Paper Tigers, Hidden Dragons: Firms and the Political Economy of China's Technological Development [1 ed.] 0198777205, 9780198777205

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Paper Tigers, Hidden Dragons

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Paper Tigers, Hidden Dragons Firms and the Political Economy of China’s Technological Development Douglas B. Fuller

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Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries © Douglas B. Fuller 2016 The moral rights of the author have been asserted First Edition published in 2016 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2015952294 ISBN 978–0–19–877720–5 Printed in Great Britain by Clays Ltd, St Ives plc Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.

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To my parents, Kathleen B. and Richard K. Fuller

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Acknowledgments

I am incredibly grateful to have had the help of so many gifted people along the way to the completion of this book. First and foremost, I wish to thank Suzanne Berger and Richard Samuels for all their guidance and patience as my dissertation supervisors at MIT’s Department of Political Science. Whatever else I’ve accomplished as an academic is in no small part the result of those years learning from them. I would also like to thank my first PhD supervisor at MIT, Cui Zhiyuan, who has always been both a gentleman and a scholar. I remain forever indebted to Tayo Akinwande and Charlie Sodini for teaching me all two electrical engineering professors could possibly teach a distressingly non-technical social scientist like myself about the electronics industry and for our wonderful times conducting research together in Asia. Richard Lester as director of the Industrial Performance Center (IPC) dispensed good humor and even better advice to all the graduate students working there. I would also like to thank a number of classmates and colleagues from MIT: David Art, Dan Breznitz, Ed Cunningham, Erica Fuchs, Wenkai He, Sara Jane McCaffrey, Dane Morgan, Apiwat Ratanawaraha, Amos Zehavi, and most especially, Yutaka Kashiwabara and Jiyoon Kim. Prior to MIT, John Zysman and Lillian M. Li inspired me to pursue an academic career involving comparative political economy and China. In my academic career, I’ve been blessed with supportive colleagues including Henry Rowen, Marguerite Hancock Gong, William Miller, Michelle Hsieh, Rafiq Dossani, Iris Xiaohong Quan, and Yo Yamaguchi at Stanford APARC, Nanette Levinson at American University, Chung-Ming Lau, Shige Makino, Kevin Au, Daphne Yiu, Gongming Qian, and John Lai at Chinese University of Hong Kong, and Dean Wu Xiaobo, Chen Ling, Wei Jiang, Chen Zongshi, Wu Aiqi, Dong Xusheng, Zhang Zhongyuan, and Mark Greeven at Zhejiang University. At King’s College London, Olivier Butzbach, Ginny Doellgast, Tony Edwards, Howard Gospel, Aditi Gupta, Gregory Jackson, Finola Kerrigan, Peter Kingstone, Hyunji Kwon, Gretchen Larsen, Dirk vom Lehn, Gerhard Schnyder, Matt Vidal, and Cagri Yalkin offered a wonderful mix of friendship and intellectual stimulation. I’ve benefited greatly from Tom Gold, Bill Hurst, Kun-Chin Lin, Adam Segal, Victor Shih, Eric Thun, Kellee Tsai, and, particularly, Matt Ferchen (who read

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Acknowledgments

much of the manuscript), sharing their insights on Chinese politics and political economy. My ongoing discussions about the political economy of development with Caroline Arnold, Dann Naseemullah, and Joe Wong have also proven invaluable to me. In Taiwan, I would like to thank Chen Shin-Horng, Huang Chang-Ling, Hsu Szu-Chien, Hu Mei-Chih, Lee Chuan-Kai, Lü Kuei-yun, Sheng Chien, Shih Chin-Tay, Su Rong, Tao Yi-Feng, Wang Jenn-Huan, Yi Meiqin, and Zhan Yaojun. In China, Dong Zhenghua, Li Yansong, Li Lihua, He Yan, Xia Jianzhong, Zhu Ming, the inimitable self-proclaimed “gourmet club of Beijing” (Cen Hong, Chen Lu, Wang Shengjun, Feng Yali, Ke Yinbin, Kang Rongping, Liu Yuanchun, and Sun Tao), Coco and Steve Terry, and, last but far from least, Liu Dong provided friendship and so much more. In Hong Kong, thanks goes to Doris Kwan, Edwin Lee, Basti Bujnoch, and Peng Zhengmin. I remain deeply grateful to David Musson and Clare Kennedy at Oxford University Press for all their hard work as editors for this book. Finally, I would like to thank my family. My wife, Wu Chun, and our children, Katherine and Madeline, have given me great support and demonstrated even greater patience during my long slog to finish this book. My in-laws, Yan Xueyun and Xu Wenjin, have helped us with childcare and so many other things in the UK and China. The Nakayamas ( Julie, Yaz, Emily, and Natalie) have been unfailingly supportive and ensured that at least one child (and one set of grandchildren) remained close to home for my parents while I’ve been abroad. I dedicate this book to my parents, Kathleen B. and Richard K. Fuller, to whom I owe simply everything.

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Contents

List of Figures List of Tables List of Abbreviations

xi xiii xv

Part I. Setting the Stage Introduction

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1. The Framework

12

Part II. State Policy, Firms, and Upgrading Outcomes 2. California (and Hsinchu) Dreaming: China’s Flailing Efforts to Replicate Technology Clusters

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3. Paper Tigers: The Weakness of China’s National Champions

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4. State-Driven Technology Commercialization versus the Globalization of R&D

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Part III. The Integrated Circuit Industry Introduction to Part III

113

5. IC Fabrication

117

6. IC Design: From Reverse Engineering to Innovation

156

Part IV. China in Comparative Perspective 7. China’s Global Hybrid Model for Development under Globalization

189

8. Importing Institutions and Comparative Capitalism

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Contents

Conclusion: China’s Economic Future and the Future Role of Hybrids

224

Appendix: Interview List Bibliography Index

231 241 271

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List of Figures

1.1 Causal chain 4.1 US utility lead inventor patents by firm type III.1 Integrated circuit value chain

24 108 115

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List of Tables

1.1

China’s NPLs in comparative perspective: NPLs as a portion of GDP (%)

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1.2

Typology of firms, causal factors, and development outcomes

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2.1

Suppliers for Taiwanese IT manufacturers in the PRC

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3.1

Production shares of IT end products in China, 2002 and 2012

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3.2

PC market share (by units sold) in China

68

3.3

Identifiable state procurement as share of Lenovo’s sales

71

3.4

Subsidies for appliances to the countryside program recipients, 2009

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3.5

China’s major telecommunications infrastructure vendors

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3.6

Global wireless infrastructure market share (revenue), 2002 and 2010–2013 (%)

84

3.7

China smartphone sales (%) by price segment, 2012–2013

4.1

Fixed asset investments and R&D by firm type (%)

108

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5.1

China’s gap with leading international IC fabrication

122

5.2

SMIC’s localization of engineering talent

135

5.3

SMIC shareholders, 2004–2012

141

5.4

SMIC board of directors, 2004–2011

142

6.1

Top ten fabless firms and state procurement, 2011

160

6.2

IC industry promotion policies

162

6.3

National IC design bases

165

6.4

Contributors to upgrading by firm type, 2001–2005 and 2007–2011

174

7.1

The four paths of development

200

8.1

Representative scholarship of the robust and fragile scenarios

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List of Abbreviations

AMB

advanced memory buffer

AMC

asset management company

CAD

computer aided design

CCP

Chinese Communist Party

CME

coordinated market economy

CMOS

complementary metallic oxide silicon

CPU

central processing unit

DRAM

dynamic random access memory

DSP

digital signal processor

DTV

digital television

EBIT

earnings before interest and taxes

ECE

ethnic Chinese economies

ECF

ethnic Chinese foreign

EDA

electronic design automation

EPZ

export-process zone

ETDZ

Economic and Technology Development Zones

FDI

foreign direct investment

FIEs

foreign-invested enterprises

FYP

Five-Year Plan

GPN

global production network

HTDZ

high-technology development zones

IC

integrated circuit

IDM

integrated device manufacturer

IFI

international financial institution

IP

intellectual property

IPO

initial public offering

IPR

intellectual property rights

ISI

import-substitution industrialization

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List of Abbreviations IT

information technology

JV

joint venture

LCD

liquid crystal display

LGFV

local government financing vehicle

LLP

limited liability partner

LME

liberal market economy

MNC

multinational corporation

MPW

multi-product wafer

NPLs

non-performing loans

OBM

original brand manufacturer

ODM

original design manufacturer

OEM

original equipment manufacturer

OS

operational strategy

PRD

Pearl River Delta

R&D

research and development

S&T

science and technology

SEI

strategic emerging industry

SEZ

special economic zone

SOE

state-owned enterprise

SOHO

small office and home office

SPC

State Planning Commission or stored program control

STB

set-top box

TTC

transnational technology community

TVE

township and village enterprise

VC

venture capital/capitalist

VIE

variable interest entity

VoC

varieties of capitalism

WFOE

wholly foreign-owned enterprise

YRD

Yangtze River Delta

Source abbreviations AFP

Agence France-Presse

AWSJ

Asian Wall Street Journal

DT

Digitimes

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List of Abbreviations DYBG

Diaoyan Baogao [Ministry of Science and Technology’s Investigation Reports]

DYCJRB

Di Yi Caijing Ribao [First Financial Daily]

EET

Electrical Engineering Times (online version)

ESJJBD

Ershiyi Shiji Jingji Baodao [The Twenty-first Century Economic Herald]

FT

Financial Times

JJGC

Jingji Guancha [The Economic Observer]

Marbridge

Marbridge Daily

NFZM

Nanfang Zhoumo [Southern Weekend]

NYT

New York Times

SS

Silicon Strategies

SST

Solid State Technology (online version)

TCNA

Taiwan Central News Agency

TENS

Taiwan Economic News Service

TT

Taipei Times

USPTO

United States Patent and Trademark Office

WSJ

Wall Street Journal

XSJ

Caixin Zhoukan (formerly Xin Shiji) [Caixin Weekly]

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Part I Setting the Stage

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Introduction

On a very hot and humid day in July of 1998, I, a naïve first-year doctoral student, unwittingly imitated those celebrated British companions of mad dogs under Hong Kong’s noon sun by making the then three and a half hour train trip from Shanghai to Wuxi in Jiangsu Province clad in coat and tie. My mission was to see first-hand the fruits of China’s efforts to leapfrog into advanced semiconductor technologies. I had been forewarned by two different sources about what to expect. Some Massachusetts Institute of Technology engineering professors had made the same trip six months earlier only to find an operation where the new fab (the fabrication facility or, in layman’s terms, computer chip-making plant) remained empty because the stateowned firm charged with operating it, Huajing, had no idea what products to turn out for the market. Later, a Lucent employee, a Chinese returnee (a term used for expatriate technologists who return home, see Saxenian 2006) involved in technology transfer from Lucent to Huajing, reported much the same. Nevertheless, the Lucent employee invited me out to see the infamous state-run 908 Project for myself. I left Wuxi that evening with two convictions: I would never be able to remove the ring-around-the-collar from the shirt I was wearing and China’s technology sector was stillborn. As it turned out, only one of my two convictions proved true. My shirt was ruined. As for China, its perceived technological rise now causes concerns about economic and technological competitiveness, not to mention national security, in many quarters. This book, based on more than a dozen years of research, explains how China’s technological development transformed the country from an also-ran to a competitor to be reckoned with in technologyintensive industries. However, the story is not so thoroughly triumphant. China’s technological development is uneven and fragile. Moreover, the firms driving China’s development are not purely Chinese. The argument in this book is that China has undertaken a path of technological development quite different from previous late developers. Whereas state policy and market institution-building are the main explanations offered

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Paper Tigers, Hidden Dragons

for the success of past developers, China has had poorly developed, if perhaps improving, market institutions and a state that is quite ill equipped to foster and guide (let alone build) the industrial firms that have driven development in late developers, such as Japan and Korea.1 In place of building robust market institutions and implementing effective industrial policy, China has instead allowed the space for a certain type of foreign firm to drive technological development in China. While foreign firms have played a constructive role in economic development in a number of late developers in the post-World War II era, they have generally done so under one of two types of state-structured parameters. In the first model, the state lured multinational corporations (MNCs) with incentives and then encouraged them to progressively build up local competencies and capabilities through upgrading each MNC’s own internal activities in the host economy. Singapore is the foremost example of this model. Other states concentrated on fostering the internal capabilities of their own domestic enterprises and then encouraged (Taiwan) or coerced MNCs using market access as leverage (Japan and Korea) to transfer capabilities to these local firms. The deployment of a vigilant and capable host government that could identify and punish MNC non-compliance was necessary in both of these models. In China, by contrast, the transnational, ethnic Chinese, technology community2 has served as the glue to bind foreign firms to China, working in the place of effective state industrial policy. Put simply, shared ethnic ties have provided the incentives to encourage ethnic Chinese foreign technology firms to locate core technology activities in China. In contrast, other foreign firms have tended to be slow to commit significant resources to the developing world when left to their own devices. Nevertheless, these shared ethnic ties alone are not enough to produce technological development.3 The story of China’s technological development is not simply one in which transnational ethnic Chinese technology networks overcome all obstacles to development. Domestic and foreign institutions external to these networks play an equally important role because these networks do not operate in an institutional vacuum in China or elsewhere. The institutions of foreign finance to which these foreign-invested firms are linked are as important as the transnational networks into which they are embedded. The importance of these foreign institutions is most clearly seen 1 See Moore (2002), Tylecote (2009), Tylecote et al. (2010), and Pettis (2013) on problems of China’s state capacity for industrial policy, particularly in the area of finance. 2 Saxenian’s (2006) work documents how the ethnic Chinese transnational technology community is just one of several of these ethnic transnational technology communities. 3 Hsu and Zhou (2010) and Kenney et al. (2013) offer critical assessments of the contribution of returnees in various countries.

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Introduction

by looking at the domestic firms that have links to the transnational ethnic Chinese technology community via returnees working for these domestic firms. Despite these transnational links, these domestic firms have conspicuously failed to advance China’s technological development because they lack robust linkages to foreign financial institutions. The ethnic Chinese, foreign-invested firms (called hybrid foreign-invested enterprises or hybrids for short) are the hidden dragons driving China’s technological development. They are hidden because they are not widely recognized as a distinct category of firms by the Chinese state and foreign and domestic analysts of China’s economy. Standing in sad contrast to them, China’s domestic firms are paper tigers. They have been the targets of the government’s industrial policies, and celebrated and feared in equal measure by foreign analysts.4 Yet the images of these firms’ technological prowess are by and large more fiction than fact, as this book will demonstrate. Beyond the domestic firms and hybrids, there is another set of foreigninvested enterprises (FIEs) operating in China, the multinational corporations (MNCs). The MNCs are those FIEs that either do not have ethnic links to China or, if they do, eschew utilizing China as an extensive base for their firm’s core competencies. The MNCs are neither hidden dragons driving technological development nor paper tigers failing to deliver on their hype. Some of these firms have contributed to China’s technological development, but their commitment to China is generally weak so China’s development would be much slower if it relied upon the MNCs to drive technological progress. Chapter 1 explains in detail the differences between hybrids and MNCs. The combination of foreign institutions and the ethnic Chinese transnational technology network that has propelled China’s technological development has important implications for three key concerns: (1) what will be China’s near-to-medium term development trajectory; (2) how we conceive of the political economy of development under globalization; and (3) how the comparative capitalism literature conceives of the integrity of national institutional arrangements. This introduction will now turn to examine each of these three subjects in turn. Following the discussion of the themes, this chapter will examine the information technology (IT)5 industry as a case and outline the organization of the rest of the book.

4

Zeng and Williamson (2008), Breznitz and Murphree (2011), and Lee (2013) are examples. The IT industry comprises computing, communications, software and consumer electronics products, as well as the software and hardware subsystems and components that go into these products. 5

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Paper Tigers, Hidden Dragons

1. Whither China? Whether China will become an economic superpower is a question that interests many. The key to answering this question is the nature and sustainability of China’s route to development. This book finds wanting and provides evidence against the arguments of the China growth optimists6 that generally center on expansion of just good enough market institutions or clever state policies or a mixture of both, but it is also critical of some of the assumptions and arguments of the pessimists. While this book concurs with many of the China growth pessimists’ compelling arguments about China’s weak market foundations and the unsustainability of China’s hyper-investment-driven growth, the book also directly challenges key arguments and assumptions of some of the pessimists, even going so far as to use the evidence they offer against them. Several commentators point to the prominent role of foreign investment in China and see weakness (Nolan 2001; Huang 2003; Huang and Khanna 2003). In this book, foreign involvement in China’s economy will be shown to be a strength rather than a weakness. Other pessimists point to China’s frail institutions to forecast economic weakness or even failure (Bird 2008; Tylecote 2009; Unirule 2011; Wong and Pettis 2013). The analysis offered here builds on these insights concerning China’s institutional weaknesses, but argues that an alternative set of institutions active in China, but located abroad, fill some of the institutional voids that could otherwise drag China down.7 Ironically, given how much China has gained from its openness, one of the major threats to embracing a mutually advantageous view of China’s economic rise is China’s own economic and techno-nationalism. However, as the subsequent chapters in this book will demonstrate, the Chinese state’s techno-nationalist gambits have thus far been constrained by certain state actors’ own interests in maintaining extensive international linkages. Thus, China’s global economic ties have continued to keep its economy on a very open path, despite the state’s sporadic efforts to scuttle them. In the last few years, however, disturbing signs of increased resistance to openness have emerged in China, from the state increasing its role at the expense of private

6 Optimist commentators, such as Dragonomics’ Arthur Kroeber and Goldman Sachs’ Jim O’Neil, tend to focus on just good enough market mechanisms and downplay concerns about overinvestment. Optimists in the scholarly community provide pro-state and pro-market arguments. Heilmann (2008) believes in the Chinese state’s flexible, experimentalist economic development capabilities. McNally (2012) celebrates a distinct Sino-capitalism featuring a capable state and a vibrant entrepreneurial economy. Nee and Opper (2012) see market institutions growing up from below. Lardy (2014) believes China’s bias towards state-owned firms has diminished as the private sector has grown and economic policies have reformed. 7 The book acknowledges and indeed details how these foreign links are a point of contestation and thus the continuation of these links cannot be assumed.

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Introduction

enterprises (the guojin mintui phenomenon8) to what foreign businesses perceive as increased protectionism. Ultimately, politics will determine whether the hybrid model can be preserved or if adequate domestic institutional alternatives can replace it. The conclusion of the book will revisit the question of China’s economic future through exploring various scenarios and the role hybrids may play in them. What is not in dispute is the positive role played by foreign institutions as an institutional stopgap, a development underappreciated by both sides of the whither China debate.

2. Beyond the State–Market Divide in Political Economy of Development In terms of development, the prescriptions offered by both mainstream economists and revisionist political economists have proven hard for most developing countries to put into practice. Mainstream economists have advocated the magic of the market, focusing on getting the prices right and eliminating government “interference.” The revisionists have advocated an active state role to foster, or even guide, development. The former prescription has run afoul of the fact that market failures abound in the developing world and marketbuilding has proven quite difficult. The latter prescription has run afoul of the fact that government failure has often proven almost as abundant in the developing world as market failure. As Stephan Haggard (2004) has observed, the number of states that have effectively pursued state-led development in its classic developmental state form are so few that it suggests that this route to development cannot serve as a realistic blueprint for the rest of the developing world. When considering economic globalization, the economists tend to be more optimistic about development. Economists view globalization as an expansion of markets whereas many revisionists fear that globalization as currently constituted undermines state capacity to foster development. China’s combination of foreign institutions and transnational networks suggests that there are alternative routes to development under globalization than the standard market and state-oriented ones. Chapter 7 will discuss this issue in depth.

3. Foreign Institutions and Comparative Capitalism Comparative political economy over the post-World War II era has principally concerned itself with the institutional arrangements of distinct national 8

The literal translation is “the state advances, the private (sector) retreats.”

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Paper Tigers, Hidden Dragons

capitalisms; foreign institutions were only considered important when implicated in the failure of national capitalisms. In other words, robust and healthy national capitalist systems were nearly impervious to effective intrusion of foreign institutions. In those nations where the local institutional arrangements were so weak as to allow foreign institutions to gain sway, the foreign institutions were regarded as complicit in the very weakness of the national systems of capitalism. The dependencia school had just such a diagnosis for the ills availing Latin American national economies. One new approach to comparative political economy that incorporates an important and potentially constructive role for foreign institutions in national systems of capitalism is the internationalization of institutions approach (Ahrweiler et al. 2006; Herrmann 2008; Lange 2009). This approach argues that firms in nations without comparative institutional advantage for their particular sectors can access institutions based abroad. The role of foreign finance in spurring China’s development is similar to the internationalization of institutions approach, but goes beyond it in two key ways. First, the internationalization approach argues only that actors involved in economic activities not related to a country’s comparative institutional advantage would seek to draw on foreign institutions. This implies that outside institutions will support only those activities marginal to the core economic activities of a given nation. This book presents evidence that outside institutions can support core economic activities. Second, the internationalization of institutions approach assumes the existence of a comparative institutional advantage. For many developing and transitional economies, assuming such a comparative institutional advantage makes little sense as the process of development is partly a process of creating such robust economic institutions. Chapter 8 will explore the full theoretical implications of China’s reliance on foreign institutions for the field of comparative political economy.

