It makes sense to being with the lessons from Japan. From the 1950s to the 1980s, the Ministry of International Trade and Industry (MITI) was one of the most powerful agencies of the Government of Japan. At the height of its influence, it is believed that it ran much of Japanese industrial policy, direct investing and the financing of research. Many of us witnessed the rise of Japanese companies across multiple industries onto the global stage and expected that Japan would become the most powerful country in the world. Japanese companies were famously the undisputed leaders in consumer electronics accounting for the majority of the global industry’s sales. Companies such as Sony, Panasonic and Sharp introduced the Walkman, personal video game consoles, the CD, and the DVD to global consumers. Today, Japan’s market share in consumer electronics has dropped significantly and the three abovementioned companies generated losses in excess of US$20bn in 2012. Much has been written about the reasons for the loss of competitiveness of Japan’s electronics industry to South Korea, China and lately Apple of the US. Looking ahead another 15-20 years, it is not difficult to envisage sector leadership passing to an altogether new set of countries, based on shifting competitive requirements and global demand patterns. This domino effect has the potential to play out globally across multiple sectors, and popular reports have low-cost China as the key beneficiary of these developments. However, cost competitiveness in a sector does not equate to the companies from that country achieving international dominance. And this raises a series of difficult questions for China’s planning model.
Looking at the example of the Japanese consumer electronics industry, commentators have pointed to many different reasons for its companies’ fall from dominance, including missing the personal computing wave, missing the software development wave, missing the internet wave, missing the international mobile communications wave, lack of investment due to overleverage, and the strength of the yen. While all of these factors are certainly true and contributed to Japanese consumer electronics companies’ decline, the basic truth remains that they failed to shift with the changes in the international industry and lost competitiveness as a result. Consumer electronics today is less about high quality manufacturing, which Japan, with its culture of craftsmanship excelled at, than about the finger on the pulse of what makes something fundamental to people’s lives. This essential intangible creative insight is captured in brand value. Once that is cracked comes the very important task of leveraging global resources through activities such as mass sourcing, assembly and integration of increasingly complex and specialised components on the one hand, and the development of software and services to create device platforms and networks on the other hand. The first of these drivers requires access to low cost labour and economies of scale, in which China today excels, and China has become the world’s largest destination for electronics manufacturing services. The second (leveraging global resources) and third (software and services) drivers of value are not at all China’s strength. So, this has not translated into leadership in consumer electronics and its share of value capture in the industry remains negligible: looking at the distribution of value in an Apple iPhone, assembled in China from components often made in China, over 60% is captured in the US in the form of profits, with another 12% of profit captured by other countries such as South Korea and Taiwan, with the balance representing the cost of input materials and labour, supplied by companies in China, generally with thin profit margins.
The example above demonstrates that value in the sector has clearly migrated from hardware to brand, software and IP, and companies like Apple and Samsung are dominating the industry accordingly. Moreover, even on the hardware side, while China may be biggest manufacturer of consumer electronics, the biggest companies in China are foreign owned like Taiwan’s Foxconn or Singapore’s Flextronics and today approximately 80% of the market is controlled by China, in many of its biggest industries is less of a global leader than a global site for certain activitiesforeign owned companies. These two factors, the distribution of value within an industry and the participation of foreign companies, mean that China, in many of its biggest industries is less of a global leader than a global site for certain activities. By way of analogy, China for many sectors provides the real estate but doesn’t control what goes on inside the building. This phenomenon is not unique to China and applies to India to a lesser extent in its IT services industry. While India hold the number 32n, 33rd and 36th slot in global IT services, international companies like IBM have similar sized footprints in India while generating five times the services revenues of the largest domestic company, TCS. For China, however, it raises the question of the sustainability of its growth trajectory, given the finite potential of an economy that does not capture the high ground of creativity or global resource leverage in its key industries. More positively, it also raises the questions of how much value the country is leaving on the table and what steps it can take to capture it.
