U.S. companies with a combined market capitalization of $10.8 trillion. Japan had 137 companies with a market capitalization of $2 trillion; the UK, 73 companies with $1.9 trillion. Hong Kong's 15 and China's six companies, meanwhile, had a market cap of $190 billion and $104 billion, respectively. China's top corporations were all energy and technology related. The latter included two giant mobile operators, China Mobile and China Unicom. In addition to CNOOC, the energy-related mammoths are China Petroleum and Chemical (Sinopec) and CITIC Pacific, PetroChina.

Global competitiveness indicators tell the same story. In business competitiveness, the United States leads worldwide. During the past few years, Japan (8th) has steadily improved its position, but China (45th) remains behind.

Last year, foreign investment by Chinese companies rose by almost one-third to $3.6 billion, and Chinese capital outflow is gathering impressive momentum, coupled with the first major international merger and acquisition (M & A) efforts by emerging Chinese multinationals such as Lenovo and CNOOC. Some observers find associations with Japan in the late 1980s just too tempting to ignore (especially now that China's debut as a volume car exporter happens to coincide with the severe problems of U.S. car manufacturers). Still, the numbers should be kept in perspective. The FDI of Chinese multinationals abroad is barely 6 percent of the foreign capital inflow to China.

Electronics giants such as Huawei may herald the coming of "Chinese Matsushitas", but yesterday's Japan and today's China are at very different levels of economic development. More than half of Chinese investments come from energy and commodities companies, from oil fields in Sudan and natural gas in Iran to iron ore mines in Brazil and Australia. Most Chinese challengers are engaged in resource-seeking acquisitions to feed China's industrial revolution and rapidly rising domestic demand. Outside the resources sector, numerous Chinese manufacturers, such as TCL and Haier in electronics and white goods, and Chery and Geely in cars, have also planted roots offshore. They seek to embrace innovation while developing global brands.

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