4. The IT Industry as a Case This book focuses on the Chinese IT industry while also examining a broader swath of industries in Chapters 4 and 7. There are several reasons for selecting the IT industry as a case. The IT industry is both a representative case and a critical case. Representative cases are those that potentially represent a wider number of similar cases. Critical cases are those that have important broad implications despite not necessarily being representative. A critical case can be one in which the previous theories predict the polar opposite outcome from the actual one. Or a critical case can be one in which the case itself is of such great import that its singularity by no means diminishes its importance. 8

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Introduction

The IT industry is representative of a growing number of industries that have fragmented production chains, in which the production chain is segmented into narrow functions carried out by different firms, as well as rapid technical change, a common feature of technology-intensive industries (Langlois 2003). There is growing evidence that firms in the developing world can take advantage of these industry attributes to become important players in these modularized or fragmented industrial production chains. These opportunities to become major firms within industrial production chains, in turn, offer developing countries possibilities for economic development (Ernst and Kim 2002; Lester and Sturgeon 2003). Thus, if China can develop the IT industry in this manner, perhaps China and other developing countries can develop a number of other high-tech industries in the same way. The IT industry also closely approximates the ideal-typical globalized industry with few trade barriers, so it can serve as a representative case of the opportunities for development under globalization. This industry has relatively low tariff barriers due to the World Trade Organization’s Information Technology Agreement (ITA). By 2000, the ITA had eliminated tariffs and duties in signatory nations for many IT products,9 which by the terms of the agreement comprised over 90 percent of the world’s IT trade in 1997 when the ITA went into effect.10 There are also other international bodies in the IT sector pushing for open trade, such as the World Semiconductor Council (WSC), which has succeeded in reducing tariffs to zero in the dominant semiconductor-producing and consuming economies, the European Union (EU), Taiwan, Korea, Japan, and the United States. China joined the WSC in 2006. The IT industry is also a critical case for two reasons. First, the IT industry is considered one of the critical technologies or general-purpose technologies of the current era (Dahlman and Aubert 2001; Yusuf and Evenett 2002; Steil et al. 2002) and a crucial one for the development of future technology areas based in part on IT technology (Anton et al. 2001; Trajtenberg 2002). Second, it is also a critical case because the Chinese state prioritizes this sector. The IT industry is one of the Chinese state’s pillar industries, industries the state considers most important to develop, and an industry that Korea, Taiwan, and Japan—the Asian neighbors China usually looks to emulate—have 9 The developing nations signing the agreement are allowed longer periods of time to adjust their tariff schedules. What is more, the nations that are WTO members but not signatories of the ITA still enjoy the tariff benefits from the lowering of tariffs by ITA signatories, which include the triad of advanced economies: the EU, the United States, and Japan. Thus, this adjustment mechanism actually works in favor of the developing world contrary to the predictions of the globalization pessimists. In July 2015, fifty-four countries, including China, Japan, the United States, and the twenty-eight European Union states, agreed to extend the ITA to include new categories of products, primarily products not yet invented in 1997. 10 China became a member of the ITA following its WTO accession.

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developed successfully. The development of technology has been a priority for decades as enunciated in the Four Modernizations11 and IT has been considered a key part of technological as well as industrial modernization.12 Examining this sector therefore reveals much about how Chinese state policy affects industry. The following chapters will demonstrate the state’s stark failure in industrial policymaking in this sector. Given its priority status assigned by the state, state neglect of this sector cannot plausibly be the cause of this failed industrial policy. China’s IT sector developed despite state failure. This fact demands an explanation.

5. The Organization of the Book The book will address the themes and issues highlighted above across the following chapters. Chapter 1 will present the overall framework and causal mechanisms by which ethnic Chinese hybrid firms linked to foreign institutions drive technological development in China’s high-technology industry. Following the first part of the book introducing and framing the argument, the next three chapters (comprising Part II) will address aspects of Chinese state policy to induce technological development and contrast them with the successes linked to foreign finance and hybrids. At the broadest level, there are two main paths to technological upgrading and innovation. One is through vibrant clusters of often initially small firms along the lines of Taiwan’s Hsinchu and Silicon Valley in the United States. The other is upgrading and innovation pursued through large firms along the lines of the Korean chaebol, Japanese keiretsu, and Western conglomerates. Chapters 2 and 3 each address one of these two broad paths to upgrading and innovation. Chapter 2 explores China’s efforts to foster clusters of upgrading and innovation through the promotion of development zones and venture capital, i.e. efforts to mimic Taiwan and Singapore’s model of upgrading as well as Silicon Valley’s model of innovation. The success of foreign venture capital, particularly foreign venture capital embedded in ethnic Chinese networks, contrasts with the meager outcomes of the domestic efforts in development zones and venture capital. 11 The Four Modernizations are the modernizations of agriculture, industry, defense, and science and technology (S&T). They were proclaimed on the eve of the Cultural Revolution, during which they were temporarily shelved only to be reaffirmed at the Fourth National People’s Congress in January of 1975 (MacFarquhar and Schoenhals 2006: 380). In 1991, S&T was moved up from third to first position in ranking of importance of the Four Modernizations (Fewsmith 2001: 47). 12 Various subsectors of the IT industry have been considered critical priority industries under every one of China’s five-year plans (FYP) going back at least to the Seventh FYP (1986 to 1990).

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Introduction

Chapter 3 looks at the Chinese state’s attempts to create national champions in a manner more akin to Japan or Korea than Silicon Valley. This chapter evaluates the historical evolution and actual technological outcomes of China’s national champions to document how the state’s embrace has stifled those firms nominated to the guojia dui (the national team) more than it has fostered them. Chapter 4 delineates state policies to support research and development (R&D) efforts in both small and large Chinese firms. It contrasts their problematic implementation with the R&D activities undertaken in China by hybrids and MNCs. The chapter demonstrates through interview and patent data that the real force behind R&D in China are the hybrids and, secondarily, the MNCs, despite the state efforts described here and in Chapters 2 and 3. Part III is a case study of one of the main technological drivers of the IT sector, the integrated circuit or semiconductor13 (or, more colloquially, the computer chip) industry. Chapters 5 and 6 examine the two most technologyintensive segments of the semiconductor production chain, the fabrication and design segments, respectively. An explicit comparison of the hybrids, MNCs, and domestic firms’ technological development efforts and outcomes demonstrates the superior developmental contribution of the hybrids in both fabrications and design. Part IV draws out the broader comparative lessons from the case of hybridled technological development in China. Chapter 7 considers the lessons for development under globalization that China’s technological development in high-technology has to offer. The chapter delineates both sectoral and other limitations of China’s hybrid-led development while arguing for its broader applicability. Chapter 8 tackles the theoretical implications of this study for the wider field of comparative political economy. China’s engagement with foreign institutions challenges some deep-seated assumptions about the role of foreign institutions in comparative political economy and adds to our understanding of the institutional arrangements of national capitalisms. The Conclusion discusses China’s economic future and the related issue of the political sustainability of China’s reliance on hybrid firms and, consequently, on foreign institutions going forward.

13 Technically speaking, the semiconductor industry is broader than integrated circuits, but these two terms are often used interchangeably even in policy and industry analysis discourse. Part III will focus on integrated circuits and thus not include discrete semiconductors, which are relatively low-tech.

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1 The Framework

This chapter will provide a more detailed account of the causal mechanisms that explain the outsized contribution of the hybrids, the moderate contributions of the MNCs, and the much smaller contributions of domestic firms to China’s technological development. The argument connects the outcomes in technological development in China back to the specific institutional arrangements of finance.1 The failures of technological upgrading are largely tied to the weaknesses of the Chinese financial system. The successes are largely due to firms that draw upon foreign sources of finance outside of China but maintain an abiding commitment to China’s development. Section 1.1 will provide an overview of the argument. Section 1.2 will examine how technological development, the outcome or dependent variable of this study, is measured. Section 1.3 will describe the methodology and data collection of the book. Section 1.4 will examine the problems with China’s industrial policymaking. Section 1.5 will rebut alternative explanations for the varying technological development contributions that this book documents.

1.1 Overview of the Argument 1.1.1 The Argument in Brief Over the last decade and a half, China has achieved remarkable technological and economic development success following a new path unknown, or at least unarticulated, by scholars and policymakers alike. I call this developmental path the global hybrid model. The global hybrid route relies on the institutions of global capital, defined here as the financial institutions of the advanced economies, and a set of firms established by ethnic Chinese 1

The argument thus builds on the insights of scholars such as Michael Pettis, Yasheng Huang, Andrew Tylecote, and Victor Shih who have documented China’s problematic political economy of finance.

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The Framework

entrepreneurs that I dub hybrid FIEs. Global capital serves to offset the inefficiencies of China’s financial sector. Hybrid FIEs combine foreign finance with a strategic commitment to develop core technological activities in China. The hybrids take the best of both worlds of foreign and domestic firms. Hybrids, as foreign firms, receive finance and the concomitant financial discipline from global capital, an option that remains generally unavailable to Chinese domestic firms. At the same time, hybrids’ ethnic ties to China often encourage commitment to local development more commonly associated with domestic firms than with MNCs. Due to this combination of foreign finance and strategic commitment to China, hybrids contribute much more to its technological development than any other type of technology enterprise operating in China’s hightech industry. They are the hidden dragons behind China’s technological development. Regarding the overall topography of China’s technology sector, this book finds that there are four distinct types of firms in China’s technology sector with three distinct patterns of technological upgrading. There are two types of domestic firms: favored domestic firms and neglected domestic firms. Similarly, there are two types of FIEs: hybrid FIEs and MNCs, the latter of which are the FIEs with stereotypically weak ties to the host economy. The three outcomes of technological upgrading are high, moderate, and low levels of contribution to technological upgrading. The hybrids contribute high levels of upgrading earning them the hidden dragon sobriquet. The MNCs contribute moderate levels of upgrading and the two types of domestic firms provide low levels of upgrading. Driving these different patterns of technological upgrading are two factors: the source of finance in China and operational strategies (also referred to in the book as OS) of the respective firms. The OS variable in turn is influenced by the presence or absence of ethnic ties to the Chinese economy. Source of finance is a binary variable with a firm either being linked to domestic or foreign financial sources. The OS of the firm is also a binary variable, with firms possessing either a commitment to basing core corporate activities in China, which we dub the China-based strategy, or a strategy where firms do not have such commitment to China, which we call the foreign OS. Ethnic ties to the local economy explain the propensity of some firms to adopt China-based operational strategies. In China, the relationship of firms to the state determines their sources of finance (Gregory et al. 2000; Huang 2003, 2008) and these in turn impact their ability to upgrade. Firms have hard budget constraints when they do not receive free financial help. With hard budget constraints firms have to remain competitive to survive. By definition, a critical part of the competitiveness of technology firms is their technology so they have every incentive to improve 13

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Paper Tigers, Hidden Dragons

their technology to keep pace with competitors. Soft budget constraints deprive firms of the incentives and even the capabilities to upgrade (Kornai et al. 2003). Firms have soft budget constraints when they can rationally expect to survive even when not competitive because others are willing to bail them out. Thus, they lack incentives to upgrade. Worse, the absence of the threat of extinction encourages them to become lax, so their capabilities suffer. A third possibility is no source of external finance. Firms without financing will not be able to invest in technological development. OS is a mix of interests and ideational factors that causes firms to perceive China either as the vital center of their operations (the China-based OS) or as just another location among many (the foreign OS). For technology firms, one core activity is corporate R&D. Thus, firms with a China-based OS will be more likely to pursue their core R&D activities in China. Beyond formal R&D, one would expect firms with a China-based OS to put greater emphasis on building up a variety of corporate technological capabilities within China. This book measures the outcome at the firm-level in terms of upgrading that is effectively embedded in the Chinese economy (see Section 1.2). The more a firm upgrades its own capabilities within China ceteris paribus the greater its contribution to China’s technological development. The two types of FIEs are more likely to contribute to technological upgrading than the two types of domestic firms. Among the FIEs, the hybrid FIEs are more likely to contribute than the MNCs. The hybrids are the most successful technology upgraders because they have both disciplined finance (i.e. credit with relatively hard budget constraints) from foreign financial institutions and the motivation to upgrade in China due to their China-based OS. This access to foreign finance is the result of the arrangement between the Chinese state and FIEs to allow both types of FIEs to invest in China while limiting their access to the Chinese state financial system. While successful upgraders, primarily FIEs, often obtain technology from returnees that personify the ethnic Chinese transnational technology networks, so too do many firms, primarily domestic ones, that have failed to upgrade.2 Thus, technology flows from the developed world are necessary but not sufficient to explain upgrading. The unsuccessful domestic upgraders lack finance (neglected domestic firms) or financial discipline (the favored domestic firms) due to their particular relationships to the state. These financial problems trump any upgrading benefits of domestic firms’ natural orientation towards China-based strategies.

X. Liu’s (2001: 204) surveys indicate that domestic firms were actually favored over foreign firms as the destination for returning Chinese technologists for most of the 1990s. Subsequent chapters will discuss a number of case studies where returnees failed to turn around domestic firms. 2

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The Framework

This book has two core propositions: Proposition 1: FIEs contribute more to China’s technological development than domestic firms. Proposition 2: Hybrid FIEs contribute more to China’s technological development than MNCs. The next two subsections will examine the two causal or independent variables.

1.1.2 Finance Favored firms have a close relationship to the Chinese state, which provides them with finance and procurement without any effective monitoring (Huang 2003, 2008; Unirule 2011; Pettis 2013). Favored domestic firms have generous access to China’s state-run financial system that undermines both firm capabilities and incentives for upgrading. In the past, the favored firms were almost exclusively formally designated state-owned firms, but as the categorization of firms as state-owned becomes increasingly difficult due to corporatization and partial privatization of state-owned enterprises (SOEs) (Guiheux 2002; Huang 2008), the mix of ownership types (i.e. state-owned and other) in the favored category has expanded. This book will document that firms that clearly are not SOEs leverage the right connections to enjoy the state’s lavish patronage including soft loans and government procurement.3 Neglected domestic firms are those that do not have access to the state financial system and other perquisites of state patronage. They are almost exclusively private firms with a distant relationship with the state. Cut off from credit, they are unable to afford the costs of upgrading (Gregory et al. 2000; Tylecote et al. 2010). MNCs can upgrade due to their financial discipline, but undertake less of it in China than hybrids because they lack the China-based OS. The FIEs’ ability to access foreign finance is as much a result of politics as of the domestic firms’ financial arrangements. The Chinese state has generally not allowed foreign firms to utilize its financial system (Lardy 1998; Pettis 2013).4 At the same time, the Chinese state opened up China to investment in 3 Here government procurement means all state purchases not just those processed under the government procurement law, which are a small fraction of government procurement. Opening government procurement to foreigners has not progressed very far in China as the system of state purchases remains very opaque and decentralized (Chou 2006). Furthermore, the National Development and Reform Commission (NDRC) and the State Council issued a directive on May 26, 2009, that stresses the imperative to buy Chinese goods in state procurement. 4 As late as 2012, foreign loans constituted only 3 percent of total enterprises loans (Lardy 2014).

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a manner that put few barriers or restrictions to foreign firms’ access to overseas capital (Zweig 2002). DIFFERENTIATING FIE S FROM DOMESTIC FIRMS

The standard depiction of the relation of domestic firms to China’s formal financial system is one of a system that grants state-owned firms preferential access to credit while discriminating against private firms (Lardy 1998, 2014; Gregory et al. 2000; Huang 20035). While the standard depiction has been and remains true (as this section will discuss further on), some analysts have mistaken many effectively state-owned or controlled firms for private firms or at least non-state-owned firms because they do not bear the official SOE designation. Building on Huang’s (2008) work, this volume offers a more nuanced approach to categorizing firms within China’s political economy. Often all firms that were not formally designated as SOEs (guoyou qiye) or statecontrolled shareholding companies6 (guoyou konggu qiye)—the non-state firms—or a very substantial portion of these firms were treated as private firms (Lin et al. 1996; Allen et al. 2008). This approach is highly problematic because China has a wide variety of corporate mechanisms outside of the formal SOEs including collective enterprises, shareholding enterprises, joint ventures (JVs) and FIEs in addition to those firms officially designated as private firms (siying qiye). Yasheng Huang’s (2008) approach of using control rights to determine the extent of private ownership and state ownership in the Chinese economy is the most sophisticated and arguably accurate approach thus far. Using Dougherty and Herd’s (2005) work as a foundation, Huang’s main insight is that some control rights that appear to be private, such as legal person shares, more often than not are actually shares owned by a state entity. Therefore, many more companies outside of the formally designated stateowned firms are actually state-owned when control rights are brought into consideration. While this book accepts Huang’s basic premise of how to determine which firms are effectively state-owned, it further contributes two insights. First, state ownership is not completely coterminous with being the object of state favor. There are firms not controlled, even indirectly, by the state that have become state champions because of their size or perceived potential. Second, Huang treats some entities listed offshore as being foreign controlled even though state-linked, domestic Chinese holding companies effectively exercise control over these offshore entities. This book does not assume listing overseas 5 Even Lardy’s optimistic account of the rise of private enterprise in China does not deny that there is continued discrimination against the private firms as state firms enjoy a disproportionate share of the loans. 6 This non-traditional translation follows Lardy (2014) because this translation better captures what these entities actually are.

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automatically means foreign control over the listed entity. Instead, it examines what entities actually exercise effective control over a given firm listed offshore. This book distinguishes FIEs from domestic firms using two sequential metrics. The first metric is share ownership. To be considered a foreign (domestic) company, foreign (domestic) entities cumulatively had to own more than 50 percent of the firm’s shares.7 This is different from the Chinese statutory definition of FIEs where such enterprises only have to be 25 percent foreign-owned to be considered foreign enterprises. The second metric is company control. Foreign (domestic) firms are those firms where foreign (domestic) entities exercise majority control. For companies where a board of directors exists and the board participants are made public, this study uses control of the board to determine control.8 For companies with less than transparent governance structures, further research into what entities have sizeable stakes in the firm has been necessary to determine the control. In any case, share ownership and effective control of the firm (foreign versus domestic) is only important insofar as it indicates the source of financing. In order to determine which domestic firms are state-favored as opposed to stateneglected, we add a third metric of the actual financial support in terms of loans and state procurement from the Chinese state to determine which nonstate-owned or controlled firms are in fact state-favored. Given the overwhelming preponderance of evidence that indicates the state-owned sector receives the majority of the loans from the state banking system (Lardy 1998; OECD 2002; Huang 2003, 2008; Shih 2004, 2007, 2008; Hope and Hu 2006; Allen et al. 2008, 2013; Unirule 2011; Pettis 2013),9 it is safe to assume that those firms majority owned by the state have access to the state banking system. For domestic firms which were not majority owned or controlled by state entities, this study collected further evidence of firms’ sources of finance and procurement to determine whether they were state-favored or stateneglected domestic firms. Chapters 3, 5, and 6 will document in detail the

7

The OECD uses this definition of 50 percent control (Huang 2008: 18). By board we are referring to the board of directors rather than the supervisory board within China’s two-tiered board structure. Research has shown the latter board has little power or influence (Teng 2010). 9 Lardy (2014) argues that private firms have received the majority of new loans since 2011, but there are reasons to think that the China Banking Society data he uses still underestimates state control and overestimates private control among enterprises (email correspondence with Victor Shih on August 25, 2015) even while recognizing that Lardy is probably correct in pointing out a lessening in lending discrimination towards private enterprise over the reform decades. Elsewhere in his book, he mislabels state-owned firms as private in a manner suggesting a cognitive bias towards seeing private firms where none exist. For example, Lardy refers to Lenovo as a private firm at the time of its acquisition of IBM’s PC division when in fact Lenovo was still majority owned by state entities at that time. 8

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state favor received by those non-state-owned/controlled firms that have still gained the state’s favor. SOFT BUDGETS AND THE STRATEGIES OF FAVORED DOMESTIC FIRMS

Technological upgrading entails high risks and high costs. The risk is high because learning or developing new technologies is difficult and the costs are high because a firm must invest human and financial resources. Larger profits than the firm would enjoy in the absence of upgrading provide the incentive to upgrade (Khan 2000a). Why are favored domestic firms, showered with easy credit and procurement from the state, less likely to upgrade? Upgrading is inherently risky, but one could plausibly argue that softening of budget constraints would free firms to take greater risks. However, evidence from other studies (Kornai 1995; Liu 2001; Kornai et al. 2003), and this one, suggests that even when such firms are willing to embark on technological activities under soft budget constraints, they will not conduct these technology activities in an effective manner. This is a probabilistic judgment rather than an absolute one. They do not completely lack the capabilities to upgrade, but the likelihood of their upgrading is low because of the curse of state favor. The state undermines favored firms’ ability to upgrade in three ways: bureaucratic goals, firm incapacity, and disincentives to upgrade. The bureaucratic goals mechanism applies only to those favored firms that are SOEs or otherwise directly controlled by state agencies. Officials higher up the hierarchy set the many goals beyond profitability by which the bureaucrats-as-managers will be judged (Kornai 1995; Huang 2003). Among them are preserving the SOE and increasing the scale and perceived technological prowess of the firm. Preserving the firm mitigates the desire to undertake anything risky, such as learning new technical skills. Increasing the scale and perceived technological intensity of the firm induces the bureaucrat-asmanager to buy expensive capital equipment that makes the firm appear cutting edge in one fell swoop. The bureaucrat-manager thus prefers this quick fix of purchasing bundles of technology to the longer-term, more difficult work of building internal firm competencies, worker skills, and valuable cooperation with external partners (Tylecote et al. 2010). These investments and increasing scale also promote the survival of the bureaucrat’s domain, the SOE, because the firm becomes either too large or too important in the eyes of the state to fail. China did go through a process starting in the wake of the Fifteenth Party Congress in the autumn of 1997 of supporting the large SOEs while letting go of the small- and medium-sized SOEs (the “grasp the large release the small” policy or zhua da fang xiao). The campaign served only to convince SOE managers that their firms should look big, although these incentives were implicit in the system earlier (Teng 2010; 18

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The Framework

Wu 2011). In sum, bureaucratic goals induce a policy of capital investment by SOEs without sufficient levels of skill and capability investment as documented by a number of scholars over the last two decades (Wu 1996; Jefferson et al. 1999; Huang 2003; Tylecote et al. 2010). Soft budgets also lead to firm-level incapacity. Easy access to state finance and procurement encourages all sorts of inefficiencies in favored firms that prevent them from doing much of anything well. They may attempt technological upgrading, but their general inefficiency in operations makes it difficult for them to do so effectively. Liu (2001) and Kornai and his colleagues (2003) note this problem of soft budget constraints undermining upgrading. This problem applies to favored firms whether or not they are state-owned.10 Procurement by the state plays a critical role in creating disincentives to upgrading. State procurement encourages firms to forgo high risk, high reward upgrading for the less risky, if potentially smaller, profits to be made from feeding at the state’s trough. These firms lack incentives to upgrade their skill set to be competitive in the marketplace. The literature on China’s industrial policy demonstrates that the Chinese state does not monitor firms effectively (Perkins 2001; Moore 2002; Huang 2003). Without effective monitoring, favored firms can simply enjoy the state’s bounty without enhancing their performance in return. Later chapters will present evidence of how procurement undermines the incentives to upgrade in domestic firms. This problem can affect state and non-state-owned firms alike, although the state firms also suffer from problems of bureaucratic goals and firm incapacitation. Just as the state has showered financial favor on some firms, it has neglected many other firms. This neglect creates a two-tiered structure of firms in China. Domestic firms that are not favored by the state have difficulty acquiring loans from the state banking system (Huang 2003, 2008; Nee and Opper 2012).11 This scarcity of capital prevents them from embarking on technological upgrading because they do not have the means to do so despite whatever ex post rewards for technological advancement they might enjoy. China has a wide variety of informal financial mechanisms (Tsai 2002), but informal financial mechanisms offer too little credit at too high a price for firms trying to compete in technology-intensive sectors (Gregory et al. 2000; Allen et al. 10 This book departs from the excellent work of Tylecote and his colleagues (2010), who argue that China’s financial bias towards state-owned firms and against private firms hurts the latter, by emphasizing the disastrous effects of China’s financial system on the very firms favored by it. Tylecote and his colleagues believe corporate governance changes in SOEs are enough to transform them into vehicles for technological upgrading. This book provides evidence that even those firms with more long-term top management teams (the main corporate governance adjustment advocated by Tylecote) have trouble staving off the inefficiencies and disincentives to perform that soft budgets create. 11 Nee and Opper (2012) point out that private firms are reliant on the profits they generate for future investments because of lack of access to the formal financial system. Lardy (2014) also points out that private firms mainly rely on retained earnings for investment.