Rethinking China’s Trajectory
Since the reforms in the 1980s, China’s development trajectory has been driven by mass industrialisation resulting from a shift from agriculture to manufacturing. A look at the breakdown of GDP by sector for a number of companies demonstrates the success of this model, with China today being the only major global economy whose industrial sector is larger than its services sector (see below). Looking at the size of the country’s agricultural sector today relative to other industrialised nations also provides some indication of the potential short to medium term sustainability of the model, with significant resource reserves in agriculture remaining to shift into industry, this redistribution of resources allowing for further industrial growth. However, over the longer term, economic growth will depend on being able to manage the shift to services, which account for 60-80% of developed countries GDP, compared to less than 45% in China today. In previous Sign of the Times we have highlighted a number of challenges associated with managing this transition from production to consumption and innovation, including the freedom of information, the freedom of labour and the freedom of capital. With regards to creating the required leading industries and, by extension, industry leaders, China also faces an additional set of challenges.
When China launched its initial economic opening up, it had an industrial base upon which to build. The legacy of over 30 years of economic planning encouraged the development of heavy industries and saw the state as a major economic participant in the form of state owned enterprises dominating their respective industries. These companies were key beneficiaries of China’s economic development and today its state owned oil majors, steel companies, utilities and also banks are among the largest in the world. Having prioritised these it did not emphasise (from a state planning perspective) the services and creative and innovation driven sectors of the economy to date, China has no comparable base upon which to build leading industries and fewer ready-made candidates for international competition. In these new sectors there are no SOEs and no home-grown giants to become the new national champions. Moreover, it is most likely that these high value added sectors could not have developed without the free enterprise and personal freedoms that are required for innovation and service provision to grow. For the coming transformation, China’s leaders will need to decide how and whether they can create large state driven industry development models of the previous wave of growth for these high value added sectors or whether they should encourage the development of a more free-market, entrepreneurial model which encourages innovation at the cost of central control.
Creating or Allowing Leading Industries and Industry Leaders
The issue facing China today is not a new one, however, and one that has played and is currently playing out across a number of high growth sectors. Looking at the strengths and shortfalls of China’s approach to date provides some insight into the likely model it might adopt in the future, even though its approach has varied from and even within sectors. The internet sector and consumer electronics industry, actually, provide two interesting case studies.
Internet Sector. The internet sector in particular is interesting in that it is less than 20 years old globally, and is one in which few countries had much of a head start of China in its development. Today China has over 500m internet users, twice the online population in the US (and growing to 750m by 2015) . China is also the home to two of the world’s top five internet firms by market cap and has an industry of start-ups and scaled players in social networking, games, media, music and e-commerce, all created within the past 15 years. Originally modelled on successful US internet companies, the first generation of Chinese companies quickly adapted their offering to the local domestic and market and begun creating localised products and services. Tecent, today one of the top five global internet companies by market capitalisation, began as a local Chinese version of ICQ, a first generation instant messaging service. The company has since changed its focus to online gaming and makes money from in-game purchases. Alibaba’s Taobao, started as an online auction site modelled on eBay, but has become one of the largest B2B and B2C shopping malls, again measured by size, with its own online payment system. Although these companies, along with Sina, whose Weibo social media messaging platform has almost 400m registered users, have to date not yet expanded to international markets. However, they are beginning to show signs of innovating and their services and technology are now finding their way back to the US and other markets where local companies are incorporating these into their own offerings.
Initially, in the absence of a domestic venture capital – entrepreneurial ecosystem, the first generation of Chinese internet companies were founded largely by Chinese entrepreneurs returning from the US and funded by international venture capital funds, despite the fact that the internet and media sectors are restricted to foreign investment, the government turning a blind eye towards the various investment structures that were employed to circumvent these restrictions. The approach to building this base has been helped by central policy. Although US internet companies made plenty of strategic and operational mistakes of their own in China, the growth of China’s domestic internet companies was also clearly helped by the increasing restrictions placed on foreign companies seeking to compete. Services like Facebook, Twitter, Youtube and Blogger are entirely blocked and Google’s various services are painfully slow at the best of times following the company’s decision to relocate its China operations to Hong Kong. Although China’s censorship of the internet plays a big role in these restrictions, the benefit to domestic companies cannot be denied. Nevertheless, there is also a price domestic internet companies pay for this benefit: censorship and self-censorship, disclosure of data and IP to government authorities, and slow internet access due to firewalls all reduce the usefulness of the internet in business and so does not transform productivity and cross-boundary thinking as it does worldwide. The question therefore remains, can any of the Chinese companies progress to something truly original and perhaps even of international appeal without the restrictions. The bigger question is whether China can create world-class levels of innovation and productivity in any given area if it does not full unlock the transformational value that the internet offers.
