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October 18, 2005 5:53 pm

China’s challenge changes the rules of the game

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The optical-sensor computer mice riding gently down a production line at the new Logitech factory in Suzhou look oddly melancholy, lying on their backs with their little USB connecter cord tails curled out behind them.

By contrast, Logitech’s effusive Italian president and chief executive Guerrino De Luca could hardly be happier, following the opening of the computer peripheral producer’s 12,000-sq metre plant in the eastern Chinese city.

“Look at the factory,” he says. “It is unbelievable what you can build with $20m here.”

Mr De Luca is not the only information technology executive pleased to be in China these days.

All around once-scenic Suzhou, bland industrial parks are filling up with factories making everything from motherboards to coaxial cables. In nearby Wuxi, a contract computer chip maker is building integrated circuits for design houses in Shanghai. More than 300m mobile phones across the country buzz with opportunities to download ringtones and sign up for SMS services. And even in the smallest towns, countless slack-shouldered teenagers hunch over broadband-equipped internet café computers playing fantasy online role-playing games.

There can be no doubt: China has joined the IT age.

Hsu Ta-lin, industry veteran and chairman of private equity firm H&Q Asia Pacific, says that a few years ago, China still had to compete with Taiwan to attract IT manufacturing investment. “Now there isn’t any argument,” Mr Hsu says. “If you want to manufacture, you go to China.”

China’s new role as IT powerhouse has sent ripples through the sector. It is now normal to see “Made in China” on the back of even high-end electronics products such as the Thinkpad notebook computers formerly produced by an IBM unit that now belongs to Chinese PC producer Lenovo.

Good data on the details of China’s role are hard to come by, but the country is an important part of the industry supply chain. China’s monthly trade surplus in electronics goods has climbed from $1bn in 2003 to more than $6bn and is still growing.

“If there was a disruption in supply from China for a few weeks, the whole world PC manufacturing chain would grind to a halt,” says Philippe de Marcillac, senior vice-president, international business units at IDC, a tech research firm.

But amid all the evidence of China’s IT success, two shortcomings are often all too easily overlooked.

The first is the fact that, despite great efforts to climb the value ladder, the vast bulk of Chinese electronics manufacturing is focused on relatively low-value parts production or assembly work. Thinkpads may be put together in China, but their Intel processing chips and Microsoft operating system keep most of the value in the US.

The second shortcoming is that the biggest beneficiaries so far have been overseas ventures. Both home truths are a challenge to Beijing’s industrial planners, but they offer comfort to international IT players, who fear that Chinese companies are just months away from seizing their businesses.

A recent report by economist Jonathan Anderson of UBS suggests that rather than taking over the role in IT supply played by neighbours Japan, South Korea and Taiwan, China has instead become a new link in the supply chain that connects its neighbours to global markets. “Based on broad trade data, China’s electronics growth still looks relatively ‘friendly’ for the rest of the world,” Mr Anderson says.

Indeed, much of the shift of production to China has been organised by foreign companies themselves, and they dominate the industry. Overseas-invested companies accounted for more than 87 per cent of China’s 2004 exports of “new and high technology” products, a category dominated by IT, according to data from the Ministry of Commerce.

Export output from foreign-owned ventures is growing faster than that of local rivals.There are plenty of exceptions. Chinese telecoms equipment manufacturers ZTE and Huawei, for example, now compete internationally with global giants such as Nokia and Lucent for contracts to build the newest “third generation” mobile networks.

Both companies are making full use of their ability to hire large corps of engineers for salaries just a fraction of those commanded by counterparts in the US, Europe or Japan.

ZTE and Huawei also spend 10 per cent or more of their revenue on R&D, allowing them to make up ground rapidly on market leaders.

Chinese companies can spend less on R&D but get more researchers, says Hou Weigui, chairman of ZTE: “In some ways this is our edge.”

The telecom equipment vendors are exceptions however. Few Chinese companies are willing to put as much into R&D. Mr De Luca of Logitech for example, notes that local competitors in the computer peripherals business usually spend less than 1 per cent, while the Swiss-US market leader invests 5.5 per cent. That means it can keep coming up with new features such as laser-equipped mice that command higher prices and fatter margins.

Chinese companies also have no monopoly of access to the 300,000 or so engineers who graduate from the country’s universities every year. Clusters of well-funded foreign-owned R&D centres are growing in Beijing, Shanghai and in second-tier cities – and they compete with local ventures for the best talent.

Mr Hou says ZTE’s two decades of experience in Chinese R&D is difficult to match, but he acknowledges that this will not be true forever. “It’s hard to say for sure, but our advantage will be relatively clear for the next three to five years,” he says.

ZTE and its peers have already largely lost any edge gained by using factories in China, as foreign IT manufacturers cut the numbers of their expatriate staff to reduce costs, while often also benefiting from special tax breaks and investment incentives.

“The good news is that we are Chinese for all intents and purposes when it comes to cost... but with the advantage that we understand the markets of the west,” says Mr De Luca.

A potential trump card for corporate China is the fast-growing domestic market. Government fiat still carries much weight, and support for local vendors can still be crucial to their development. But it is much less prevalent than many might think.

Mr Hou at ZTE, for example, complains that telecom equipment vendors are not given the level of domestic market protection available elsewhere.

Electronics industry regulators have spent more time trying to limit the number of local mobile phone handset manufacturers than trying to keep out foreigners. Efforts to support local electronics companies by imposing special standards have so far borne little fruit.

China is already a much more open market than Japan or South Korea were when they started to become IT powers, and its barriers to entry are still falling as it implements promises made as part of its 2001 accession to the World Trade Organisation.

“The pace at which China is opening sectors gives local companies limited time to develop,” says Gordon Orr, chairman of McKinsey for China. “If a multinational can come to China and take advantage of lower costs, what can the Chinese competitor do that is different and better?”

In some areas, home-grown ventures still have an edge. Telecoms services, for example, are still highly protected. And foreign online games companies cannot directly enter the market, giving local distributors such as Nasdaq-listed Shanda an opportunity to build huge businesses and to start to develop their own products.

L ike much of Chinese business,  however, the internet sector is  plagued by a “me too” culture.  Every good idea is immediately copied by new entrants to the benefit of few. Even the best companies can struggle to develop because of dysfunctional local capital markets and the lack of a healthy venture capital system. Cheap bank credit makes up some of the gap, but only at risk to an already shaky financial system.

Mr Hsu of H&Q says another concern is a general lack of creativity, caused in part by reliance on rote learning even at the best Chinese universities. But he remains confident that the country will be able to establish itself in higher-value areas such as industrial design. “China is poised to elevate itself from the factory of the world to the engineering centre of the world.”

Mr Hou of ZTE agrees, saying he believes in the “intelligence and wisdom” available in China. “This quality will certainly play a more important role in the whole world’s high-tech industry in the future,” he says.

It would certainly be foolish to assume that China’s IT sector will forever be dominated by foreign business. Many of the cohorts of managers being trained by overseas ventures and science students overseas will be the entrepreneurs of the country’s future. And weak intellectual property protection will continue to allow local ventures to break into markets that might otherwise be closed to them.

Chinese companies are sure to be increasingly important in the global IT business in coming years. But for most international market incumbents, the game is still theirs to lose.

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