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2008; Tylecote et al. 2010). China conspicuously lacks the deep stock markets and venture capital and private equity that are most effective in developing new industries (Allen et al. 2008).12 COMPARATIVE METRICS ON CHINA’S FINANCIAL MALADIES

China’s state-owned formal financial system is widely recognized for providing certain firms favored by the state with very soft budget constraints.13 The large body of research (OECD 2002; Huang 2003; Shih 2004, 2007, 2008; Hope and Hu 2006; Unirule 2011; Pettis 2013) on the excessive lending to favored enterprises in China that results in the maladies of soft budget constraints (Kornai 1995) has assumed a standard of comparison of the wider world of financial systems beyond China. Foreign financial systems, while not providing perfect allocation of credit, offer far harder budget constraints than China’s state-run system does. China’s foreign finance overwhelming comes from OECD countries, the three ethnic Chinese economies (ECEs) of Taiwan, Macau, and Hong Kong,14 and the tax haven economies, primarily the Cayman Islands and the British Virgin Islands.15 The claim here is only that these financial systems distribute credit more efficiently than the egregiously inefficient Chinese system. To prove that China’s system is strikingly inefficient, two sets of data will be used. The first compares China to sets of other countries using several accepted metrics for financial systems developed by La Porta and others (La Porta et al. 1997, 1998; Levine 2002). The second compares China’s level of non-performing loans (NPLs) to other countries. Both sets of data provide evidence that China’s financial system performs poorly not just against OECD countries but even when compared to other developing countries. The Chinese financial system has two well-known features. It is bankcentric and strikingly inefficient at financial intermediation (Hope and Hu 2006; Shih 2007; Naughton 2007; Allen et al. 2008). This can be seen by 12 Indeed, the retained earnings approach to investing also does not suffice to invest in these high-technology activities as Allen et al. (2008) and the history of high-technology investment in ethnic Chinese, high-technology Taiwan point out so Lardy’s (2014) celebration of the ability of Chinese private firms to retain earnings to invest does not really help such firms enter technologyintensive industries. Nee and Opper’s (2012) examination of private firms in the “advanced” Yangzi River Delta also provides evidence for this lack of technology-intensive investment. 13 This subsection draws on Fuller (2013). Revised and reproduced with permission from Journal of Development Studies (tandfonline.com). 14 While Hong Kong and Macau are Special Administrative Regions of the People’s Republic of China, their financial systems are distinct and much more market-based. 15 Cumulatively, the ECEs and tax havens contributed 60 percent of China’s foreign direct investment (FDI) from 1985 to 2005. A large portion, possibly even a large majority, of the tax haven FDI is from Hong Kong and Taiwan (Naughton 2007: 413) and offshore investors who want to invest in technology start-ups in China often choose the tax havens as well. The United States, Canada, Japan, and the EU countries, the core countries of the OECD, account for another 25 percent.

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The Framework Table 1.1 China’s NPLs in comparative perspective: NPLs as a portion of GDP (%) Year 1997 1998** 1999** 2000 2001 2002 2003 2004 2005 2009 2013

China*

US

Japan

South Korea

India

Indonesia

Taiwan

4.0 19.4 45.0 40.0 26.0 22.0 21.4 14.6 3.0 8–40****

0.8 0.8 0.8 0.8 0.9 1.1 1.0 1.0 0.7 3.3 2.9***

5.1 12.7 12.6 11.1 15.6 14.1 11.3 7.3 4.0 3.6 3.8***

3.1 6.7 12.2 6.9 2.5 1.8 1.9 1.5 1.0 1.5 2.6***

3.1 3.2 2.8 2.8 3.0 2.5 2.2 1.7 1.3 1.2***

0.1 5.2 3.8 2.7 1.7 2.0 1.5 2.1 1.5 1.0 0.6***

6.5 7.9 9.1 10.3 13.0 10.4 7.7 5.1 3.2 1.8 0.9***

Sources: Allen et al. (2008, 2011); Davies (2013); and March 2013 email correspondence with an investment bank analyst. * The figures here for China are double the nominal rate provided the Chinese government and listed in Allen et al. (2008: 523) and Allen et al. (2013: 64). The nominal rate among other things does not include the NPLs already taken off the banks’ books by the state’s AMCs and loans that have been rolled over when they should have been declared nonperforming. The figures are double the nominal rate because scholars generally believe these government figures to be far too low and probably understate the NPL problem by at least half (see Shih 2007; Allen et al. 2008: 525 ). Allen et al. (2013) actually use double the nominal NPLs in their Table 3C. ** Allen et al. (2008: 523) also note that the Chinese authorities understated the size of the NPLs during 1998 and 1999 even more than they did for the later years. *** The figures for 2013 are the 2010 figures for these countries as 2013 figures were not available. **** The investment analyst cited the low estimate of NPLs to be Goldman Sachs’ at 8 percent and Paul Davies cited estimates ranging from just under 20 to 40 percent of GDP.

comparing data on China’s financial system to data on other financial systems drawing on the classification of systems and data from Levine (2002) and La Porta et al. (1997, 1998). While China’s bank credit is much higher relative to its gross domestic product (GDP) than any of the other groups of countries, it is four times more costly to manage assets in Chinese banks than the average of the other systems, i.e. the banking system is very inefficient. Finally, the financial efficiency metric [log of (total floating supply/GDP/overhead costs)] is lower, meaning much less inefficient, than any of the other groups. Indeed, the sample average is 2.01 whereas China’s is –0.60 (Allen et al. 2008: 513). As a consequence of the lending bias towards favored firms, China has built up a large quantity of NPLs. The size of these NPLs relative to GDP has been much larger in China than in other countries, developing and developed, and points again to the inefficiency of China’s banking sector (Table 1.1). Since 1999, China has set up state-run asset management companies (AMCs) to buy a large amount of NPLs from the banks at face value. While this maneuver has temporarily improved the financial state of the banks by relieving them of the burden of bad debts (shown in the declines in NPLs starting in 2002), the underlying cause of this high level of NPLs, the poor performance in allocating credit on the part of the banks, has not been resolved (Naughton 2007; Shih 2007; Allen et al. 2008; Pettis 2013). Thus, the NPL problem continues. 21

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Indeed, recent estimates suggest that the number of recognized NPLs probably ranges from 20 to 40 percent of GDP (Davies 2013).16 The current global financial crisis, as bad as it is, does not really challenge the notion of China’s comparatively greater financial inefficiency for two reasons. First, the global crisis did not grow out of banks’ inability to distribute loans to creditworthy borrowers in commercial enterprises while continuing to lend to bankrupt or poorly performing ones. Rather, some large financial institutions began to make highly leveraged bets on new types of financial instruments that they did not fully understand; this brought the healthy functioning parts of the banking system down with the rest (Blair 2008). Second, even in the United States, the epicenter of the crisis, NPLs as a percentage of GDP are still far lower than China’s have been over an extended period of time. At the height of America’s recent financial crisis, the NPLs were 3.3 percent of GDP (Allen et al. 2013). Two important trends potentially challenge business as usual in China’s financial system. First, over the last several years as growth has slowed down, the very low and even negative real interest rates enjoyed by state-favored firms in the past are not as favorable as they were. Another important change is the gradual deregulation of interest rates over the last several years.17 However, both of these movements themselves face countervailing currents in the form of continued state support for propping up the bad debt already out there (FT 5.15.2015) and continued interference by the People’s Bank of China in banks’ interest rates (WSJ 5.14.2015). Nevertheless, if these trends gather steam, then the cheaper cost of capital state-favored firms have enjoyed through their better access to the banking system may come to an end. This issue will be revisited in the conclusion of this book given its import for the allocation of capital.

1.1.3 Explaining Operational Strategies OS derives from a mix of interests and ideational factors that causes these firms to perceive China either as the vital center of their operations (the 16 Author’s email correspondence on March 13, 2013, with an investment bank analyst whose job it is to follow the health of the Chinese banking system stated that the lowest reasonable estimate for then current spring 2013 NPLs was Goldman Sachs’ estimate of 8 percent. He thought, however, that this estimate was much too low and NPLs would grow to be much higher from an even higher base than Goldman’s estimate. Bloomberg News (April 13, 2011) was already predicting in 2011 a surge to between 15 and 30 percent of GDP over the next few years as the government once again began belatedly to recognize NPLs as NPLs. 17 The liberalization of lending rates was announced in July 2013. Following some initial moves on long-term deposit rate liberalization in August 2015, the People’s Bank of China announced much broader liberalization of the deposit rates in October 2015 although there will still be some regulation to prevent excessive competition (see this October 23, 2015, statement from the People’s Bank of China, downloaded on October 27, 2015: ).

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China-based OS) or as just another location among many (the foreign OS). OS is a measure of a firm’s determination to place core corporate activities, activities that the corporation relies upon for its competitiveness, in a particular location or locations. Thus, the China-based OS is a commitment to base these core corporate activities in China. Why would any foreign firms embrace a China-based OS, as the hybrid FIEs have? Hybrids share a common feature that explains their propensity to adopt a China-based OS: they all have ethnic Chinese management.18 The research for this study did not start out with the objective of examining ethnicity as a factor in explaining firm strategy or technological development. Only in the course of conducting research did it become obvious that certain foreigninvested firms shared a China-based OS and empirically all of these firms had ethnic Chinese management. Moreover, I structure the definition of the China-based OS in such a way to allow for the possibility of non-ethnic Chinese firms adopting a China-based OS (see Appendix A). I need to stress that the connection between Chinese ethnicity and adoption of the Chinabased OS is probabilistic rather than deterministic, and while all the causal links are probabilistic rather than deterministic, the probability of Chinese ethnic management embracing a China-based OS is lower than the relevant cause and effects in the other causal links in Figure 1.1. With these caveats in mind, insights borrowed from the nationality of multinationals literature help to explain the propensity for firms with ethnic Chinese management to adopt a China-based OS. This literature, based on empirical observations of MNCs’19 behavior, argues that firms concentrate core resources in their home bases. This research gives lie to the idea of the truly multinational enterprise (Hu 1992; Wade 1996; Doremus et al. 1998; Hirst and Thompson 1999; Cohen et al. 2009). Explanations for the continuation of this practice vary. Some argue that firms have developed competitive strengths that rely on the specific institutions of the home economy (Hall and Soskice 2001).20 An alternative interest-based 18 I use management because part of the ownership of these firms is from foreign financial institutions, which may or may not be ethnic Chinese. Nevertheless, even in the case of start-ups where the majority of shareholders (the venture capitalists) are often not ethnic Chinese, the teams of managers in charge of running these firms are ethnic Chinese and have significant equity stakes and board representation. The managers sold investment stakes of their firm on the basis of their China-based strategy so there is no reason to think that the non-ethnic Chinese foreign finance will try to change the strategic orientation towards China of these hybrids. I uncovered no instances of this and I heard reports of just the opposite, foreign venture firms attracted to invest in hybrid firms precisely because these firms were “China plays.” See Grimes (2004: B1). 19 In this subsection, MNCs refer to the general category of multinationals rather than the specific subcategory of FIEs in this study. 20 The varieties of capitalism literature (Hall and Soskice 2001) is not very applicable to the case of hybrid FIEs in China because this literature assumes, at least implicitly, that domestic corporations’ utilization of the strengths of the home economy is a product of a long historical co-evolution. The hybrids and China’s institutions simply have not had the time to co-evolve in this manner.

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Dotted line indicates less deterministic relationship

Operational Strategy

State-Firm Relations

Sources of Finance and Markets

Incentives and Capabilities for Upgrading

Technology Strategy

Upgrading Outcome in China

Technology Inputs (follow the finance)

Figure 1.1 Causal chain

argument would be the limited information available to firms about foreign economies. Firms generally know more about how to operate at home than they do abroad (Dunning 1988). An ideational argument could be centered simply on patriotism. Firms are more often than not run by managers of the same nationality and these managers do not simply make firm decisions based on cold profit-maximizing principles if the decisions adversely affect the home economy. Another ideational argument is that firms believe that their competitive advantages are linked to distinct features of the home economy even if that belief is not necessarily correct. A third would be that they have certain ideas about the just distribution of resources within their home economy that dictate what activities should be kept at home. Doremus et al. (1998) combine ideational and interest aspects in their arguments of nationality of MNCs. The connection between these ideas about the nationality of firms and the hybrids’ China-based OS is not a simple assertion that ethnic Chinese firms will act as national Chinese firms. Indeed, there is evidence that some ethnic Chinese firms forcefully reject a China-based OS. Taiwan’s TSMC has been quite hostile to China and is not any less of an ethnic Chinese firm because of this anti-China sentiment. As discussed further in Appendix A of this chapter, this book categorizes firms like TSMC that eschew a China-based strategy as MNCs rather than hybrids. Instead of assuming all ethnic Chinese will embrace a China-based OS, the literature informs us of the ways socio-cultural knowledge and ideas possessed by ethnic Chinese are conducive to adopting a China-based OS. 24

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By drawing on their socio-cultural knowledge, ethnic Chinese firms have some of the same informational advantages in China that MNCs have in their respective home countries because these ethnic Chinese firms have lower information barriers in understanding and operating in China. Socio-culturally informed ideas influence their behavior as well. There is a nationalist/parochial component for some ethnic Chinese, just as there are nationalist/parochial motivations that encourage MNCs to favor their home base.21 Finally, there is an element of ideas influencing interests. These ethnic Chinese (perhaps due to ethno-nationalist pride) may believe there are benefits to being China-based even when these advantages do not actually exist. MNCs exhibit the same attitude when they insist that certain activities must be done in the home country even when these supposed advantages are not realizable. Here, it is not necessary to decide whether it is interest or ideas shaping interest that lead some ethnic Chinese firms to adopt a China-based OS. It is sufficient that either motive encourages them to adopt this strategy. I should stress that the OS argument does not privilege the ideological reasons for a China-based strategy over the instrumental ones. The firms that adopt China-based OS attempt to maximize their utilization of China’s resources because they believe this provides a competitive advantage. The hybrid firms do not maximize the Chinese resources directly and solely out of a desire to help China. However, such a strategy makes more sense for those attuned to the local culture. Furthermore, it would be foolish to ignore nationalism as part of the motivation to embark on a China-based strategy because many ethnic Chinese say that they returned to help build a prosperous and strong China.22 Appendix A of this chapter delineates how this book measures whether or not a firm has a China-based OS.

1.1.4 Summary of the Causal Argument In summary, the Chinese state’s relationship to firms determines their sources of financing. In turn, the sources of financing determine the technological upgrading efforts of the firms. Different sources of finance provide distinct 21 For some countries, one could argue that immigrants also adopt a nationalist bias towards their adopted country, but China is not an immigrant country so the chance of this happening among non-ethnic Chinese foreigners is quite low. For ethnic Chinese, it is a different matter. There is an ideology in China regarding ethnic Chinese foreigners, so-called Overseas Chinese (Huaqiao), as fellow Chinese rather than as foreigners. Sun Yat-sen, the founding father of modern China revered on both sides of the Taiwan Strait, was a US citizen who learned about the Chinese revolution he supposedly started while taking a train in the middle of the United States. 22 I did not bring up the nationalist motivation proactively in interviews due to the sensitive nature of talking about such topics with a foreigner, but some of the interview subjects still stated that this factor was part of the motivation. Segal (2003) also found nationalism a motivation for local Chinese entrepreneurs.

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incentives/disincentives for upgrading and provide or deprive firms of the financing needed to obtain the necessary technology inputs in terms of human capital, capital equipment, and technical knowledge. While the foreign sources of financing apply to both types of FIEs, hybrids and MNCs, it is the hybrids’ China-based OS that encourages hybrid firms to utilize the incentives, finance, and concomitant capabilities bestowed upon them by foreign finance and its relatively hard budget constraints to intensively pursue technology activities in China. The combination of the sources of financing and the operational strategy of the firm together determine the firm’s technology strategy (see Figure 1.1 and Table 1.2), which in turn determines the upgrading outcomes in China. This book maintains that greater corporate technological efforts in China will, on average, lead to higher technological contributions to China, and the research found much evidence to support this contention. State–firm financial relations explain why domestic firms fail to contribute to upgrading as much as foreign firms (Proposition 1). The Chinabased OS of hybrid firms explains why hybrids contribute more than MNCs (Proposition 2). The causal explanation uses deterministic language, but the argument recognizes that the causal chain is probabilistic rather than deterministic, i.e. the independent or causal variables will increase the odds of the predicted outcomes occurring but do not guarantee that they will occur in every case.

1.2 The Dependent Variable: Contributions to Technological Development Technological upgrading encompasses two analytically distinct types of upgrading: learning and innovation. Technological learning means advancing into more technically difficult production activities without reaching the technology frontier. Technological innovation means advancing into more technically difficult activities that advance the technological frontier. The technological frontier is the most advanced technical knowledge in the world for one particular activity. For example, 38 nanometers (the lower the number of nanometers the more advanced the technology in this case) was the technological frontier of manufacturing-ready semiconductor lithography process technology for logic chips in 2011 according to the International Technology Roadmap of Semiconductors (ITRS). Firms that advanced from 500-nanometer process technology to 180-nanometer technology in 2011 were conducting technological learning. Firms that would reach 20 nanometers soon after 2011 were engaged in technological innovation as they pushed forward the technological frontier. Technological upgrading incorporates both learning and innovation. We do not assume that one or the other is the key to economic development. By 26

Table 1.2 Typology of firms, causal factors, and development outcomes Finance

Technology inputs (follows finance)

Capabilities and incentives to upgrade

Operational strategy

Technology strategy (technology activities in China)

Contribution to upgrading in China

Neglected domestic firms

Little access to finance

Low capabilities: No finance No technology

China-based OS but no capabilities to undertake technology activities

Do not pursue upgrading because of low feasibility and high risk

Low

Favored domestic firms

State banks and procurement offer unmonitored and lavish financial support i.e. soft budget constraints

No access to finance so no access to technology inputs Have access to finance so have access to technology inputs

China-based OS but disincentives to upgrade so motivation irrelevant

Generally do not attempt to do technological upgrading; the few attempts are poorly executed

Low

MNCs

Access to finance but finance offers harder budget constraints relative to Chinese state banks/ procurement

Same as above

Foreign OS so lacks positive bias of interpreting market signals in favor of placing activities in China

Try to enhance technological capabilities but not necessarily in China

Variable (Low to Moderate)

Hybrid FIEs

Same as above

Same as above

Mixed capabilities: Access to finance Access to technology Soft budgets undermine capabilities Disincentives because of soft budgets High capabilities: Access to finance Access to technology High incentives: Hard budget constraints plus technologybased competition Same as above

China-based OS interprets market signals in a manner favoring activities in China

Try to enhance technological capabilities in China

High

Source: With permission of the Shorenstein Asia-Pacific Research Center, reprinted from Fuller (2008: 93, table 4.1).