The Crux of the Matter. The internet is a platform that drives us all to cross-boundaries. It plays on our curiosity and our need to connect. It leads us to knock down the barriers that are personal, social, intellectual, cultural and many, many others. It gives us the freedom to taste the thoughts of the Buddha and Hitler, Einstein and Anais Nin, Ben Hur and Tom & Jerry, , the Bible and Playboy and even teaches us how to make anything from a cake The internet give us the freedom to taste the thoughts of the Buddha and Hitler, Einstein and Anais Nin, Ben Hur and Tom & Jerry, , the Bible and Playboy and even teaches us how to make anything from a cake to a bomb, how to meditate and how to start a revolution. Is China ready for this? to a bomb, how to meditate and how to start a revolution. . If China’s internet players are to be creative, innovative and truly productive at a world class level they will need this access. If not, China’s leaders will create a population that merely trades with each other and sends “safe” and trivial messages to each other. In effect China will have decided to stay for the next few decades in the manufacturing era and could use this to continue to bring the next generation of rural population to this era. However it is most unlikely that the population will wait. The internet, travel and broadcast media will allow to seep through the censor’s net the messages of a more “cool” and rich life that the open world is enjoying and this will disturb the status quo. To contain this will require a harsher system of controls and the cycle of control and freedom will play out as it has in history.
Consumer Electronics. In consumer electronics China has been reasonably successful in building strong domestic competitors, even though government involvement in the sector has been somewhat inconsistent. Chinese companies, for example, make all five of the top five best-selling TV brands in China. Originally white goods manufacturers, companies like Haier and Hisense evolved over time into diversified consumer electronics companies that have moved increasingly up the value curve, from low end commodity products to increasingly direct competition with Japanese and Korean companies, largely without overt government support. In more complex smartphones too Chinese companies represent three of the top five smartphones vendors in China (although Samsung and Apple are the number one and three companies, respectively). The two leading Chinese companies are Lenovo, the world’s largest computer manufacturer and Huawei, the world’s second largest telecom equipment manufacturer. Lenovo is effectively a state-owned company (with the government owned Legend Holding Group controlling over one third of the company’s shares) and Huawei is privately held (with the level of government involvement in the company being a matter of intense speculation). Though Huawei is at pains to distance itself from the Chinese government, the company has clearly benefitted from its close relationships with Chinese state owned telecom monopolists, who control the world’s largest national telecommunications market in which Huawei has a market leading share. This benefit cuts both ways. Taking the example of Japan again, for example, the country’s leadership in consumer electronics should have translated well to mobile telephony. DoCoMo, the domestic telecom giant, in the early 2000s innovated to meet domestic needs in an exemplary manner. However, it had a tight grip on the consumer electronics industry in Japan that supplied its phones and its defacto “national champion” status enabled it to stop its domestic industry from mastering mobile technologies and this handicapped them in global competition.
Finally, it is worth pointing out that China to date has not actively restricted foreign companies from competing in the consumer electronics space, and the government has limited itself to patriotic appeals to buy domestic products, combined with the occasional media campaign against foreign brands. The effectiveness of these measures is questionable, though, as the result of the recent multi-media attack on Apple demonstrates. The company was subjected to a month of attack in print, TV and social media over its warranty policies and customer service, culminating in an editorial in the (state-owned) People’s Daily titled “Smash Apple’s Incomparable Arrogance”. The editorial however, sparked a social media backlash of consumers against a wide range of state-owned companies, whose service levels were compared unfavourably to Apple’s and the campaign was quickly dropped.
The Crux of the Matter. The question remains, can China be a leader in consumer electronics without allowing its people to think “out-of-the-box” of rules that govern Chinese society. Japan is a highly rule-based society where the rules are mostly unstated. Yet in the 1970s and 80s, its creativity found a home in the consumer electronics industry and its manufacturing excellence enabled it to dominate consumer electronics and it defeated RCA, Zenith and Philips. Japan unleashed engineering excellence to deliver breakthrough thinking in products like the Sony Walkman, the CD and the DVD. However, as the internet era came, its rules (unstated of course given the Japanese culture) did not allow it to embrace well the integration of thought across boundaries (mobile, communications, technology, media and information, services and personal) that would be required to create the new generation of solutions. And so we came into the Apple era. The personal device is the gateway into a world beyond regardless of where we are by connecting us to others and to the virtual world of the internet. It allows us to talk, read and broadcast and has become the primary tool for exchanging pleasantries, for wasting time, for managing business affairs, for protesting about local and national matters and for organising the Arab Spring.