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conceiving technological upgrading broadly, as encompassing both learning and innovation, I ensure that firms undertaking one of these activities will be counted in the contributions to technological upgrading in China. Terms such as learning, catch-up, and fast followership generally refer to what is defined here as technological learning. Fast followership suggests building competencies by following closely behind the leading firms. Innovation generally implies technological innovation. Leapfrogging often means one or the other, but conveys the sense of skipping phases of past industrializers. This book does not argue for a particular path or strategy of technological learning. While in developing countries technical learning does in fact play a larger role than innovation, this book remains open to the possibility of discovering innovation as well as learning in China. The research uncovers some cases of technological innovation though technological learning comprises most of the technological upgrading found. Thus far technological upgrading has been described at the level of the nation, but technological activities are usually done within individual firms, universities, and research laboratories. Technology activities are ones requiring technical knowledge, whether process knowledge (knowledge necessary to carry out production), or product knowledge (knowledge necessary to design or redesign products). The research uncovered differences in the quality of technology activities at the level of the individual firm. Along with firms, I examine commercial technological activities in research institutes as well. I use four steps to determining whether a firm contributes to technological upgrading: (1) a comparison of the firm’s technology to China’s general level of technology; (2) a comparison of the firm’s technology to the international technology frontier; (3) a check for the commercial viability of the firm’s technology; (4) a check for the embeddedness of the firm’s technology. Turning to the first step, the book wants to understand in what ways China as a country has succeeded in technological upgrading, but the research gathered data from firms. How to square this circle to generalize from the firm to the nation? The book measures technological activities within the firm against the standard of technology widely available in China regardless of whether or not the technology is new to the firm. Thus, I do not count as upgrading those domestic firms that only manage to upgrade their technology to the Chinese average in their particular technology. The book does consider foreign firms bringing technology that is more advanced than China’s general level as upgrading even if the technology is not the most advanced the firm 28

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possesses. To give an example, if a firm moves from making shoelaces to making shoes, one could interpret this movement as technological upgrading for the firm. However, given that China has thousands of firms capable of making shoes, this intra-firm upgrading would not constitute technological upgrading for China as the technology of shoemaking is widespread. On the other hand, if an electronics firm brought to China the technological knowhow to design notebook computers in 2000, this would be considered upgrading given that China had few design capabilities in this area in 2000. It would be judged as upgrading even if the firm had only brought the technology for mature generations of notebooks, which the firm already possessed, to China, i.e. from the firm’s own perspective, it was not engaging in upgrading its overall technical capabilities. Another qualification is that the general level of technology is the general level outside of the firm. Some firms are so large relative to the size of their sector in China that expansion of their technological activities (e.g. training more workers in the same technical skills) would not be an increase in the general skill level in the relevant technology for China as a whole, but would count as an increase in skill level outside of the firm. To control for large firms, the general level of technology used to measure upgrading is the level of technology outside the firm under examination. A nation could very well upgrade its level of technical skill, but not reduce the number of possible competitors because many other nations also were able to improve their technical skill level. One way to examine whether or not a nation has improved its technology relative to the global community is to measure if firms in that nation have narrowed the gap between their own level of technology and the international technological frontier, the most advanced technical knowledge in the world for one particular activity. In this way, one can capture China’s relative technological gains or losses to gain a sense of where China has moved up the technological hierarchy of nations.23 In the course of research, when I discovered that the firm was actually lagging further behind the frontier than in the recent past, I discounted the upgrading. The reason to discount such upgrading is that this upgrading may simply reflect the general diffusion of technology globally (e.g. 100 years ago, few places had electricity and now it is widespread even in the developing world) and suggests China has not actually moved up the technological hierarchy of nations.

23 Moving up the technological hierarchy of nations means moving from those simple technologies that every country possesses to more sophisticated technical knowledge that are dominated by smaller and smaller oligopolies of nations and perhaps eventually to the apex of technological hierarchy where one nation monopolizes a particular technology, e.g. Japanese domination of active matrix liquid crystal displays prior to Korean and Taiwanese entry.

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The third step is to determine whether a firm’s upgrading is commercially viable. This research only counts technological upgrading that might be commercially viable as technological upgrading. By commercially viable, a firm or organization, such as a research lab, has to be able to sell a service or good embodying the upgraded technology in the marketplace and have a reasonable chance of earning a profit. This standard is lower than showing that the product or service is already enjoying a positive return because this book accepts that markets are not always efficient in the short term. With these short-term market inefficiencies, a firm with a competitive product still may struggle in the near term given that firms hone their competencies over time through marketplace competition. In a developing country with many firms struggling to learn new skills, immediate profitability would be too high a bar that would cut out many potential winners from the purview of this study. How to discern which firms’ technological upgrading might plausibly become commercially viable? The method used here is a process of elimination. Firms that have not sold a good or service in the competitive marketplace or have sold goods and services in the marketplace only at a loss over time are not considered to be commercially viable. I also eliminated those firms that have a commercial presence only through state support, i.e. firms that without state support would have had to sell at a loss in order to remain in the commercial marketplace over time. Information about the extent of state support is often hard to come by (especially in China), but the rule of thumb used here is that those firms that consistently sell more than 50 percent of their output to the Chinese state over time are considered to be subsidizing their commercial presence through government procurement.24 Such firms are not considered to be competing in the commercial marketplace. By restricting technological upgrading to potentially commercially viable projects, I narrow the focus to technological upgrading that has the potential to have a positive impact on economic development. The basic assumption in accounts of technological upgrading as a critical component of economic development in the developing world (Pack and Westphal 1986; Kim and Ma 1997) is that the technological upgrading is done under conditions of economic efficiency. The standard of economic efficiency used may be longer-term dynamic efficiency, where the net social benefits (firm profits plus positive externalities) discounted over time are greater than the net social costs (firm losses plus negative externalities) discounted over time (Khan 2000a), or short-term static efficiency, in which markets clear (price of a good and costs of production of the good are in balance) almost 24 Using only procurement to control for subsidies actually is setting the bar low for statefavored firms because many of these firms have subsidization through cheap loans.

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immediately. Thus, these accounts focus on organizations, usually firms, working to commercialize technology under the assumption that noncommercial technological upgrading, such as R&D for national defense systems conducted in military research institutes, could very easily be economically inefficient.25 In the context of China’s great asset-destroying banking system, commercially unviable technological upgrading is even more likely to be economically inefficient (Wu 2002). A firm may appear to be contributing to China’s technological upgrading because its technology activities in China are closer to the technological frontier than typical for China, but this evidence alone is insufficient to prove that a firm is actually contributing to China’s technological development. A firm could conceivably have operations in a developing country, but have the technology remain in control of foreign expatriates (Jomo and Felker 1999). Many foreign firms with impressive technological capabilities operate with very shallow (if any) technology roots in China (Quan and Chesbrough 2010). To measure the ability of the host economy to capture technology, this book uses the concept of embeddedness. Essentially, the technological activities undertaken by the firm in the host economy (in this case China) have to be rooted firmly within the host economy so they are not solely dependent on the firm’s decision to locate such activities in the host economy. The two main channels embedding firms’ technology in a host economy are utilization of local technical personnel and local suppliers to carry out the technology tasks. Firms embed their technology only when they increase the technical knowledge of the host country’s employees or suppliers and, consequently, come to rely on the local employees or suppliers for some technology activities. Upgrading without embeddedness consists of firms bringing in knowledge necessary for technology activities that are more advanced than the current domestic level, but do so without an effort to train local employees or suppliers to be able to take part in the technology activities. I draw these two main technology mechanisms from the findings of the large empirical literature on technology transfer in developing countries26 and from my empirical research in China. While there may be alternative mechanisms, I have not found any in China. In fact, I also have found far less evidence of foreign firms upgrading local suppliers than training employees.

25 Russia and especially its precursor, the Soviet Union, represent the classic case of impressive technological capabilities in its state military–aerospace industrial sphere that did not prove to be able to spur economic development. I thank Chris Howe of SOAS for pointing out this example. 26 The literature is too large to do full justice to, but the following works detail these mechanisms: Lindsey (1986); Markusen (1991); Kawakami (1996); McKendrick et al. (2000); Fosfuri et al. (2001); Ritchie (2002).

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To give some examples from the research, young women from the countryside taught how to pick and place parts into a printed circuit board are not considered to be technically trained as the knowledge passed to them is very limited: they are simply taught how to put one particular component into the board or other equally simple tasks. Such knowledge is easily taught and widely available among the millions of women who have worked in electronics factories across China and elsewhere in developing Asia. Training an electrical engineer how to use electronic design automation (EDA) tools to take part in the design of manufacturing- and product-ready computer chips is considered the transfer of technical knowledge to the locals. It is thus upgrading because such skills are not common even among engineers in China. With these skills, the engineers move closer to the international technology frontier. Thus, EDA training meets the standards of being upgrading, as well as embedded. While the four-step process to identify contributions to technological development focused on the firm-level aspects of embedded upgrading, technological upgrading has to be embedded institutionally as well. Training local workers and suppliers to do progressively more sophisticated technical activities alone does not guarantee that such practices will persist in the domestic economy if the firms training them leave. In addition, the larger economy needs to have institutions that encourage continued use of the technical knowledge contributed to the economy by firms. This requires an institutional framework that encourages foreign investment and new firm creation. In other nations, foreign investment would not be necessary because domestic investment could finance technology activities, but in China, domestic investment is skewed to inefficient firms with political connections. Thus, foreign investment becomes critical to investment in technological activities and new firm creation. To provide some examples of variation across the dependent variable, let’s start with a major success case, SMIC. This firm basically singlehandedly took China’s wafer fabrication technology from many years behind the international frontier to being a fast follower (Steps 1 and 2). The firm has pursued this fast follower approach while competing in the international marketplace with most of its sales overseas (Step 3). Most importantly, the firm has competed through training up local engineers and has all of its major operations in China with only sales offices abroad (Step 4). In sad contrast would be Founder, a Chinese firm that started with a burst of innovation in Chinese language printing technology, but allowed itself to be displaced from that market (going backwards rapidly on Steps 1 and 2). More worrisome still, the firm has become heavily reliant on state-controlled markets and state procurement to survive (fails at Step 3).

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1.3 Methodology and Data This study is based on an extensive set of semi-structured interviews with foreign and domestic firms, government officials, and venture capitalists in greater China. In total, over more than twelve years from March 2001 to April 2013, I conducted 499 interviews in nine provinces and provincial-level municipalities in China, including the three big hubs of China’s IT industry (the Pearl River Delta, the Yangzi River Delta, and the Beijing-Bohai Gulf Region) as well as with industry participants in Taiwan, Hong Kong, Silicon Valley, and elsewhere in the world. Additional interviews were conducted in 1998, while follow-up interviews were conducted from 2013 to 2015. Given the large number of interviews and the duration of the research, this interview data contains rich longitudinal data on the development of China’s IT industry. To check my interview findings against broader trends and other information sources, I also conducted extensive secondary research including Chinese news reports, commentaries by Chinese economists and technology policy experts, and government documents as well as Western news and industry sources. The key to this data collection method was triangulation of data by interviewing firms up and down the value chain from the firms under study. Thus, firms’ self-reporting was not accepted at face value. There are many reasons a firm might want to inflate or deflate its actual capabilities when interviewed and these incentives might be further enhanced in transitional economies with more opaque institutional environments (and thus more restriction on the flow of information) such as China. Firms’ claims had to be verified with those in a knowledgeable position while also being outside of the firms under examination. Outside the production chain, venture capitalists active in investing in the IT industry were good sources of information on firms as they tracked many of them as potential investments. Similarly, I checked the claims government officials made about the efficacy of various policies with the “consumers” of such policies, the firms. Given the networked nature of the industry, many interviewed firms were simultaneously subjects of study in themselves and sources of verification about the claims made by their customers, suppliers, and government policymakers.

1.4 China’s Problematic Industrial Policymaking While the Chinese state has effectively implemented a range of policies from massive expansion of secondary and tertiary education to building infrastructure widely and quickly (Bardhan 2010), China’s strategic industrial policies 33

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have not been very effective as past research has documented (Beardson 2013; Lardy 2014; Moore 2002) and subsequent chapters in this book will show. Strategic industrial policies are those policies to shift resources to a particular sector in order to achieve outcomes that are economically efficient for the economy as a whole.27 Efficiency can include dynamic efficiency in which the net social benefits outweigh the net social costs over time in addition to static efficiency where the immediate benefits outweigh the immediate costs (Khan 2000a). China faces four serious constraints to the effective pursuit of industrial policy: (1) the structure of the state apparatus, (2) the bias of credit allocation towards SOEs and the resulting managerial deficiencies of these firms, (3) large information asymmetries, and (4) corruption. The first such constraint is the structure of the state apparatus. As early as the 1960s, foreign scholars (Schurmann 1968) identified what the Chinese called the tiao tioa kuai kuai jurisdictional conflict between the vertical lines of the authorities descending from the central ministries (tiao tiao) and the horizontal lines of authority emanating from the regional or local governments (kuai kuai). The central Chinese state has a very hard time establishing priorities and the horizontal authority versus vertical authority conflicts undermine any priorities established (Lieberthal and Lampton 1992; Lu and Tang 1997). Fragmented authoritarianism also prevents China from pursuing policies that require coordination across the relevant bureaucracies (Moore 2002). The second issue is the basic flaw of how the state allocates credit to firms as discussed in Section 1.1.2. A critical part of this misallocation of finance is the management of credit to SOEs, combined with their internal mismanagement, each of which hinders any attempts to discipline SOEs for poor performance (Moore 2002; Huang 2003).28 Moore (2002) argues that government–industry relations are marked by industrial paternalism in which state agents take care of the firms under their purview rather than exercising discipline over them. With soft budget constraints, there is dual

27 This definition paraphrases Ha-joon Chang’s (1994: 60) definition while omitting the perception of the state from the definition, as the state could perceive something as efficient that is in fact not efficient. 28 Naughton (2010) makes the important point that the centrally-owned SOEs under the State Asset Supervision and Administration Commission (SASAC) have rewarded their managers with incentive schemes based on maximizing the value of the assets starting in 2004. However, Richard McGregor (2012) among others would point out that most of the top managers are still party-state officials with eyes on a larger political game beyond maximizing the asset value of a particular SOE so that the incentives in place might be dulled or skewed in a direction away from economic efficiency. Indeed, Naughton acknowledges that the Chinese Communist Party’s (CCP) Central Organizational Department controls the top appointments in the SASAC-managed companies although he views it as a way for the government to assert control in event of things going wrong. Skeptics (Walter and Howie 2011) would counter that the Organizational Department cadres, like all other bureaucrats, are unlikely to leave unexercised the power they are given.

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dependency, with the state agents exercising paternalistic tendencies towards the firms and the firms demanding such paternalism. The third constraint for China is the much larger information asymmetries faced by central government bureaucrats in monitoring firm performance. First, China’s geographic expanse and large population make monitoring and coordination a much more difficult task than was the case for China’s Northeast Asian neighbors, which successfully pursued strategic industrial policy. Contrasting it with Park’s Korea in the 1960s, Perkins (2001) notes that negotiating with enterprises in China would involve thousands rather than dozens of participants, as it has in Korea.29 Haggard (2004) highlights the important role exports played in evaluating performance of firms in Taiwan and Korea and how this simple metric was useful for both its clarity and the inability to manipulate it in a low-cost manner. In contrast, China has had less reliance on exports overall and domestic firms are much less involved in exporting than was the case in Taiwan and Korea so the Chinese state has less opportunity to employ exports as a metric of success. Finally, a number of scholars point to a level of corruption far beyond the transactional grease seen in the developmental states of Japan and Korea (Perkins 2001; Pei 2006). Lin (2001) and Richard McGregor (2012) suggest that corruption is endemic to a capitalist system where the lack of any separation of powers makes the local party chief a law unto himself.30 Are there major challenges to these arguments about the Chinese state’s incapacity to conduct strategic industrial policy? There have been a number of works that looked at local developmental states driving development,31 but the evidence for successful targeted industrial policy in China is rather thin.32

29 Naughton (2010) makes a similar point comparing coordination problems in China today to Japan in the 1960s, especially with foreign firms so active in China. 30 For an explanation of how China has managed thus far to have high levels of growth along with high levels of corruption, see Wedeman (2012). 31 There is the literature on the economic policies of Chinese localities and some of this literature makes broad claims about local state capacity. However, none of these claims really constitutes strategic industrial policy as we have defined it. Belcher and Shue (2001) go so far as to say that there is a local developmental state in China, but their example really consists of state provision of public goods and does not include state-led upgrading of the industrial structure of the locality from lower technology to higher technology industries. Similarly, the local state corporatism literature exemplified by Jean Oi (1999) primarily focuses on localities that originally owned as well as managed their local firms. These localities did not pursue strategic industrial policy in the sense of getting the prices wrong to upgrade industry. Rather, the township and village enterprises of these locales conformed to the market signals sent by the wider economy. 32 There have been a number of studies that have argued that the central state is very active, particularly in sectors deemed strategic or the commanding heights of the economy where it wants to maintain greater control (Pearson 2005; Hsueh 2011). Naughton (2010) has gone further and offered the conjecture that state ownership and concomitant massive investment have been beneficial for growth. However, these studies do not demonstrate that the state policies targeting these sectors directly led to upgrading of firm capabilities in these sectors nor do they intend to do so.

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Several scholars have examined particular industries in which they claim that state intervention has been conducive to development, but these studies do not provide evidence of success at the level of strategic industrial policy as defined here. Thun’s (2006) insightful examination of local governmental efforts to develop the auto industry suggests that Shanghai’s more centralized command structure for the industry was particularly conducive to the development of auto suppliers. However, it appears that most of the technical know-how has remained largely with the foreign JV partners rather than the local partner, SAIC. Turning to high technology, Harwit (2008) has ascribed the growth of the telecommunications industry in China to a developmental state. However, his benchmark for success is mainly about the size and growth of the market and competitive consumer prices rather than development of major firms that can compete internationally. China undoubtedly has lots of state intervention so it superficially resembles Korea or Japan in their developmental heydays, but the quality of the firms the Chinese state targets and the rigor of its implementation could not be more different from its Northeast Asian neighbors.

1.5 Alternative Explanations In the existing literature, there are a number of alternative explanations that could account for differences in upgrading performance among firms in China. I will rebut each of them.

1.5.1 Tax Favoritism for FIEs Fu (2000) argues that foreign firms have received excessively beneficial treatment from the Chinese state in the area of taxation. Simply put, domestic firms are being taxed to innovative inertia while the foreign firms receive all sorts of tax breaks. Huang (2003) acknowledges that the FIEs have received more generous treatment than local firms historically though he also notes that reforms in the tax treatment of domestic enterprises have decreased this bias. The main counterargument is that it is simply not true. FIEs may on paper have had slightly favorable terms of taxation under the old corporate tax regime until 2012, when the tax rates of foreign and domestic firms converged. However, the reality of effective taxation (the percentage of profits actually paid in taxes) under the old regime was actually in favor of domestic firms (Choi 2006, 2009). Huang (2008) himself points out that domestic firms 36

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often created FIEs to avoid taxation.33 The second problem with this argument is that the nationality of firms in the technology sector does not seem to matter. The technology firms examined in this book more often than not have benefited from a variety of preferential tax measures regardless of their nationality. My visits to more than thirty different industrial zones, parks, and incubators in China indicate that both foreign firms and domestic firms enjoy low rates of taxation. In none of these zones were the preferential policies limited to foreign firms. In some of the zones, local firms actually predominated. Third, as Huang (2003) has pointed out, the enterprises favored by the state have received preferential financial treatment far outweighing their tax disadvantages.

1.5.2 The Pre-existing Technological Advantage of FIEs One could plausibly argue that foreign firms contribute more to industrial upgrading simply because these firms generally have more technology than local firms. However, many of the hybrids, the very firms at the forefront of upgrading in China, are new firms, or classic start-ups. These firms do not have an archive of technology. The only technology they have is the tacit knowledge brought by the employees and codified knowledge that they buy. Thus, they are not at an advantage over state-favored firms that lure employees with tacit industry knowledge and have the means to buy codified knowledge. Indeed, through the end of the 1990s, domestic firms were more successful than foreign ones in luring back returnees (Liu 2001). Nor are the newly founded hybrids at an advantage against large, often long-established MNCs in the same industry segment. If it were simply the technology embodied in the firm, one would predict that the MNCs in the same industry segment would contribute far more to technological upgrading than the hybrid newcomers. In reality, hybrids generally contribute more to upgrading than the MNCs. This generally holds for both the level of technology and even local technical staff trained, despite the much smaller size of most hybrids.

1.5.3 Ethnic Network Argument A third counterargument is that ethnic networks determine which firms upgrade in China. One could imagine such an argument as an extension of 33 Huang (2008) uses the Chinese state’s legal definition of FIE, which is a firm with at least a nominal 25 percent foreign stake, but the firms he mentions as using this status in at least some of their local operations, such as Lenovo and Haier, actually do not meet the criteria for foreign ownership set by this book either in terms of 50 percent foreign shareholding and/or effective foreign control of the board. Thus, the firms using legal FIE status for the purpose of lowering their taxation prior to the tax reforms were still domestic firms.

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Hsing’s (1998) excellent work on the importance of ethnic connections for the operations of Taiwanese firms operating in southern China. While this book recognizes the role ethnicity plays through returnees and firms from ethnic Chinese economies, ethnicity alone does not determine the upgrading outcomes. If Chinese ethnic connections were all that was required for upgrading, then the domestic firms would be on an equal footing with the returnees and the ethnic Chinese from abroad. Finally, there would be no differentiation between those ethnic Chinese firms that were simply MNCs and those hybrids that adopt a China-based operational strategy.

1.5.4 The Sheer Weight of the Foreign Sector Another plausible counterargument is that the relative weight of foreign firms in terms of industrial and R&D investment determines their advantage. In actual fact, FIEs do not have a relatively large proportion of industrial investment or R&D investment in China. Instead, domestic firms dominate both categories of spending and hybrids actually have a lower share R&D investment than MNCs (see Chapter 4).

1.5.5 The Returnees as the Determining Factor One could argue that the only factor that really matters in determining contribution to upgrading is the number of returnees flocking to firms of a certain type (Saxenian 2006). In this view, FIEs have been able to attract more returnees than domestic firms and this attraction determines their success. There are several problems with this argument. First, survey evidence from 1992, 1995, and 1998 indicates that returnees regularly went to domestic enterprises more frequently than domestic ones throughout the 1990s (Liu 2001). If returnees alone were the key, then one would expect better performance from domestic firms than from FIEs during the course of the 1990s. Subsequent chapters will document how returnees in the last fifteen years who went to domestic firms, particularly state-favored ones, have failed to turn them around. In line with previous research critical of the returnees as a deus ex machina for technological development (Hsu and Zhou 2010; Kenney et al. 2013), this book will present evidence demonstrating that something beyond recruiting the returnees is critical. The book will show that some returnees, who had worked for very unsuccessful local firms and achieved little, went on to contribute greatly to China’s technological future via hybrids. Finally, there is the problem that this returnee-only explanation fails to differentiate between the performance of the hybrids and the MNCs. Many 38

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MNCs attract returnees in large quantities, but this book will provide evidence that hybrids contributed more to China’s technological upgrading.