The question is the same, one either embraces the freedoms of a more dangerous world in which one’s values are the only barrier (and even those may well change for better or worse) or one builds walls to keep disruptive ideas out. The lesson for China is that the level of change in the world at large is such that China’s electronic companies cannot be the Apple of their industry without the level of innovation that comes from a truly open society. China can still create huge domestic companies given the size of its population (and their size will rank them amongst the biggest in the world) and populations that want cheap and basic functional products (a sizeable worldwide market) will buy them. As China’s cost structure increases there will be someone else who will supplant China over the long run. Where local companies create sophisticated domestic products for sophisticated domestic audiences and these overlap perfectly with the same audiences worldwide, they will score well overseas. One-off hits are therefore possible. But hardly anyone who cares about highly creative and highly functional products will want most of China’s home-grown products. And as its own population prospers and can afford more it will need to create more and more barriers to the penetration of its markets by others to ensure the domestic success of its companies.
Which Industries Can China’s Domestic Players Dominate With its Existing Political Model
Without the “openness” we have talked about above and with its current political and economic development model, China can still lead industries and create global industry leaders, albeit in a more limited field of sectors than it aspires to. Today, China’s leading domestic companies can dominate global industries that have the following characteristics:
- Low cost and basic functionality. This applies to industries where the product is simple in functionality and is bought worldwide based on its cost such as light manufacturing, textiles, bulk chemicals, basic resources (e.g. aluminium), etc.
- End of life cycle.This applies where the innovation phase is over and even if the product is highly functional, its engineering is well understood and commoditisation has kicked in so that brand hardly matters such as fine chemicals and electronic components (e.g. memory chips)
- Transnational taste. This applies where the domestic preference and the foreign one overlap such as to some extent in its film sector, food and fashion industry.
- Large scale but low cost engineering service components. This applies where the need is for the provision of cheap semi-skilled and low-skilled labour.
- Finance. Particularly project finance, where the need is for finance and can encompass a broad range of financing including project finance, private equity and debt financing.
So, What’s the Best Model for Industry Development?
As China positions to shift its economic development model, the examples above demonstrate that there are three models the country can pursue with regards to the development of industries and industry leaders. Each model carries different execution risks and challenges and is more or less suited for different industries. China’s leaders will need to choose between the following:
- Protected National Champions. As stated above, a model focused around protected national champions would be the closest to China’s historical development model. Although this had previously focused on wholly state-owned enterprises, privately held domestic leaders could also become protected national champions. For example, both Lenovo and Huawei are global leaders in the industries with the ability to position themselves, and be recognised by the government, as national champions, making them tempting targets for government support and favouritism. Should China seek to adopt this model, it will need to significantly modify the original version of its national champion policies. The first generation of national champions were created to effectively concentrate government investment, particularly in capital intensive sectors like infrastructure, and create widespread employment, rather than to create international competitors. While the case may still be made for employment schemes in state-owned monopolies in sectors such as utilities and telecoms, the idea of a digital media content monopolist is likely bound for failure. Further, over the long run, forced industry concentration has proven to be inefficient, un-economic, innovation stifling and prone to corruption, an issue that the Communist Party, itself the government monopolist since 1949, is clearly aware of and the new leadership is determined to address.
- Protected Domestic Industries. China may choose to pursue a model similar to the one used in the internet sector, encouraging local sector development by accepting international IP and capital but limiting direct foreign competition. China’s media content sector is another good example of this model, with only a limited number of foreign films (subject to strict and sometimes what appears to be random censorship) allowed to be screened annually and strict broadcasting rule favouring domestic content. With this approach, China can clearly build strong and vibrant domestic industries. What is unlikely is that this model has the ability to create companies that can compete effectively internationally. With highly favourable dynamics in the domestic market, Chinese companies will likely be tempted to remain highly local, adapting their products to domestic tastes at the expense of internationally competitive ones. And while this approach may work in creative and services driven industries like media, it is unlikely that China can build a world class automotive sector, rather than just a domestically strong one, without competing internationally.