Appendix A: Measuring Operational Strategy Given evidence from elsewhere in the world that suggests the home base bias of even large MNCs (Hu 1992; Wade 1996; Hirst and Thompson 1999), it is safe to assume that domestic Chinese firms treat China as their home base. Determining the operational strategy of FIEs is a much more complicated task. Measuring the proportion of a firm’s technology activities in China conflates the OS and the variable it affects, the technology strategy. Saying that firms that have more technological activities in China are more likely to upgrade begs the question of why they have more technological activities there. To assess the OS of the FIEs,34 a wider net must be cast. Firms must meet two requirements to be considered to have a China-based OS. The first requirement is that the firm’s functional global corporate headquarters must be in China. Here we define functional headquarters as the place where the firm has its senior management and their support staff. The second requirement is that the firm must have explicitly articulated a plan to make intensive use of China’s human resources as a core component of firm strategy. This plan for utilization of China’s human resources must place China’s human resource utilization (excluding unskilled factory labor—universitytrained engineers in factories would be included) as an equal or higher priority than utilization of human resources in locations outside of China. While determining a given firm’s plan was usually ascertained through firm interviews, some firms had public proclamations of this strategy as well, such as VIA’s “China’s chip” campaign emphasizing the design of chips in China by Chinese as a core component of VIA’s plan to survive and thrive. There are in fact two distinct subcategories of FIEs that often have China-based OS: start-ups and established firms. However, there is a bias if the OS of start-ups and established firms are measured by the same standards. As new firms might have been founded at least with the idea of concentrating operations in China, they do not have large operations already built up outside of China when they create their China strategy. By contrast, established firms (defined here as firms established prior to 1997) have mature headquarter functions in their original home economy before they embraced a China-based OS, so it stands to reason that their headquarters are there rather than in China. For start-ups, typically technology enterprises founded by mainland Chinese returning from abroad (the so-called returnees), a China-based operational headquarters and a publicly articulated China-based strategy are required. For established enterprises that have embraced a China-based strategy, generally those from the ECEs of Hong Kong, Taiwan, and Macau, firms are not required to have their headquarters in China to be considered to have a China-based OS. Instead, these established firms are required to have a headcount (excluding unskilled workers) in 34

The next six paragraphs draw on Fuller (2010b).

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Paper Tigers, Hidden Dragons mainland China that is larger than any of their operations outside of their original home base. There is also a difference between measuring the self-described China-based strategies of returnee start-ups and established firms. Whereas the returnee start-ups must embrace a self-described China-based strategy, I only require established firms to place the utilization of resources in mainland China on par with utilization of resources in the firms’ original home base. While there are examples from Hong Kong of firms simply abandoning it for the mainland, most firms create “twin towers” (to borrow the phrase of Taiwan’s Inventec) with one in China and one in the original home economy. Established firms that describe their strategies as such will have met the standard of a self-described China-based strategy. Taiwanese firms also do not have to make this strategy a public one because technology firms from Taiwan have been under great political pressure not to invest heavily in the mainland in the recent past. If these firms articulated such a strategy during the course of my interviews, it was sufficient to meet the strategy criterion. Non-ethnic Chinese firms (meaning firms not run by ethnic Chinese management) were held to the same criteria. Established FIEs only had to meet the standard that established firms were required to meet. Foreign-invested start-ups had to meet the more stringent requirements of returnee start-ups. The research did not uncover any non-ethnic Chinese firms that embraced a China-based strategy. There was one nonethnic Chinese start-up that met the criterion of an articulated plan to intensively use Chinese human resources, but this firm’s core operations and functional headquarters remained in the United States so it did not meet the headquarter criterion for a Chinabased OS. In short, this firm aspired to the China-based OS, but failed to meet the harder standard of implementing such an OS. This firm went out of business before it could back up its talk of a China-based strategy with actual implementation of such a strategy. With these two metrics to measure a China-based OS, one can categorize firms in China independent of this author’s own categorizations. For start-ups, if the firms do not have their functional headquarters (as defined previously) in China, or do not have an articulated plan to make intensive use of China’s human resources expressed in the firm’s own documents or through interviews, then the firm is deemed to not have a China-based OS. For established firms, the functional headquarter metric is replaced with a headcount in China metric. To give two examples of how one can determine the OS of a given firm using published sources external to this study, let us look at the Beijing-based firm, Vimicro. As described by Zhou in The Inside Story of China’s High-Tech Industry, Vimicro, a start-up founded in 1999, has its functional and formal global headquarters in Beijing with its senior executives there and has a publicly articulated strategy to use extensively the human resources of China rather than elsewhere (Zhou 2008: 132–3). Thus, this firm clearly has a China-based OS despite being an FIE. Similarly, Inventec, an established firm (i.e. founded prior to 1997) from Taiwan, meets the two criteria for a China-based OS: (1) the firm publicly embraces in its “twin towers” strategy extensive utilization of China’s human resources (excluding factory labor) on par with using resources in its original home base of Taiwan and (2) has a larger headcount (excluding non-skilled labor) in China than anywhere else but Taiwan.

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Part II State Policy, Firms, and Upgrading Outcomes

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2 California (and Hsinchu) Dreaming China’s Flailing Efforts to Replicate Technology Clusters

2.1 Introduction Scholars have often emphasized China’s efforts to follow in the footsteps of Japan’s keiretsu and Korea’s chaebol (Keister 2001; McNally 2012) by pursuing giant corporations with advantages of scale and scope economies and indeed as Chapter 3 will show, the Chinese state has tried to foster such champions. However, scholars who have looked at economic policy at the central (Heilmann and Shih 2013) and local level (Chien and Zhao 2008; Yang and Wang 2008) note that China has also implemented policies that try to mimic the cluster advantages of Silicon Valley or, closer to home, Taiwan’s Hsinchu. Through an examination of two separate policy areas related to upgrading and innovation, development zones and venture capital, this chapter argues that central and local government policies aimed at creating ever more technologically capable firms in vibrant clusters of techno-entrepreneurship have by and large failed to accomplish these goals. An example of the failure to foster clusters is the electronics cluster in Shijie Township in Dongguan, Guangdong Province.1 One Taiwanese firm2 in particular became a cornerstone of this township’s electronics industry. And yet, this same firm has been emblematic of the lack of local upgrading that often occurs in China’s development zones. Even after manufacturing for over a decade in China at the time of the interview and with a huge production site 1 While discussing Shijie Township here, there are reports that the exiting of the industry from Dongguan generally has continued unabated ever since the global financial crisis (ESJJBD February 11, 2014). 2 As much of the information for this account came from the firm itself, this firm must remain anonymous.

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(relative to Shijie’s size) employing 20,000 workers in multiple factories, this firm still had not employed local suppliers to any significant degree. What is more remarkable is that this behavior comes from a firm that has a Chinabased OS (Interview 207). Even as this firm was ramping up production and R&D in China and in the process embedding itself in China through its increasing reliance on Shanghai’s human capital that it helped to train, the firm was not reaching out to local Chinese firms and not becoming tied to Shijie. Production was localized in the area, but the local suppliers were primarily Taiwanese and Hong Kong firms. After more than fifteen years in the Pearl River Delta (PRD) site, the firm simply decided to pull up its stakes and move production to other places in China where presumably it received a better deal on land and taxes, and it was easy to do so because there was no important local supplier base tying the firm to the locale. The local government, both worried and furious, threatened to make the firm pay back tax rebates the local government had granted if it moved. The compromise was that the firm essentially slowed down the move by allowing worker attrition (turnover is high in factories in China) to lower the level of workers to less than a quarter of its former size in a few short years.3 Moreover, the firm’s R&D had never come to Shijie in the first place despite local inducements for the firm to do so. Instead, the firm had concentrated R&D in Shanghai given that city’s concentration of science and engineering talent that serves to lock those more technically sophisticated activities in place.4 This failure of local governments to embed firms in their local environment is common across China, and this chapter will explain the reasons for these failures. This chapter first examines how the political incentives for local officials negatively affect the management of and, consequently, the upgrading outcomes within China’s development zones (Section 2.2). In Taiwan and Singapore, officials in charge of specific zones and local districts played key roles in fostering the upgrading of the local industrial environment. Ostensibly, China set up its zones to mimic such policies. Indeed, Singapore’s government was brought in to help run one such zone in Suzhou. Thus, it is reasonable to ask if such zones have played a role in China similar to that in Taiwan and Singapore. However, it must also be said that the very incentives that have undermined long-term upgrading have had one positive outcome. They have aligned local officials’ interest with the necessary economic openness to allow hybrid firms to flourish by accessing foreign institutions while being located in China.

3

Interview on January 14, 2015. I am not claiming that Shanghai does not also offer financial inducements, but rather that those inducements are not the driving force for the “stickiness” of those R&D activities to Shanghai for this firm and others. 4

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Section 2.3 turns to the issue of venture financing of technological entrepreneurship, an area in which the Chinese state has been active since at least 1984. Foreign venture capital has been able to fund China’s technological entrepreneurship even as state-dominated domestic venture capital has by and large proven incapable of doing so.

2.2 Cadre Incentives and the Lack of Upgrading in Development Zones For the last several decades, China’s system of assessing cadre performance has placed great emphasis on various aspects of economic development including industrial production, industrial fixed-capital investment, total investment, investment growth, and GDP growth (Zweig 2002; Landry 2008). With such hard economic assessment criteria in place, local government cadres have been keen to find outside investors to come to their jurisdictions to help the cadres pass muster when they are assessed. In terms of development, these incentives have proven to be a double-edged sword. On the one hand, these incentives aligned the interests of local governments with business in order to encourage the local state to be a helping instead of a grabbing hand (Qian 2003; Rodrik 2006b, 2011; Xu 2011). Furthermore, these incentives helped to create and extend the geographic space in China that was open to foreign investment, and from the late 1990s, a space in which wholly foreign-owned enterprises (WFOEs) could exist with relative ease (Sutter 2000; Fuller 2003; Naughton 2007). Of course, as Zweig (2002) has cogently argued, the benefits of outward openness enjoyed by the initial set of Special Economic Zones (SEZs), combined with the economic performance metrics for officials, motivated the demands for further liberalization of FDI by local officials. Without these inducements to create a better environment for FDI and especially WFOEs, the whole hybrid model would have been well nigh impossible. On the other hand, the major downside to these hard economic performance requirements has been that local cadres tend to focus on attracting investment to the detriment of pursuing policies to promote upgrading. This section will explore this downside in detail. The first subsection delineates the incentives at work for local officials due to central government policies. The second subsection describes the behavior of zone officials. The third subsection examines upgrading outcomes in the zones.

2.2.1 Incentives for Local Officials The central and provincial governments have long had hard economic targets, such as investments amounts and local industrial production, as part of the 45

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evaluation system for local cadres. In 2007 and 2013, there were central government announcements about reforming this evaluation system away from hard economic criteria, but there is little evidence that these systems have changed. Land development for revenue purposes, like cadre career advancement incentives, have spurred local governments to seek as much careerist economic development as possible and have become a particularly important motivation in recent years.5 Economic hard targets have been important criteria to judge local cadre performance (Tsui and Wang 2004; Cai and Treisman 2006; Yang and Wang 2008; Fewsmith 2013). While empirical studies show the overall relationship between prior performance and subsequent career advancement to be complicated,6 there is also a wealth of empirical evidence that local cadres take economic targets seriously. First and foremost, local cadres prioritized economic goals, especially benchmarks for industrial investment, as previous research (Zhong 2003; Whiting 2004) and the author’s interviews with officials from thirteen national zones (discussed later in this section) attest. In other words, whether or not meeting these targets eventually helped their careers, interviews and previous research suggest that local officials’ 5

Kung et al. (2013) date this change of motivations towards land revenue and away from industrial development to the central government’s move to take 50 percent of the enterprise tax from 2002 onwards whereas the business tax with half its revenues generated from real estate and construction remains in local hands. 6 Shih et al. (2012) have presented the strongest empirical challenge to the link between economic performance and cadre promotion. However, their work looks at the “power elite” of the CCP’s Central Committee rather than party-state cadres at lower levels. At the provincial level, a number of scholars have found links between economic performance and promotion (Maskin et al. 2000; Chen et al. 2005; Li and Zhou 2005) although Shih and his co-authors rightly retort that these findings are limited to state rather than party officials. More important for the concerns of this chapter is the link between economic objectives and cadre promotion at the sub-provincial levels because the development zones are run at these levels. At this sub-provincial level, the link between economic performance and cadre promotion appears stronger (Edin 2003; Whiting 2004). For the sub-provincial level, Landry (2008) argues that because the one-level down nomenklatura system creates competition between officials in economically similar areas at the same time that economic performance metrics are part of what is used to evaluate cadres, one can have both political promotion for good economic performance and lack of punishment for the laggards. Therefore, the promotion rewards for economic performance are somewhat dampened just as chances for punishment are because cadres are compared to cadres in similar regions and because of the general reluctance to punish officials who have the sad lot to govern more economically challenged areas. As Landry (2008: 106) puts it, the CCP “actively rewards officials who can claim economic success, but rather than pushing out those who cannot, the Party simply allows them to remain in place longer and possibly reach the rank of local party secretary.” Thus, it is not surprising that Landry’s empirical investigations find mixed results for impact of economic performance on promotion in line with the mixed findings of Guo (2007). Tao et al. (2010) are even more skeptical. A further caveat to literature’s mixed findings is that much of the literature looks at macroeconomic outcomes (e.g. Landry’s economic performance metric is per capita GDP growth rates), but industrial investment metrics seem to loom much larger in actual practice of motivating local cadre behavior (Wu 2011; ESJJBD 6.27.2014). As this chapter will argue, the focus on luring investment, zhaoshang yinzi, has been particularly deleterious to technological upgrading.

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perception is that economic metrics mattered for their careers. Despite the attempted 2007 reforms to lessen the emphasis on hard economic targets, zhaoshang yinzi (attracting investment) remains a priority task for local cadres who still feel under great pressure to secure industrial investments (Wu 2011; ESJJBD 9.17.2010). While the Third Plenum of the Eighteenth Party Congress in 2013 was supposed to signal a shift away from the investment-heavy manufacturing growth model and the December 2013 notice by the CCP’s Central Organization Department reiterated the intention to move away from hard economic targets for cadre evaluation, in 2014 Premier Li Keqiang re-emphasized hard economic targets for local officials, stressing that the growth rate of 7.5 percent is “legally binding” (WSJ 6.22.2014). Other recent reports attest to local officials’ continued fixation on zhaoshang yinzi (ESJJBD 6.27.2014; JJGC 3.30.2015). A second incentive to pursue zhaoshang yinzi and other hard economic targets is revenue rather than professional advancement. Land is used as collateral for the bank loans needed to build the infrastructure for the zones and, critically, for the accompanying commercial/residential projects.7 These commercial/residential projects are revenue generating in two ways. First, the government does not subsidize the buyers/users8 of commercial/residential projects whereas they do subsidize the costs for industrial investors in the parks in order to attract them in the first place. Second, the business taxes generated by these commercial activities are kept as local revenue, rather than shared with the central government, whereas the value-added tax (VAT), the primary tax paid by industrial firms, is shared. Building and expanding industrial zones is an excellent excuse to build these profit-making and taxgenerating commercial districts. On top of this, zone creation and expansion can justify land grabbing. The compensation given by local governments to the current users of the land, usually farmers, is generally very low (Yang and Wang 2008; Su and Tao 2015). A 2011 study found that the average compensation given to farmers was USD 17,850 whereas the average selling price to commercial developers was USD 740,000 (Magoff 2013). Su and Tao (2015) argue that the ability of local governments to make money off land development associated with the service sector and housing, rather than the hard economic criteria for cadre performance handed down from the central government, is what has really driven the new post-2008 boom in zone development in China’s interior. This mechanism for funding industrial expansion is not a wise one, Su and Tao warn, because making

7 The loans are typically borrowed via local government financing vehicles (LGFVs) owned by, and acting on behalf of, local governments. 8 Legally speaking, land is not bought and sold in China. Instead, the user rights for fixed periods of time are bought and sold.

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money off leasing land to services and housing has been dependent on a land bubble fostered by China’s easy credit conditions in the wake of the global financial crisis. Without these inflated prices, the enormous amount of industrial park building is not financially sustainable. This unsustainability is not just on the cost side as there is already a large oversupply of industrial land. China, which already has an enormous amount of land devoted to industry, also averages 40–50 percent of new land development for industry whereas the global average is 10–15 percent. At the same time, the state has become increasingly fiscally dependent on land sales. From 2008 to 2013 there was an explosion in land sales as a percentage of total government fiscal revenue from one-sixth of total revenue to one-third (Zhongguo Jingji Zhoukan 7.22.2014). Su and Tao’s warnings (submitted for publication in early 2014) appear prophetic as land sales began to slide in 2014 with new property sales falling by 7.6 percent in volume and by 6.3 percent by revenue. In the first quarter of 2015, both volume and revenue fell by 30 percent (Zhiwu Chen 2015). The downside of these formal political incentives for investment and economic growth and the unseemly informal ones (e.g. opportunities for land grabbing) is that they are conducive only for industrial investment rather than longer-term upgrading of industrial activities. Over ten years ago, scholars were already arguing that these incentives were leading to economically irrational and damaging investments designed to boost short-term growth figures without creating any real long-term value for the local economy (Zhong 2003).9 Of course, evidence on the ground suggests that China’s local officials’ behavior displays a mix of predation and pursuit of central government-set economic targets. For example, in one of the areas that Ong (2012) deems to be among the more economically successful local governments,10 a vice mayor bluntly told me that local officials in every bureau hit firms up for bribes, but the burden wasn’t high because economic success had created a lot of firms and the officials demanded very modest sums from each firm. He contrasted this situation to thoroughly predatory local governments in a neighboring province that his region was designated to help by steering 9 There is a literature, albeit one mainly concerned with the earlier part of the post-1978 reform era, that is much more sanguine about the local state’s role in economic development, namely local state corporatism (Oi 1992, 1999; Walder 1998). However, Ong’s (2012) careful study of several different locales demonstrates that local states had their share of developmental failures as well as successes, and that the success cases, such as Zouping and Wenling, were in mature industry sectors. Using Richard Doner’s (2009) dichotomous categorization of development into structural change and upgrading, one could argue that these Chinese successes in mature sectors are emblematic of the structural change commonly seen in industrializing low-income economies without blossoming into the upgrading that leads to sustainable development out of the middleincome trap. 10 In order to protect the identity of this interview subject, the name of this municipality and the adjacent province are anonymous.

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investment there. He had gone to the neighboring province to see the local investment projects that his city had funded, but the local officials there told him that they could not visit them because the mountain roads were basically impassable. He understood that the local officials had just pocketed this money and his county and municipality had seen such behavior time and again from local officials in the poorer neighboring province. He added that in this more predatory environment, there was a bit of a vicious cycle: impoverished areas with few firms made it hard for the few firms there to survive since there were just a few “golden cows” which the officials rapidly bled dry (Interview 149).11

2.2.2 Priorities and Behavior of Local Zone Officials This subsection will examine the behavior and priorities of local zone officials. First, it will document how local officials are still in the grip of “zone fever” in which they seek to create new zones and expand existing zones. Second, it will show how local zone officials concentrate almost exclusively on zhaoshang yinzi to the neglect of upgrading. Third, the subsection illustrates methods local officials use to game the hard economic targets they’re given. ZONE FEVER

The ongoing phenomenon of “zone fever,” in which local governments lobby for permission to create and promote zones, sheds light on the problems of upgrading in these zones, due to the ways that zone fever shapes cadres’ behavior. David Zweig’s (2002) excellent work on development zones implied that by the start of the twenty-first century the central government caused zone fever to abate by allowing a large number of such zones across the country. This expansion supposedly satisfied the demands of local and regional governments for zones’ policy advantages, principally in terms of taxation, that national zone status conferred for attracting investment, particularly FDI. However, since the publication of Zweig’s work, zone fever has continued. In fact, the number of national-level High-Technology Development Zones (HTDZs) and Economic and Technology Development Zones (ETDZs) has nearly doubled since the beginning of this century, with 89 HTDZs and 108 ETDZs by 2011.12 In response to continuing zone fever, there have been new 11 A businessman from the same county confirmed the vice mayor’s account of controlled corruption going hand-in-hand with help from the county authorities and contrasted it with the predation he had experienced at the hands of officials in other parts of China by saying, “When they speak Putonghua [as opposed to the local county dialect] we don’t dare pick up the phone” (Interview 151). 12 These figures are from Torch High-Technology Center (2011) and ESJJBD (4.18.2011).

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provincial and national level qingli zhengdun (“clean up and reorganize”) campaigns to close down zones. A national reorganization campaign in 2003 demonstrated how much zone fever had gotten out of hand as the central government shut down over 4,000 zones (70 percent of the total number of zones) representing 65 percent of zone land (NFZM 1.20.2011). The National Audit Office in 2014 conducted what has been described as its largest and most intensive audit of land usage by local governments. Not surprisingly, it found that development zones were the largest cause of land usage, and once again the state has ordered the closing and reorganization of zones (ESJJBD 5.8.2015). Why has zone fever continued given these problems? The answer does not lie with tax policy. While national zone status confers tax advantages, these benefits probably are an unlikely motivating factor because of the widespread use of illegal tax breaks (i.e. tax breaks more generous than those sanctioned by the central government) by local governments inside and outside of zones (Tian 2006; Interview 210). There is evidence that among foreign investors, investors from the ECEs, and secondarily other investors from East Asia, were much more likely to seek out such illegal tax breaks, than Western MNCs (Interviews 118, 141).13 Recent policy changes have reduced the scope for inducing investment via tax policy. The new tax law that came into effect in 2008 officially curtailed the ability of national-level zones to give lower tax rates of 15 percent on high-tech firms as the requirement that the firms must reside in these zones was dropped. There was also a crackdown on the widespread abuse of liang mian san jian ban (“two-free, three reduced in half,” i.e. two years tax free and three years paying at half the enterprise income tax rate) tax rate, but these moves did not effectively curtail tax competition based on these illegal tax breaks since much of the tax competition had contravened national law in the first place (Interview 434; ESJJBD 9.17.2010).14 The State

13 Several people who were not zone officials but were familiar with the workings of zones brought up the use of these illegal tax breaks in zones (Interviews 181, 182). 14 One interesting aspect of the illegal tax breaks is that many were out in the open, i.e. local governments had public documents stating what these tax breaks were (ESJJBD 9.17.2010). Indeed, officials of most of the zones visited by the author stated to the author that they offered liang mian san jian ban to all investors and did not mention that this policy directly contravened national law, which by and large reserved such tax breaks only for foreign (including Hong Kong, Macao, and Taiwanese) investors under specific circumstances. For officials and investors, the further underthe-table deals received primarily by ECE investors were illegal because they went beyond the illegal but public tax breaks promised to investors in public documents released by local governments. One Taiwanese firm complained to the author that the development zone in north China in which the firm’s factory was located would not extend benefits beyond those sanctioned by the central government, but then the interviewee acknowledged that some “hightech” firms had been able to receive a special “two free, six reduced by half” that was obviously not within the central government’s preferential policies (Interview 224). Tian (2006: 130–1) discusses “tailor-made” tax breaks for individual firms including some truly outrageous tax concessions, such as a “ten-free, ten reduced by half” concession offered by a Suzhou zone to a German firm.

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Council’s 2014 notice15 calling for “cleaning up” local preferential tax breaks appears to be meeting significant local passive resistance and criticism (JJGC 3.30.2015). The goals of zone expansion and administrative rank promotion for the zone appear to drive zone fever in the twenty-first century. National zone status confers upon cadres the ability to acquire more land and thus more revenue and outflank immediate bureaucratic superiors.16 It is extremely common for zones to be able to acquire more land once the park’s status has risen in rank, a practice so common that many zones put together their future expansion plans while they are applying for higher status (ESJJBD 2.22.2012). As for bureaucratic hierarchy climbing, officials can accrue higher effective status than their jurisdictional rank normally affords them as their respective zones are promoted. For example, in Jiangsu, the party secretaries of municipalities with very successful zones, such as Suzhou and Wuxi, are members of the provincial politburo standing committee and thereby outrank all but one of the vice governors of the province despite Suzhou and Wuxi only being prefecture-level cities (Interview 448). INVESTMENT AS THE PRIORITY FOR LOCAL ZONE OFFICIALS AND NEGLECT OF UPGRADING

Career and revenue incentives affect cadre behavior, as zone policies prioritize attracting investment and neglect the upgrading of local firms and workers. Through their behavior and statements, zone officials have demonstrated that attracting investment, zhaoshang yinzi, is their dominant priority; cadres have basically not even attempted proactive policies to promote upgrading within their zones. In the course of my own research, I interviewed officials in thirteen of the national development zones in the three main geographic clusters (the Pearl River Delta, the Yangtze River Delta and the Beijing–Bohai Gulf region) of China’s high-tech industries, as well as one zone in central China and one in western China. These zones included the largest zones in terms of investment and industrial production as well as some middling ones. One would expect that if there were significant upgrading efforts spurred by zones’ cadres it would be in one of these large coastal zones where such industries clustered.17 15 “Guanyu Qingli Guifan Shuishou Deng Youhui Zhengce de Tongzhi” [Notice Concerning the Cleaning up and Ordering of Tax and Other Preferential Policies], September 2014. 16 Kunshan’s innovations did not stop at luring investment. They also have an administrativecum-political dimension. Chien (2013) documents Kunshan’s administrative strategies and innovation as it has successfully maneuvered around its direct jurisdictional superior, Suzhou Municipality, to acquire special budgetary and revenue rights and party rank for its party secretaries not accorded to other county-level cities. As of 2001, Kunshan was able to completely exempt itself transferring revenue from the value-added tax (Yang and Wang 2008). 17 A range of zones were included to see if differences in location, time, and scale would have impacted the zone officials’ behavior.

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Within each zone’s management organization, a striking number of personnel were devoted to seeking investment capital, yet not one of these zones had personnel devoted to upgrading firms’ activities or the activities of local suppliers. In the few zones where some unit existed which could potentially play such an upgrading role, it turned out to be a non-entity.18 Some zones even admitted that the function of their “incubator” departments was to provide low-rent office space to firms, rather than to offer guidance to the incubated firms (Interviews 118, 186, 232).19 One park official under a national zone admitted that an incubator was under consideration, but that the park was reluctant to establish it because it did not seem useful to the goal of making the park profitable so it might be put off (Interview 125). This lack of interest in the incubator facility existed despite the fact that the zone governing the park had planned for each of its subsidiary parks to have an incubator (Interview 179). Again and again, I heard from officials and firms located in these zones that the main service the zones offered was in navigating the red tape of China’s bureaucracy with firms stressing that such bureaucratic assistance was basically the only useful service.20 Of course, as suggested earlier in the accounts of taxation in zones, the subtext of many of these comments about red tape most likely was that the zones were helping resident firms circumvent central government law. Neither any local official nor firm inside the zones reported any significant activities undertaken by the local governments to foster upgrading of suppliers or workers’ skills. To the contrary, many zone officials were quite frank that zhaoshang yinzi was their main obsession (Interviews 118, 119, 125, 140, 141, 143, 225, 232, 434, 448). In an interview that took place after the 2008 tax law came into effect, a zone official stated that despite supposed curtailment of liang mian san jian ban and other tax breaks, “The development zones [still] have a lot of competition. Without tax breaks the zone would be empty.” She also admitted that the zone basically granted “name brand” firms the best deals, including cheap land, without examining what the firms were actually going to bring to the park. In one case, a very large firm was given land to use for R&D, but the firm never in fact made use of the facility for R&D (Interview 434).21 18 For example, one large zone had a three-person “technology department” but all they did was facilitate online applications for the process of being approved as high-technology firms in order to receive the appropriate tax breaks for that status (Interview 231). 19 At the same time, provincial or central government programs supported the programs to build such centers so they represented cost-free buildings from the perspective of local officials (Interviews 117, 118). 20 Many firms and zone officials said this. For example, Interviews 136, 153, 154, 179. 21 This zone happened to be one of the geographically closest to the central government. The Chinese often justify the lack of central control by saying “The mountains are high [and] the emperor is far away.” In this case, there were no mountains and the emperor was in close proximity, but in the face of strong incentives to increase investment, local officials were more

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Another episode exemplified local officials’ myopic focus on investment. In a meeting with officials from one of the most successful zones in the Yangtze River Delta (YRD), the officials confided in me that they were hatching a new scheme to attract investment. They wanted to hire a famous consulting firm to write a glowing report about their zone, which they then would release to the public as a form of advertising, to bring in more investment. When I questioned whether the report would be favorable enough to suit their marketing aims, they maintained that if they paid the consulting firm enough, it would write what they wanted. They did then backtrack a bit and say perhaps there could be a more balanced internal report as well, but the consulting firm would have to write a positive public report that they could use to attract new investors (Interview 143). While there is no evidence that they were able to recruit one of the globally prestigious consulting firms for their scheme, the ploy itself encapsulates the explicit emphasis on investment over upgrading. Such advice was simply a public relations ploy in the service of attracting investment. Even in the wake of the State Council and Ministry of Finance’s orders to stop the use of illegal tax breaks in 2014, bureaucrats in a major national zone in western China admitted that there was still a lot of competition with other zones to attract investment; this was often done by providing free factories and lots of publicly built infrastructure. Furthermore, the Electronics Major Projects Office of this zone was created to help recruit one large semiconductor firm to invest, and once that recruitment was done, the office simply shifted its activities to recruit other investment rather than making any attempt to localize the supply chain of this major investment.22 While the political incentives for this behavior are clear, Chinese local governments’ neglect of industrial upgrading stands in stark contrast to the tremendous efforts made by local officials in Taiwan and Singapore to ensure that the incoming investment contributed to the technological development of the local economy (Wade 1990; Mani 2004). In both Taiwan and Singapore, effective programs were in place through Taiwan’s Ministry of Economic Affairs and Industrial Technology Research Institute and Singapore’s Local Industry Upgrading Program to ensure that MNCs transferred technology and, especially in Taiwan’s case, upgraded the technical capabilities of local suppliers (Kawakami 1996; McKendrick et al. 2000; Doner 2009). The stark difference between the proactive upgrading efforts in Singapore and Taiwan and the neglect of upgrading among local governments in China

than willing to subvert central control. And this zone had already been very successful in attracting investment for a number of years so it was not the case of a latecomer willing to take outsized political risks to catch up. 22

Interview with two zone officials on November 18, 2014.

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stems largely from the differing incentive structures for the officials charged in all three cases with interacting with MNCs and technological development. In Singapore and Taiwan, success in upgrading local activities was a metric used to evaluate officials’ performance (Wade 1990; Kawakami 1996; McKendrick et al. 2000; Mani 2004). In China, the hard economic criteria used to evaluate local officials were not fine-grained and well defined enough to hold local officials accountable for upgrading instead of just the quantity of investment. The incentives steered officials towards simply pursuing investment-driven growth. Thus, it is hardly surprising that industrial upgrading, particularly of local firms, has been scarce in these zones even though the central government envisioned that the incentive structures for local government cadres would spur development.23 The continued efforts to reform the incentives system, such as the policies announced in 2007 and 2013, demonstrate that the Chinese leadership recognizes the incentives in place are no longer encouraging sustainable development policies on the part of local governments. The fact that these reforms have failed to result in substantial changes in actual practice and that top leaders, such as Premier Li Keqiang, push reforms on some days and continue investment-driven growth on others24 simply demonstrates the bind in which the Chinese leadership finds itself. Unwinding China’s investment-centric model is necessary and yet such reforms will lower growth in the short term25 to levels that are politically painful to a regime predicating its legitimacy in large part on delivering the economic goods. LOCAL ZONE OFFICIALS GAMING THE SYSTEM

With the competition among zones and the incentives for local cadres, the urge to game the incentive system in their favor is too tempting to ignore for many local officials. Two common methods of artificially boosting local performance have been setting up fake enterprises and the practice of fei di (flying land). These ploys to game the system take place both within zones and

23 Of course, other factors beyond incentives for officials can account for failed upgrading policies. Thailand tried to mimic Singapore’s Local Industry Upgrading Program, but failed miserably. The evidence suggests that the incentives may have been the right ones, but political infighting higher up in the political hierarchy and inadequate organizations to represent Thai enterprises in this endeavor doomed the effort (Doner 2009: 121). Even in Taiwan, efforts in certain sectors failed because of the poor fit between those sectors and Taiwan’s industrial structure (Fuller et al. 2003). 24 Premier Li not only pushed growth targets hard in 2014 as mentioned earlier in this chapter. He also urged banks to lend more in 2015 as growth slowed (WSJ 4.17.2015). All of which goes against the grain of the reforms proposed at the 2013 Third Plenum to move away from China’s unsustainable investment-centric model. 25 Pettis (2013) among others makes this link between even successful reforms and lower growth in the short term.

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one level up within the governments of the jurisdictions in which the zones are located. In the past, local government tolerated or even encouraged firms to pretend to be FIEs in order to receive lower tax rates. With the convergence of domestic and FIE tax rates from 2008 to 2012, this gambit has lost its allure. However, FIEs have additional value for local officials in that their investment counts as FDI, one of the metrics usually used to judge performance. A domestic firm masquerading as an FIE may be of some utility in this regard because it moves the investment from domestic industrial investment to the FDI category and both are usually performance metrics for local officials.26 To artificially increase their domestic and foreign investment, local officials have cleverly created many fake enterprises of domestic and foreign variety alike. Sometimes they have done this in cahoots with favored entrepreneurs. A recent example is the unfolding scandal in Lianyungang in Jiangsu Province where the local government, possibly with the aid of businessman and member of the local Chinese People’s Political Consultative Conference, Zheng Junbo, set up many fake enterprises in order to count them as part of their investment target (ESJJBD 6.27.2014). Even quite prosperous areas have used this trick. An academic who worked occasionally with national zones in Suzhou Municipality told me that about 20 percent of the firms registered in one of Suzhou’s zones and 20–30 percent in another did not actually have any operations in these zones.27 Another way to game the system is through fei di, flying land. Flying land allows established zones to set up branches of their zones in other counties/ cities or even occasionally different provinces. Typically flying land involves some split of tax revenue and economic performance (e.g. increase in investment and GDP) between the two jurisdictions even though the tax revenue and economic performance derive from the destination jurisdiction. The problem with this procedure is that local governments are credited with meeting economic targets even though these economic activities are not actually in their own jurisdiction. When provinces, such as Jiangsu, in the process of encouraging the movement of investment from more established locales to less established ones within the same province have tried to bar the sharing of tax revenue and the credit for investment received, they have met such fierce resistance that they have had to drop demands. The sharing of the tax revenue also calls into question the sustainability of this flying land for the recipient locales because they have to develop the industrial land without full access to the local tax revenue thus created.

26

In areas without much FDI boosting that category may be more valuable. Conversation in August 2002. The scholar thought some of these firms took money from the local government and then took off, either stealing the money outright or moving to another zone. 27

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One might be able to justify this behavior on development grounds if the flying land moved from the prosperous coastal regions to parts of the interior that might not be able to lure investment. Such a cross-regional movement is more likely to diffuse industrial technology where it is sorely lacking, but prosperous provinces have tended to block their local governments from doing such cross-provincial deals. Cities in Anhui made it clear in 2010 in the YRD Economic Coordination Meeting (Chang San Jiao Jingji Xietiao Hui) that they would welcome splitting of tax revenues in any jointly developed parks with the cities from Jiangsu, Shanghai, and Zhejiang (ESJJBD 3.30.2010). Since then, these three coastal provinces28 have either proactively blocked proposed flying land from their local governments to those in Anhui or cajoled local governments to keep such transactions within their respective provinces (NFZM 4.25.2013). Given this poor record of cooperation, Anhui itself is placing more emphasis on intra-provincial flying land projects despite the fact that it does not have anywhere near the number of prosperous zones as the coastal provinces with which it had previously sought to cooperate.

2.2.3 In Search of Emerging Local Suppliers in China’s High-Tech Zones Taiwan’s Hsinchu Science-Based Industrial Park (HSBIP) served as one of the inspirations for China’s ETDZs and HTDZs. These zones were supposed to achieve agglomeration economies and other cluster effects with the helping hand of the state, and thereby spur technological upgrading of local firms just like HSBIP had done. Did the HTDZs and ETDZs follow in HSBIP’s footsteps by upgrading the technological capabilities of local firms in technologyintensive sectors? To answer this question, this subsection looks at whether or not domestic firms in the YRD and the PRD have been able to emerge as significant suppliers to the Taiwanese IT hardware producers. The Taiwanese IT producers are important for two reasons. First, they are the dominant IT hardware producers for many categories of goods in these regions and, second, they have actually been open to new suppliers, as 19 percent of their suppliers are new ones (Yang and Hsia 2013). The evidence reveals a striking lack of such upgrading in terms of the emergence of local suppliers. Some have hailed certain zones as particularly innovative, especially Kunshan in Jiangsu Province, so it is worth examining this county-level city in more detail. Kunshan does have a history of being institutionally, if not technologically, innovative. It was the first county in China to adopt the landleasing system in the late 1980s and early 1990s. It also set up an Export-Process 28

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Zone (EPZ) in 2000 that went beyond just serving as a tax-exempt zone to one doing away with basically all the cumbersome regulations around importing and exporting goods (Chien and Zhao 2008). Furthermore, these innovations, especially the EPZ, preceded central government directives on such policies, and only later received ex post facto endorsement by the central government (Chien 2007; Interview 112). It is undeniable that these innovations succeeded in their aim to lure industrial, particularly foreign, investment.29 There is much less evidence that these innovations have prompted any embedded upgrading. Chien and Zhao show that Taiwanese investment moved from simpler components to more complex IT goods, such as personal computers (PCs), from the 1990s into the first decade of the twenty-first century, but they fail to take into account the movement of the international technology frontier when asserting that this change is upgrading. They also did not reckon with the industry’s well-known Stan Shih’s Smile Curve.30 The Smile Curve states that the final assembly of IT hardware is a commodity business located at the bottom of the smile (i.e. the lower down on the smile the less value capture). Where you capture value is towards the dimples with marketing at one dimple and design and manufacture of certain technologyintensive components at the other (Dedrick and Kraemer 1998). Kunshan is simply stuck at the bottom of the smile despite changing its product mix. More worrisome still, and this applies to Taiwanese IT production networks across China, very few domestic firms entered the supply chain. Despite the wholesale movement of Taiwanese IT production networks to the development zones of the PRD and YRD, Yang and Hsia (2013) found that in the YRD at best only 11 percent of the total value was procured from mainland companies and that was in the very mature motherboards segment. For notebook production and LCD production, the sourcing from mainland firms constituted only 3 and 5 percent of total value, respectively. Given the differing value of these products (notebooks are still much more valuable than motherboards), the overall value-weighted average (not given in Yang and Hsia’s piece) would likely be much closer to 3 than 11 percent. Additionally, with 53 percent of value being sourced in the mainland and 19 percent of the value

29 Kunshan’s innovations did not stop at the luring investment. They also have an administrative-cum-political dimension. Chien (2013) documents Kunshan’s administrative strategies and innovation as it has successfully maneuvered around its direct jurisdictional superior, Suzhou Municipality, to acquire special budgetary and revenue rights and party rank for its party secretaries not accorded to other county-level cities and their party secretaries in Jiangsu Province. This suggests that Kunshan’s leaders have had great political acumen. As of 2001, Kunshan was able to completely squeeze out Suzhou Municipality from any tax revenue from the value-added tax (Yang and Wang 2008). 30 Stan Shih is the founder of Acer, one of Taiwan’s most successful IT firms, and his Smile Curve is widely acknowledged within the global IT industry as an accurate depiction of the industry’s value capture opportunities (Dedrick and Kraemer 1998; author interviews).

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being procured from new suppliers to the firm, the low amount captured by local firms cannot be attributed to the lack of opportunity. My own interviews in the YRD region confirm the lack of local mainland suppliers in these production networks found by Yang and Hsia.31 Yang and Hsia (2013) argue that Taiwanese networks in the PRD have even less localization than those in the YRD. This lack of localization is despite the fact that a number of Taiwanese firms producing desktop PCs and networking equipment set up manufacturing operations in the PRD in southern China prior to the large-scale investment by Taiwanese firms in the YRD. Most of the firms in the PRD set up operations in the latter half of the 1990s whereas most of the firms in the YRD set up after 2000. One could imagine that these firms should have more local suppliers given their longer time on the mainland, but my findings coincide with Yang and Hsia’s that PRD localization has been even farther behind that of the YRD.32 My interviews with the PC firms that set up in the PRD in the mid-to-late 1990s revealed that they did not use any significant local Chinese suppliers. If their local suppliers were not originally from Taiwan, they were other foreigninvested firms in the area (Interviews 157, 197, 206). These other foreigninvested suppliers seemed to be principally Hong Kong-invested firms except for one firm that had its supplier list dictated by its customers. This firm remained in the original equipment manufacturer (OEM)-mode33 where the customer supplies the designs of the products to be manufactured. Since its customers were primarily American, the vendors they designated tended to be Chinese plants of American contract manufacturers (Interview 157). The two largest network equipment makers from Taiwan claimed that they were willing to use local Chinese suppliers, but did not do so because they could not find any good ones (Interviews 80 and 81). The passage of time did not seem to induce the emergence of significant local suppliers as shown by the firm in Shijie mentioned at the beginning of the chapter. After ten and even fifteen years it still had very few local 31 Interviews 3, 4, 5, 6, 8, 9, 113, 114, 162, 163, 172, 191, 192, 193, 198, 205, 206, 207, 216, 220, 242, 243, 246, and 304. An additional interview on April 18, 2014, with industry researchers in Taiwan who follow this sector on the mainland very closely confirmed the continuation of these dynamics. 32 In the PRD, I interviewed seven of the large Taiwanese IT operations. I did not include one of the firms in Table 2.1 because I did not have an interview with the firm after 2000. I also did not interview one major PC manufacturing site and several of the large motherboard manufacturers. Neither secondary sources nor information from my industry interviews indicated that the firms I did not interview were substantially different from the firms I interviewed in terms of their PRD sourcing practices. 33 Original equipment manufacturer (OEM) mode or OEM relationship in IT industry parlance means the firm did not design the products for the branded firm, but simply did the manufacturing for the branded firms. This use of the term OEM is somewhat confusing because for many industries OEM refers to the firm with the brand. In the IT industry, such branded firms are referred to as original brand manufacturers (OBMs).

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China’s Flailing Efforts to Replicate Technology Clusters Table 2.1 Suppliers for Taiwanese IT manufacturers in the PRC Company

Start of production in PRD site

Products

Interviews (includes additional interviews with HQ and other plants)*

Significant mainland suppliers

TW1

1992/1993

Power supplies

No

TW2

1996

TW3

1996/1997

Interviews 81, 166

No

TW4

1996

Network equipment Network equipment Desktop PCs

Interviews** 113, 207; follow-up in January 2015 Interviews 80, 158

No

TW5

1997

Interviews 157, 304; follow-up in April 2014 Interviews*** 197, 242

TW6

1999

Interviews**** 153, 206

No

Motherboards; desktop PCs Desktop and notebook PCs

No

No

* The initial interview was a PRD plant interview. The additional interviews were not always plant visits, but they were interviews that provided information on the PRD manufacturing operations. ** The initial interview was a plant visit that took place as part of a cooperative project on January 25, 2000. *** The initial interview was a plant visit that took place as part of a cooperative project on January 23, 2000. **** The initial interview was a plant visit that took place as part of a cooperative project on January 26, 2000.

suppliers (Interviews 207, and January 14, 2015). The ability of such a longterm industrial resident to move at will exemplifies the utter failure to embed the supply networks of these factories in the local economy. Table 2.1 shows the various Taiwanese assemblers and their supplier situations in the PRD. Following in line with Stan Shih’s insights, one could reasonably argue that what countries aspiring to upgrade their technological capabilities should aim for is R&D rather than a manufacturing supplier base, at least for industries characterized by value chain segmentation, fast product life cycles, and the commoditization of most manufacturing activities such as IT. Sensible as this view may be, China has failed in its endeavor to create domestic R&D powerhouses as we shall see in Chapters 3 and 4. Thus, the alternative for China to upgrade from the bottom up by fostering capable suppliers along the lines of previous Taiwanese IT hardware success becomes more pressing. Unfortunately, this bottom-up route thus far has yielded as few successes as China’s attempts to take the commanding heights of R&D in high-tech have.