- World-Class Competitive Industries. Finally, China can adopt the US approach to creating world class industries. The US has been an undisputed global leader in technology for the past 50 years, with now only limited direct government involvement in the sector. While government, whether through university funding or the military, has supported fundamental R&D (which have delivered innovations like GPS, the Internet and digital photography among other things), the commercialisation of innovations has been left entirely to China has made one of history’s greatest leaps in freeing its people from the limitations of structural poverty and it has done this making it’s centrally controlled political model a virtuethe private sector. Similarly while the US has created policies favourable to the deployment of risk capital, it has left the funding of companies to the private investors. The result is a vibrant and competitive industry that remains world-class regardless of who the transient industry leaders are. IBM was followed by Microsoft, which has now been replaced by companies such as Apple and Google, but US tech and internet leadership has never been in doubt. Adopting such a policy in China would require a step change in its leaders’ thinking, effectively trading a loss of control for industry growth and innovation. It will also require an acceptance that China leading industries and industry leaders may not be “Chinese”, just as entrepreneurs from all over the world come to Silicon Valley to start their companies. The biggest industry success stories, from Japanese cars to Scandinavian telecoms, were built upon this model, and if China is serious about creating leading global industries, it is the one it will likely need to adopt.
China has made one of history’s greatest leaps in freeing its people from the limitations of structural poverty and it has done this making it’s centrally controlled political model a virtue. It has also done this far better than democracies like India. The virtue of this model provides enormous lessons to other centrally controlled states. Where the leaders overthrown in the Arab Spring failed was in utilising their central control to deliver this level of prosperity. Logical choices follow from this of course in terms of what next for China’s development. There are two valid options, namely:
- Spread the Manufacturing Revolution. This entails the following policy thrusts:
- Spreading its industrial revolution to include more and more of the countries rural population,
- Maintaining, broadly, the same level of restriction on domestic access to information,
- Protecting local industry from foreigners who might usurp national leaders,
- Attracting and incentivizing foreign manufacturing and intellectual property to the country to enable local learning, imitation and copying, and
- Strictly controlling its cost structure to ensure it is low cost by world standards.
- Begin the Innovation and Services Revolution.This entails the following policy thrusts:
- Open access to the internet and media while maintaining the standard international monitoring for extreme security threats,
- Open access to foreign players where there are scaled domestic players and selectively others until restrictions only apply to limited matters such as M&A that would harm well-defined national interests,
- Actively encourage foreign and domestic venture and private equity investing removing restrictions on repatriation of profits and structures for participation and in parallel revise bank lending rules in favour of smaller, private and asset light services businesses to encourage the growth of innovative companies over larger state owned industrial companies,
- Focus on state funding to promote R&D in the form of fundamental research at the university and institute level as well as private sector research grants to encourage market-based innovation ecosystems for the commercialisation of new technologies,
- Implement and enforce a rigorous regime for the protection of intellectual property, including patents as well as trademarks, to provide security for the private sector to invest in and commercialise innovation.
If the manufacturing revolution is spread across the country, China can continue to bring onto its platform the next wave of the “hopefuls” from the population of the rural areas. This is a necessity even if China begins the innovation and services revolution. However, the principles, policies and practices that enable the innovation and services revolution will not be contained to the services sectors. Running “One China, Two Systems” is difficult enough when applied across the boundaries of mainland China and Hong Kong and clearly would be too difficult to run within the mainland. It is likely that the less free gravitate to the same level of freedom as the most free. China’s education ministry has understood the issue of innovation and openness and has been grappling with this difficult issue for at least a decade. This is now one of the Big Questions for the country’s leadership as a whole. The positive is that the country has a legacy of success and the difficulty is that too.
1. Company annual reports
2. Capturing Value in Global Networks: Apple’s iPad and iPhone – Kenneth L. Kraemer, Greg Linden, and Jason Dedrick, 2011
3. More correctly, GDP ratios between sectors shift due to different sector growth rates, which in turn are driven by the allocation of capital and resources.
4. China the Freedom Advantage – April 2012
6. Google is the market leader in search in virtually every major economy with the exception of China, Korea and Russia, which have domestic leader. The market leader in Japan, Yahoo, uses Google search technology