2.3 The State and Venture Capital The Chinese state has recognized that some countries, such as the United States, have fueled investments in cutting-edge sectors through venture capital (VC) where investors, via hopefully experienced and savvy managers of the venture fund invest in high-risk and thus potentially high-reward investments, typically over a ten-year life for the fund. Since 1984 China has made 59

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attempts to mimic these VC institutions because it views them as vehicles to success in high-technology industries. Foreign VC entered China over twenty years ago when IDG came into the country in 1992. And yet, the practices and institutions of the two types of VC firms have not converged. This division is essentially a microcosm of the larger institutional divide between hybrids and domestic firms. Foreign venture capitalists keep everything offshore except the final onshore operating company into which the funds flow whereas domestic venture capitalists have everything onshore.34 Originally, significant legal and tax-related obstacles blocked Chinese companies from pursuing the type of limited partnership structures typical of VC structures in the United States and other places where VC has flourished (Gompers and Lerner 2002). Changes in the domestic regulatory have overcome many of the legal obstacles for domestic VCs35 inherent in the 1997 Partnership Law,36 such as the lack of distinction between general and limited partners. The 2007 reforms to the Partnership Law distinguished between general and limited partners and made the latter a non-taxable identity. Furthermore, foreign natural persons and legal “persons” were allowed to invest in domestic limited partnerships. To encourage more investment in VC, the Ministry of Finance and State Administration of Taxation issued a Circular Concerning the Tax Policies for the Promotion of Venture Capital Enterprises in 2007 that allowed limited liability partners (LLPs) to deduct 70 percent of their investments from their income tax liabilities (MacKenzie 2007). Changes to the Company Law in 2005 also explicitly recognized the legality of different share classes with correspondingly different claims on control and dividends. Arguably these changes have allowed VCs the leeway to better align investment risk with economic and corporate governance rights. However, even with these changes, complex custom packaging of rights that varies across investors (a practice that is common in Silicon Valley) is still not possible in China. While the state has made improvements in the legal environment for venture funding, there are still serious impediments to the domestic growth of these firms. Unsurprisingly in an economy where the state dominates 34 To quote one recent study of the VC industry on exactly this point: “The essential differences between the two models, i.e., the foreign model and the domestic model, are clear. In the case of the foreign model, all of the activity, except for that of the ultimate operating company, takes place offshore, while in the domestic model all the activity takes place within China. In almost all cases, the vast majority of the capital invested by the VC fund in the offshore holding company is actually used to invest in the operating company—that is, the funds do flow into China” (Zhang et al. 2009: 94). 35 In this chapter, VCs refers to venture capital firms whereas VC can refer to venture capital in general or one venture capital firm. 36 The 1997 Partnership Law as the name implies established the legal guidelines for enterprises structured as partnerships.

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finance, the foremost problem is that most of the domestic venture funds are directly or indirectly from the state.37 Among other policies, the government has made use of guidance funds that invest in firms directly and via VCs.38 Since the mid-1990s, municipalities and provinces have also set up dozens of such funds, but Lerner (2009: 148) rightly criticizes the lack of any public evaluations of these funds’ effectiveness.39 At the same time, China’s state financial system suffers a double weakness from its lack of long-term institutional investors. The lack of institutional investors limits the sources of VC beyond the problematic state sources (Zhang et al. 2009). Additionally, China’s equity markets are also not attractive due to the lack of these institutional investors (Allen et al. 2008; Pettis 2013) so it is not thus far a good exit option for VC. The hand of the state weighs heavily on China’s equity markets and unintentionally obstructs the construction of a healthy market for VC exits. The state regulates which firms can do an initial public offering (IPO), as well as when they can do so; it even closed down China’s IPO market for fourteen months until the start of 2014. This interference has simply created a backlog of firms waiting to IPO on domestic markets.40 This backlog serves to deter rather than encourage VC exits on domestic equity markets. After promising in the wake of 2013’s Third Plenum to let market forces drive equity markets, regulators put in new restrictions (WSJ 5.20.2014) and intervened in the markets to cap IPO valuations in a bid to guarantee profitability for IPO investors (WSJ 7.20.2014). After all of these interventions, the state also rhetorically whipped up the 2014–15 equity bubble and then tried to stop the bursting of the bubble at great cost including closing the IPO market again for four months in July 2015. Thus, it is not very surprising that foreign VC-invested Chinese firms are still looking to list overseas. They are motivated to do so by the deep capital markets abroad, especially the United States, and the opportunity an international IPO has to enhance their global brand. Furthermore, foreign equity

37 In 2006, 37.2 percent of domestic VC funding was from official SOEs, public institutions, and government directly. Banks, security and trust companies, other enterprises, and listed companies made up another 44.7 percent of the investment and at least part of this investment was indirectly from the state. For example, most banks and security and trust companies are state-owned. Public firms are often functionally owned by the state, even if not recognized as formal SOEs. Similarly, a vague category of “others” comprised 7.5 percent. Individuals made up a mere 4.8 percent. Foreign investment was only 5.7 percent (Zhang et al. 2009: 91). 38 MOF and MOST, July 6, 2007, “Interim Measures for the Administration of Guidance Funds for Promoting VC Investments in Small and Medium-sized Technology Enterprises [科技型中小企 业创业投资引导基金管理暂行办法》的通知].” 39 Presumably one of the motivations of these funds was a useful way to drive up investment in these jurisdictions. State banks were more than likely amenable to loaning money to such statesanctioned funds. Thus, the local authorities were not overly concerned about the funds’ efficacy in terms of promoting entrepreneurship, and as we shall see later, often steered the funds to other uses. 40 There are still 675 firms on China’s IPO waiting list (WSJ 12.7.2015).

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markets’ crisis of trust in Chinese companies has passed as the bad ones have been weeded out and 2014 was a record-breaking year in terms of the amount of money raised by Chinese listings in the United States. Scholars have documented the problems that state agents face in managing VCs in China and around the world (Wright 2007; Lerner 2009).41 State VCs often fail to add value and in China’s case have often subsidized assetdestroying activities rather than offering solutions to market failures (Wright 2007). In China, many nominally non-state VC organizations are effectively state-owned and run organizations. They suffer from the same maladies because institutionally they face the same constraints that state VCs do. To acquire an understanding of VC investment in the technology sector in China, I conducted interviews with twenty-four foreign and domestic VC firms active in China. There were interviews with nine domestic, nine ethnic Chinese foreign (ECF)42 and six foreign VC firms. Here the terms ECF and foreign are used because the ECF venture capital firms do not necessarily match the criteria of hybrids and the foreign venture capital firms are all multinational venture capital firms that do not have an ethnic Chinese background. However, the ECF venture firms do share features with the hybrids in that they have ideational and interest-driven motivations to invest relatively more in China than the typical foreign venture capital firm. Ultimately, ECF and foreign venture firms both support more technologically intensive startups in China than the domestic VCs, but the ECF VCs outperform the foreign ones. In other words, the foreign institutions outperform the domestic ones in providing financing for technological entrepreneurship, but ethnic ties also matter. There is a dramatic difference in the number of investments in technologyintensive start-ups across the three types of VCs. Technology-intensive start-ups are those start-ups that aim to create products (both tangible and intangible) that embody a significant amount of technological knowledge and skills. These firms depend on their technical skills even if not cutting-edge to differentiate their products in order to ensure firm survival and success. Cutting-edge technical skills are not necessarily needed for firms to survive and thrive in developing countries. Nevertheless, the core engineering teams embodying these firms’ technical skills are key to these firms’ ability to survive, compete, and generate value. In contrast with the technology-intensive firms were start-ups competing on business models or differentiated approaches to services. The strength of

The next five paragraphs draw on Fuller (2010a). Here the term ethnic Chinese economy (ECE) is not used because some of these ethnic Chinese foreign VCs are based outside of the ECEs. To give an example, Walden is very much an ethnic Chinese-managed firm although based in San Francisco (Saxenian 2006). 41 42

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their technical teams was not the basis upon which these firms competed. Instead, they were employing other strategies for survival. For example, some commercially oriented start-ups sought to be first to market with a certain business model or service new to China. Unfortunately, other start-ups attempted to survive by making the most of their connections to gain access to state procurement channels. Two criteria differentiate technology-intensive firms from technology-light ones. If these firms created new tangible products in-house and production (as opposed to sales or other ancillary functions) required the employment of university-educated engineers as the majority of employment43 (measured either in terms of total wages or total employment headcount), then they were technology-intensive. The focus of Chapter 6, fabless integrated circuit (IC) design houses, is an example of this type of firm. If firms were creating new intangible products (including design services for the technologyintensive firms creating tangible products as just defined) while having the same predominance of university-educated engineers, then they were technology-intensive. For example, software service firms are this type of firm.44 Technology-light firms were those that met neither of these criteria because they did not create any technology-based products and services, or did not meet the engineering employment requirement in the production of these products.45 The domestic VCs made the fewest investments in technology-intensive firms (16) while they had many investments overall (130). In fact, the domestic VC investments could have been as high as 230 for the VCs covered because an interview subject stated that one large municipal fund via six state-run VCs had made 100 additional investments, many of which were not even commercial investments. The ECF VCs made the most technologyintensive investments at 48 and had the highest proportion since their total investments were 78. The foreign VCs were in the middle with 44 technologyintensive investments out of 166. 43 The employment criterion required the use of these engineers for production broadly defined and not simply for manufacturing. For example, fabless design firms produce chip designs in-house but outsource manufacturing of the tangible chip. 44 Some question whether software service firms are technology-intensive, but technical skills are the critical component for these firms’ competitiveness as studies of offshoring have demonstrated (Dossani and Kenney 2007). 45 I did not interview every firm invested by one of the interviewed VCs in order to determine if they fit these criteria. Instead, I determined whether or not an investment was technologyintensive by checking whether the investment target corresponded to the profile of firms likely to meet the technology-intensive criterion. For example, a call center would not correspond to the profile of a technology-intensive firm because it would not require sufficient engineering to service calls. In contrast, a software firm would be deemed a technology-intensive firm because the firm would likely employ a sufficient proportion of engineers to produce its software products or services relative to total staff. These profile assessments are based on my empirical observations of Chinese technology firms based on the wider set interviews conducted for this book.

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The Chinese government has continued to address the issue of VC through the outpouring of largesse. Following up on the announcement of the Medium-Long-Term Plan in 2006, the Ministry of Finance (MOF) and Ministry of Science and Technology (MOST) announced in 2007 the creation of a Venture Guiding Fund to spur VC investments in high-tech SMEs.46 As of 2008, the fund had invested in six venture investment funds and contributed 8.2 percent of all venture investment in 2008. This move also spurred regional and local governments to continue their own guidance funds. According to a 2009 MOST report (Wang et al. 2009), there were already thirty such funds set up by local governments by 2008 accounting for 10 billion RMB in total funds.47 And yet, many problems remained. Despite the rather broad definition of high-tech, traditional industry still accounted for almost half of the investment by China’s VC industry. In 2012, the fund spent over two billion RMB to encourage VC, but the trend continued with traditional industry now overtaking high-technology sectors as the majority target for investment. Moreover, there has been a decline in seed and early stage investing as a percentage of total projects from roughly half of all projects during the 2006–9 to 40 percent or less in recent years. In the United States, seed and early stage investing projects typically constitute more than half of total projects (Wang et al. 2013). Thus, at best, much of this funding is taking on the characteristics of private equity investment rather than VC investment geared to supporting technological entrepreneurship. Most of these funds have not invested wisely. Lerner (2009) notes that most of the VCs backed by Chinese state funds have not been successful and simply overheat the venture market. This emphasis on supporting domestic firms, while understandable, has not led to impressive results for domestic firms. It did not lead to upgrading of suppliers in development zones. The next two chapters will show that domestic firms generally have not produced significant innovation.

MOF and MOST, July 6, 2007, “Interim Measures.” It was probably in response to the all-too-typical overenthusiasm of the local governments that the National Development and Reform Commission (NDRC), Ministry of Commerce (MOC), and MOF released their guidance on setting up such funds in 2008. 46 47

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3 Paper Tigers The Weakness of China’s National Champions

In 2004, twenty years after the founding of a number of what became prominent companies, including Lenovo (formerly called Legend),1 Stone, and Haier, an opinion piece in Jingji Guancha (The Economic Observer), an influential economics newspaper in China, observed that none of these companies were joyously celebrating their twentieth birthdays despite the fact that everyone loves birthday celebrations (JJGC 7.12.2004).2 The op-ed piece went on to explain that these firms had nothing to celebrate because they, and China’s large firms in general, had failed to become firms of international influence and stature. The marker of this extraordinarily disappointing performance was the inability of these firms to make the transition from gong (manufacturing) to ji (technology). The author blamed the myth of “Made in China” for this tragedy. Firms and analysts alike had assumed that manufacturing scale economies would somehow induce the creation of core technologies. Instead of investing in technology, firms concentrated on short-term profits and telling baseless “technology tales” (jishu gushi) about their products, stories that were particularly useful in securing government loans and procurement but that did little to develop the core technology capabilities of Chinese firms. A number of Chinese technology firms rhetorically embrace mao gong ji (trade to manufacturing to technology) as an upgrading route that involves shifting from manufacturing to technology. Mao gong ji has been attributed to 1 For the rest of the chapter, the computer company formerly called Legend will be referred to by its current name Lenovo, but the holding company owning a controlling share of Legend/Lenovo, Legend Holdings, will be referred to as Legend Holdings as that remains its English name. In Chinese, Legend/Lenovo is Lianxiang Jituan and Legend Holdings is Lianxiang Konggu so there is no differentiation between the names Legend and Lenovo in Chinese as both use the word Lianxiang. 2 The fact that they were founded in 1984 was most likely no accident because it was in October of that year that the Third Plenum of the Twelfth Party Congress signaled continued commitment to economic reform through its Decision on the Reform of the Economic Structure.

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Liu Chuanzhi, one of the founders of Lenovo, but others have applied it to describe a range of Chinese large technology companies. Unfortunately, this strategy appears to have failed to produce significant technological capabilities among domestic firms. This chapter will examine large Chinese IT industry firms backed and even created by the state in its bid to create a Chinese equivalent of the very large firms in Japan and Korea. It argues that, with the exception of Huawei, these firms have proven to be technological paper tigers. Just as these firms’ technological capacities suffocate in the warm embrace of the Chinese state financial system (see Chapter 1), so too have these firms been unintentionally undermined by tremendous but nearly unconditional support through China’s state procurement system and other subsidies. In this chapter, I will focus on telecommunications equipment and computer-related products because these have been the two largest IT product segments in China (see Table 3.1). The firms in these areas are increasingly involved in the IT services segment so examining the hardware firms provides some insight into the IT services sector as well. Although traditional consumer electronics, such as televisions and other audio-visual equipment, is also quite large, this segment is generally of low technological intensity according to both my own findings and organizations that rank technological intensity of industry segments (OECD 2004). The sophisticated integrated circuits that go into these traditional consumer products are covered in Chapters 5 and 6. Given the large size of the telecommunications and computer segments, the next two sections will focus on large Chinese firms active or originating in the computer and telecommunications segments; the discussion also draws some comparisons to hybrids active in these areas. These sections will show two patterns. Formally state-owned firms with explicit state support from the Table 3.1 Production shares of IT end products in China, 2002 and 2012* Product categories

2002 Share of total production in China (%) 2012 Share of total production in China (%)

Telecommunications Computers Traditional equipment consumer electronics

Software IT Other** services

27.9

30.7

25.8

4.8

3.2

7.6

23.4

37.7

32.3

N/A

N/A

6.6

Source: Ministry of Information Industry 2002 document provided to the author and 2013 Zhongguo Keji Tongji Nianjian. * The 2012 figures somewhat overstate the sectors’ shares because IT services and software are not included in the 2013 Zhongguo Keji Tongji Nianjian [2013 China Statistical Yearbook on Science and Technology]. ** For 2002, this category for includes a wide range of products including radar, chemicals used in electronics and electrical machinery. This category is larger than it should be because the data did not allow for the separation of end products from components.

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beginning, such as Datang, have basically failed to make a significant technological contribution. More interestingly, with the exception of Huawei, those firms that moved from the periphery to the center of state favor, often dubbed minying qiye (privately-managed firms), such as Lenovo, witnessed the atrophy of their technological capabilities as a consequence of the state’s embrace. These two findings suggest there has been some limited competition among firms but that the competition is sufficiently restricted that original insiders never disappear entirely, despite all their deficiencies. In contrast to the vibrant and fierce high-tech markets abroad where large firms emerge and disappear with great frequency,3 firms that are completely unsuccessful in the marketplace such as Great Wall and Datang continue to survive on government procurement and grants.

3.1 Computer Firms Since the entry of China into the World Trade Organization (WTO) in late 2001, the major Chinese PC firms of the time, with the exception of Lenovo, have seen their share of China’s PC (desktop and notebook) market shrink (see Table 3.2). Formally state-owned champion, Great Wall, has done very poorly and the university-founded enterprises (xiaoban qiye), such as Founder, Tongfang, and Ziguang have shrunk. Even after WTO entry, foreign firms were not allowed to open their own retail networks until 2005 and yet only Lenovo used that non-tariff barrier to build up a significant competitive advantage over the foreign firms.4 Lenovo is the main topic of this section on computers because it has been by far the most successful of the Chinese computer firms in terms of sales. However, even Lenovo has been a technological laggard, relying on acquisitions rather than fostering internal technical capabilities to compete.

3.1.1 Lenovo’s Technological Prowess: More Myth than Legend Lenovo has been at the forefront of China’s development of technology companies over the last two decades. While some continue to invoke Lenovo

3 Witness the demise of such large successful IT firms as Digital Equipment, Compaq, Lucent, Nortel, and Sun Microsystems as independent entities, the abandonment of once major business units by the likes of Nokia, Ericsson, and Siemens and even the disposal of the semiconductor arms of most conglomerates in Japan. 4 China’s WTO accession agreement scheduled the opening of computer retail distribution for December 2004, but according to the US–China Business Council, China only opened up retail distribution to foreign firms in 2005.

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Paper Tigers, Hidden Dragons Table 3.2 PC market share (by units sold) in China Firm

2002 (%)

Firm

2005 (%)

Firm

2006 (%)

Firm

Lenovo Founder Tongfang Dell HP Great Wall Hedy (Qixi) Others

28.3 10.5 6.5 6.2 3 2.9 2 40.6

Lenovo Tongfang HP Dell Founder Hedy (Qixi) Great Wall Others

33.3 15.6 15.2 12.1 8.2 4.3 2.4 8.9

Lenovo Dell Tongfang HP Hedy (Qixi) Founder Great Wall Others

33.3 13.6 11.8 7.6 7.5 6.9 2.4 16.9

Lenovo Acer Dell Asus HP Others

2011* (%) 35.5 9.5 9.4 5.7 5.3 34.6

Firm

2013 (%)

Lenovo Dell HP Asus Acer Tongfang Haier Apple Samsung Sony Others

34.7 9.0 6.3 6.2 6.2 3.9 3.4 1.7 1.7 1.1 25.8

Source: CCID for 2002, 2005, and 2006 data, the Brand Channel for 2011, and Barclays for 2013. Note: Foreign firms (including ECE firms) in bold. * 2011 figures are 2011 Q4 figures.

as a major contributor to China’s technological development,5 an examination of Lenovo’s record of technology development reveals a different story. Like Founder (discussed later), Lenovo’s initial burst of innovation soon after its founding quickly dissipated in the wake of Lenovo establishing close connections to the Chinese state. Unlike Founder, Lenovo has undoubtedly been able to expand its revenues, principally through foreign acquisitions and defense of its home market—abetted by state procurement and regulation— but it has neither maintained its early innovative edge nor maintained the technological advantages it acquired from others. Despite many people calling Lenovo a private or privately managed (minying) firm, the firm’s own executives acknowledge the large state stake in the firm. Until 2009, the Chinese Academy of Sciences (CAS), a government research organization, owned 65 percent of Legend Holdings, which in turn held 57 percent of Lenovo as late as 2003 (Bradsher 2003).6 Today Legend Holdings’ shares have been reduced to 32.5 percent; executives own an additional 7.3 percent of Lenovo and the rest of the shares are publicly traded in Hong Kong (WSJ 1.30.2014). Legend Holdings itself received outside investment from private China Oceanwide in 2009. Oceanwide bought 29 percent

5 And attribute Lenovo’s success partially to it being a private firm (Huang 2003, 2008), quasiprivate firm (So 2001; Segal 2003; Zeng and Williamson 2008; Breznitz and Murphree 2011), or a product of successful enterprise reform (Gu 1999). 6 In any case, Legend Holdings and Legend Jituan/Lenovo were basically the same firm using the same personnel until 2001 when Legend Group Holdings was hollowed out and left with only a few old timers (Interview 33). In recent years, Legend Holdings has become quite a diverse holding company with fifteen different affiliates (JJGC 9.29.2014) although all the others pale in size compared to Lenovo. Five of these subsidiaries are in the highly regulated and state-dominated area of finance and insurance, which is another sign of Legend Holdings’ close ties to the state.

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of Legend Holdings so the shares of CAS were correspondingly reduced to 36 percent. The Employee Shareholding Society of Legend Holdings owns the remaining 35 percent.7 There are four reasons to see these ownership changes as being less of a profound transformation for Lenovo’s relationship to the state than one might think. First, CAS still controls Legend Holdings, most likely in combination with the holding company’s Employee Shareholding Society. In China, those in charge of a state firm, rather than some autonomous organization that actually represents the employees, typically control such employee shareholding funds (Teng 2010). Second, China Oceanwide is very close to the Chinese state (Scissors 2014). Third, Legend Holdings is by far Lenovo’s largest shareholder. Most importantly, Lenovo is unquestionably still one of the state-favored firms and has been since 1992. Lenovo did start on the mao gong ji (trade to manufacturing to technology) trajectory as a firm trading in computer parts in Beijing.8 However, soon after its start, Lenovo skipped over manufacturing and went straight to technology. Lenovo was the first firm to develop and successfully promote a Chineselanguage add-on card for PCs in 1985.9 Liu Chuanzhi and ten other former employees of ICT started the firm and they then persuaded Ni Guangnan, the inventor of ICT’s Chinese word-processing technology, to join them. His Chinese language word-processing add-on card quickly dominated the Chinese market given that foreign products were often of poor quality and used traditional characters.10 However, soon after Lenovo’s triumph of ji (technology), the firm reverted to a path of mao (commerce) that would prove a slippery slope into technological senescence. Commerce does not necessarily lead to this result, but in the context of Lenovo’s evolving relationship with the Chinese state, this proved to be the path to perdition. As foreign firms were not allowed to distribute their computer products until 2005, AST, one of the largest computer firms of the 1980s, hired Lenovo as AST’s sole distributor in China in 1987. This relationship drove Lenovo’s expansion of its national distribution network in the late 1980s. This network became a key to Lenovo’s future growth. Due to the prevailing hostile attitude towards firms outside the formal state sector and the jealous guarding of its bureaucratic interests, the Ministry of 7 This information is from Legend Holdings’ website at and was downloaded on September 11, 2014. 8 Much of this history of Lenovo/Legend’s early days is based on the account of the firm in Qiwen Lu (2000: 63–103) and Ling (2005: 19–210). 9 To be exact, CAS created this technology before transferring it to Lenovo so this spurt of innovation cannot be directly attributed to Lenovo. 10 The People’s Republic of China uses a simplified Chinese character system instituted after the 1949 revolution. Hong Kong, Macau, and Taiwan use the traditional or complex Chinese character system.

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Electronics Industry (MEI—the forerunner of the Ministry of Information Industry) did not grant licenses for PC manufacturing to firms outside of the state enterprise system. With its large distribution network for computers and computer peripherals, Lenovo desired to start manufacturing its own PCs. Given the MEI restrictions, Lenovo decided to invest in Hong Kong and even for this it needed state permission. Lenovo found a Hong Kong partner, Daw, and a Chinese state partner, China Technology, to create Hong Kong Legend Technology Incorporated. China Technology was a critical partner as this firm was able to acquire loans through the state banking system. Quickly after forming Hong Kong Legend, the new firm acquired a small local motherboard (the electronic board, which holds chips, and is the core of the computer) firm, QDI. QDI had rather limited technology resources. In fact, the firm had just two engineers, and they left the firm soon after its acquisition by Lenovo. In the early days of Lenovo’s motherboard business, much of the development of motherboards rested upon the shoulders of Ni Guangnan. By 1990, the group managed to create two R&D teams under Ni. The Beijing team did localization work—creating Chinese language software for computers—and tested the motherboards. The Hong Kong team did the hardware design for the motherboards. Lenovo decided to enter the PC market with its own brand of PCs. With its manufacturing outside of China, it no longer needed MEI’s approval. The firm, however, began to set up production in Shenzhen as a nominal JV with a foreign firm, QDI, and two domestic ones, Beijing Legend, and Shenzhen Science and Technology Industrial Park Corporation.11 Legend’s motherboard business expanded rapidly. The firm became the fifth largest motherboard supplier in the world supplying five million motherboards. Seventy percent of the business was overseas. At the same time, the firm began to sell PCs successfully in China, surpassing MEI’s Great Wall Company as the largest Chinese PC firm and trailing only IBM and AST in the market in 1993. Although MEI had originally tried to protect its own firm, Great Wall, through licensing requirements, MEI relented in its discrimination against this non-SOE12 that had created innovative software and had ownership links to influential CAS. In 1992, MEI designated Lenovo one of the national computer production bases and the firm was included in the still powerful national production plan (Lu 2000). This act heralded the beginning of Lenovo’s entrance into the fold as a state-favored firm. Lenovo was able thus to endure another three to four years of losses on top of the losses suffered in 1991 and 1992 (Lim 2002). Without state support, such perseverance would have 11 12

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QDI and Beijing Legend each had 45 percent and Shenzhen had 10 percent. Although majority owned by a state entity (CAS), Lenovo was not a formally designated SOE.

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The Weakness of China’s National Champions Table 3.3 Identifiable state procurement as share of Lenovo’s sales Year

1994

1995

1996

1997

1998

1999

2000

2002

2003

State procurement as share of sales (%)

13.9

21.7

31.3

28.3

27.8

25.9

25

27.4

28.2

Source: “Legend Holdings: Thinking Different,” Nomura Securities, October 3, 2001; and Zhang and Wan (2003). Note: For the pre-2002 statistics, it is not clear if the source counted education as part of the sales of the state. However, the education sales were much lower at that time as the state had not started the major procurement drive for universities that began in 2000.

been unlikely. The consequences for Lenovo’s innovation, however, were disastrous. Over the next several years, Lenovo’s share of the Chinese computer market increased. Lenovo moved its production site to Huiyang, an underdeveloped area near Shenzhen, and concentrated production there. At the same time, Lenovo became more embedded in the state’s patronage network winning a bid for a large national information technology tender in 1996. The state’s direct procurement jumped from an already significant 21 percent to a substantial 31 percent of Lenovo’s sales (see Table 3.3). This may have been the push that persuaded Yang Yuanqing, the manager in charge of the PC business and Lenovo’s future CEO, to give the business one last try. Indeed, even after losing money for the previous five years, the firm still slashed prices (Lim 2002). In 1997, it surpassed the major foreign providers to become the largest PC vendor in China. Inside Lenovo, all was not well however. The chief of technology, Ni Guangnan, wished to pursue continued investment in technology so the firm could retain its market for Chinese software for PCs and expand into new areas, such as semiconductors. His emphasis on technology came into conflict with CEO Liu Chuanzhi’s vision of Lenovo as a firm that would make a gradual transition to technology. These strategic differences came to a head in 1995 and Ni Guangnan, the engineer responsible for basically all of Lenovo’s technical achievements, was ousted from the company (Jiang et al. 1999). Entering the state’s favor undermined the incentives to innovate because Liu realized that the firm could continue to enjoy state support even while forgoing the costs of technological development. Even as Lenovo gained market share, the firm lost ground technologically. Foreign software vendors, such as Microsoft, created good Chinese language programs for PCs that completely displaced Lenovo from that market. More disturbingly, Lenovo gradually lost ground in its technical–manufacturing nexus, motherboards. QDI was not even a global top-ten motherboard firm by 2000. By 2001, Lenovo had to look outside the firm for the latest motherboard technology because it had lost its capacity to design quality motherboards. The firm was also already purchasing heavily from QDI’s main Taiwanese competitors by that time (Interview 59). 71

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For motherboard technology, Lenovo set up a JV with one of Taiwan’s largest motherboard firms, Gigabyte, in 2001, with the ostensible purpose to jointly develop motherboard technologies. I visited the Lenovo facility in Shenzhen where the two firms were supposedly cooperating on R&D. What I saw was a team composed entirely of Taiwanese technical staff from Gigabyte’s factory in nearby Dongguan assisting in the transfer of their designs to Lenovo. A discussion with one of the senior Taiwanese managers from Gigabyte at Lenovo confirmed that Lenovo was not taking any active part in development of new motherboards. Soon after, Gigabyte, realizing that Lenovo’s scheme for the JV was to receive Gigabyte’s technology without providing adequate compensation, cancelled the JV (Yi 2003). Analysts correctly predicted that Lenovo would exit the motherboard business due to its loss of competency in this area (Zhang and Wan 2003) and Legend subsequently sold half of QDI to another mainland firm, Ramaxel, in 2003. Behind this gradual withering of Lenovo’s technical capabilities was generous state support. In the late 1990s, the state, through both government and educational institutions, purchased up to half the computers in China. Even in 2002–3, Lenovo was selling over one quarter of its products to state agencies and state educational institutions and the firm was projected to continue to do so for the foreseeable future (Zhang and Wan 2003). State procurement was essentially subsidizing Lenovo’s losses in the commercial sector. For the five years ending in March of 2002, it is estimated that Lenovo’s earnings before interest and taxes (EBIT) was a “razor-thin 0.6 percent” (CFO Asia, February 2004).13 Additionally, some of Lenovo’s corporate sales were sales to statefavored firms, which were strongly encouraged by the government to buy from Lenovo and other state-favored firms (Interview 51). As one executive in one of the big domestic computer companies said, the quasi-private (minjian was the term the interlocutor used) firms, such as Lenovo and Founder, and the state had reached a moqi (implicit understanding) that would keep foreigners out of direct and indirect government procurement on security grounds in the context of the government’s xinxihua (“informatization”) drive. Given this understanding between the state and its computer champions, the executive said he viewed the gradual opening up of China to MNCs under the WTO without worry because the state would still be there to help its favorite firms (Interview 209). Prior to its acquisition of IBM, Lenovo was unsuccessful in developing and acquiring technology beyond its original desktop PC products. Lenovo like other domestic Chinese firms had been dependent on Taiwanese original design manufacturers (ODMs, i.e. contract manufacturers that design as well 13 Of course, as a state favorite Lenovo most likely enjoyed real negative interest rates to help cushion its bottom line.

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manufacture) for its notebooks. Of the large Chinese computer firms, Lenovo tried the hardest to acquire notebook technology, but its efforts failed. First, Lenovo tried to set up a JV with Toshiba in Shanghai with the idea of learning from its JV partner. Once Toshiba realized how little Lenovo actually knew about notebook manufacturing and how much it wanted to learn from Toshiba without adequate compensation, Toshiba grew leery of the JV project. Lenovo was stuck with an empty notebook production line it had no idea how to run. Eventually, Lenovo sold this factory to a Taiwanese firm (Interviews 188, 234). After the fiasco with Toshiba, Lenovo tried to learn notebook manufacturing from one of its major suppliers of notebooks, Taiwan’s FIC. As FIC was a larger player in desktop rather than notebook manufacturing, the quid pro quo for winning the Lenovo order was to let some Lenovo engineers come to Taiwan to learn some of the technology. The arrival of the engineers from mainland China, the place to which all of Taiwan’s manufacturing seemed to be moving, understandably caught the attention of Taiwan’s press and raised the level of economic anxiety felt in Taiwan. Nevertheless, sources close to FIC laughed at the attempts of Lenovo to learn their technology. Their perspective from having interacted with the Lenovo engineers extensively was that the Lenovo engineers did not understand how complex thermal conductivity problems are in notebook computers (i.e. if notebooks are not designed well, they easily heat up and burn out) and FIC did not do anything to help them learn these skills. In FIC’s judgment, it would be a very long time before Lenovo would be capable of designing a notebook computer on its own. Other industry insiders agreed with the assessment of FIC insiders (Interviews 99, 234). A similar scenario played out with D-link, one of Taiwan’s largest telecommunication equipment ODMs. Lenovo constructed a JV between D-link and Lenovo’s subsidiary, Digital China (Shenzhou Shuma), to sell small office and home office (SOHO) telecommunication equipment in the Chinese market. However, Digital China brought nothing to do the deal except its sales network and clearly wanted to acquire D-link’s technology for use outside of the JV so D-Link terminated the deal (Interviews 132, 158).

LENOVO AND IBM

IBM had been trying to rid itself of its loss-making PC division for several years before it sold its unit to Lenovo in December 2004. After a 2003 trip by IBM’s CEO, Samuel Palmisano, to Beijing to meet an unidentified high-level government official involved in economic policymaking so as to receive the state’s permission to engage in talks with Lenovo (Lohr 2004), IBM approached Lenovo with a sales proposal. Lenovo decided to buy IBM’s PC 73

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division for cash and stock. This purchase catapulted Lenovo into third place behind Dell and HP in global PC market share. Lenovo succeeded in building upon its IBM acquisition to become the largest computer firm by unit sales if not by revenue. This victory, however, has turned out to be a pyrrhic one. From 2005 until today, PC (in this section meaning specifically personal computers using the Windows-Intel or Wintel standard as opposed to those using Apple’s or other alternative operating systems) prices have collapsed whereas Apple’s computers have suffered a relatively mild decline in their average selling price. Lenovo’s prices have suffered worse than other PC makers’ even though Lenovo enjoyed a major lift in its selling price right after the purchase of IBM. Prior to the purchase, Lenovo’s computers were selling at approximately half the price of IBM’s and the merger combined Lenovo’s rather small market share with IBM’s, which was four times the size of Lenovo’s. This not only drove Lenovo’s worldwide market share from 2.6 percent in the third quarter of 2004 to 7.7 percent in the third quarter of 2005,14 but also boosted its average selling price to above all of its main international competitors’, with the possible exception of Dell.15 Unfortunately, in an industry where all the major firms except Apple saw their prices drop by at least 20 percent in nominal terms (so in real inflationand-quality of product-adjusted terms the collapse was even worse), Lenovo fell even further. Dell’s average selling prices remained higher and HP’s surpassed Lenovo. By the third quarter of 2013, even lowly Asus, a Taiwanese contract manufacturer turned computer brand which had made its biggest branded splash with netbooks (cheap, small, no-frills notebook computers), had almost caught up with Lenovo. Apple’s computer prices were double those of Lenovo in 2013. Profitwise Lenovo’s PCs have had a bumpy ride since 2005. Like Dell and Acer, Lenovo has lost money on each unit sold at certain points in time, although Acer was consistently profitable until 2011. Here Lenovo’s emerging scale advantage over other PC firms due to its growing unit sales does not appear to have been much of an advantage possibly because Lenovo relies heavily on outside ODMs in PCs now, especially notebooks (Barclays June 11, 2014).16 In contrast, HP and Asus have been consistently more profitable per

14 This sales increase actually marked a slight setback for Lenovo because the combined worldwide market share of Lenovo and IBM in the third quarter of 2004 would have been 8 percent. 15 The data for Dell’s average selling prices from 2005 to 2013 in The Guardian (January 9, 2014) did not start until the first quarter of 2007, whereas for the others it started in the fourth quarter of 2005 (with the exception of Asus which was not a large active branded player in this market at that time). 16 With the acquisition of IBM, Lenovo did finally acquire the technology to build notebooks and did so for several years. However, it did not do so very efficiently and decided to outsource most notebook production again in 2008 (Yuanta Research October 2, 2009).

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PC, since 2007 and 2010, respectively. Indeed, after 2006 Lenovo never had even one quarter with more profits per PC than HP, and in revenue terms, HP’s PC sales are still larger.17 Of course, all the PC markers pale in comparison to Apple’s very profitable computers, which still earn ten times the average of the PC makers’ per computer profits (The Guardian, January 9, 2014). Lenovo has essentially traded prices and profitability for market share in an increasingly commoditized PC market. Lenovo’s purchase of IBM should have secured it the capabilities to produce notebook computers efficiently and effectively because that was an area where IBM had retained in-house expertise. Unfortunately for Lenovo, the firm proved inept at maintaining these capabilities. Retention at the Japanese R&D center it acquired from IBM’s PC division was a problem. In 2011— seven years after the IBM agreement was signed—these problems actually pushed Lenovo to create a JV called Lianbao with one of its Taiwanese ODM manufacturers, Compal, in the hope of improving its own manufacturing capabilities.18 The acquisitions did not stop with IBM. Lenovo also acquired a majority stake in NEC’s Japanese business in 2011 and Brazil’s CCE, in 2012, but these additions have not changed Lenovo’s high sales volume, low prices conundrum. A major reason for Lenovo’s dilemma is that the firm still depends very heavily on the Chinese market. Lenovo’s reliance on China has been part strategy and part the inducements of state intervention. Earlier state protection forbidding foreign firms from setting up their own distribution channels gave Lenovo an advantage with its large retailer network. State procurement has been a large and significant share of the Chinese market over time and the Chinese market has been the largest PC market (in unit sales) since 2010, a size that has helped push Lenovo’s unit sales given its entrenched position in the Chinese market. At the same time, China’s market still tends to be a low price one as befits a still developing country. Whereas in the immediate aftermath of the purchase of IBM, almost three quarters of Lenovo’s sales were abroad, today 50 percent of sales are from China.19 Seventy percent of Lenovo’s profits also come from China as the firm has had to compete by cutting prices more severely abroad where it lacks state subsidies and the strong retailing network it has at home (Hui et al. 2014). The firm has become more China-centric rather than less since the IBM acquisition. 17 For the twelve months up to July 31, 2014, HP had USD 33 billion in revenues from PCs whereas Lenovo’s total revenues for all activities was 38 billion for 2013 of which approximately 80 percent was from PC sales (WSJ 6.19.2013; WSJ October 6, 2014). 18 Interview with three IT industry analysts on April 18, 2014. See also WSJ (9.28.2011). 19 Research firm International Data Corporation’s figures from Steven Millward, “Bow Down Before Your New Chinese Overlords: Lenovo Passes HP as World’s Top PC Maker,” Tech In Asia, July 11, 2013. Downloaded from on November 7, 2013.

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Paper Tigers, Hidden Dragons Table 3.4 Subsidies for appliances to the countryside program recipients, 2009 Company Lenovo Haier Founder Tongfang HP TCL Great Wall Southeast Computer Acer Mialata Bluestar Hasee (Shenzhou)

Percentage of rural subsidies 43.97 27.75 15.04 10.97 0.69 0.61 0.38 0.32 0.19 0.03 0.02 0.01

Source: Yuanta Research 2009. Note: MNCs (including MNCs from the ECEs) in bold.

What Lenovo really did effectively is protect and expand its Chinese market. Prior to the opening of retail to MNCs, Lenovo expanded its already established retail network to over 3,000 stores by 2009 (Yuanta Research October 2, 2009). It had additional plans to expand to 700 county-level stores and 7,800 township-level retail stores as well as “convenience window” coverage in 32,000 administrative-level villages as part of the state’s Appliance to the Countryside Program that subsidized computer purchases in rural areas from 2009 to 2012. Lenovo, as shown in Table 3.4, was the largest beneficiary of this state subsidy program. Lenovo was also one of fifteen participants in the “Old for New” subsidies program from 2009 to 2011 that involved swapping old home electronics for new, energy-efficient ones for which the government spent 30 billion RMB on subsidies.20 The outsized role of the Chinese market in Lenovo’s profits derives from a combination of state support boosting its bottom line and Lenovo’s deep retail reach in China that lowers its distribution cost for low-end PCs (Yuanta Research October 2, 2009). Lenovo’s deep distribution network and strong links to the state have provided it great advantages in fending off competitors in order to retain its dominant position in the Chinese market. However, Lenovo’s leading position is as much a curse as a blessing. The state has continued to come up with new ways to bolster state procurement for favored champions like Lenovo,21

20 There was no list of the specific subsidies received per firm available. The only foreign firm to receive subsidies was Sony. 21 For example, the new push for government procurement to use only Chinese operating systems effectively keeps out MNCs like HP that have already signed binding agreements to use Windows 8 in all their new PCs (JJGC 10.27.2014).

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but this support inadvertently hampers any moves by the company towards technological upgrading or new methods of doing business. HP has been more profitable at selling computers than Lenovo for all but one quarter since Lenovo emerged as a global player with its buyout of IBM. And yet HP’s Meg Whitman decided to split up the company by spinning off the PC and printer business units into HP Inc. and concentrating higher growth, higher margin enterprise-focused servers and software in the renamed HP Enterprise. Similarly, Dell has been taken private in order to give it time to turn itself more completely into a firm selling services rather than PCs.22 Dell is focusing on software, data centers (i.e. the cloud), and security solutions to provide complete end-to-end enterprise solutions (including PC hardware) to customers (Fortune 5.22.2014). HP Enterprise’s strategy looks similar to Dell’s except they have eliminated the PC business completely as they believe hardware is not necessary to sell their enterprise solutions. Lenovo seems stuck in the mode of selling commoditized PCs in the post-PC era whereas its main competitors have moved into the cloud and on to hopefully greener pastures. In 2014, Lenovo once again reverted to its strategy of driving growth through foreign acquisitions. While it is too early to say if these mergers will succeed, they reflect a familiar pattern with Lenovo buying into relative mature “high-tech” product segments. Lenovo cut a deal with IBM again, this time acquiring IBM’s money-losing x86-server business.23 According to Macquarie Equities Research (3.7.2014), IBM will still have a larger server business than Lenovo’s after the sale (20 percent of worldwide market share versus 12 percent), even though Lenovo has increased its global market share twelve-fold through this purchase. Of course, the state is lurking behind this deal as well—in 2014, the Chinese state made a concerted push to drive out foreign producers in state-linked markets, such as banking (XSJ 6.16.2014). Thus, the timing has been near perfect as far as Lenovo is concerned, even though the low-end x86-server market appears to be heading along the same path of declining profitability as PCs.24 Instead of following the mao gong ji strategy it claims to have followed, Lenovo has gone from technological innovation to relative stagnation despite its large sales numbers. Rather than a triumph of absorbing foreign technology capabilities, Lenovo’s IBM acquisition proved it capable of absorbing the PC 22 Dell was already more diversified away from PCs than Lenovo since over 40 percent of Dell’s employees were already working on the services side in 2011. Maijia Palmer’s 2011 wrap-up of Michael Dell interview at , viewed October 14, 2014. 23 x86 here refers to the x86 Intel processors that run this type of relatively commoditized servers. IBM will retain its more technologically sophisticated, higher margin server business. 24 Lenovo’s other acquisition is Motorola Mobility from Google, which will be discussed in the telecommunications section.

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business and Thinkpad brand but not able to maintain the capabilities that allowed IBM to have a competitive edge, reflected in the higher prices IBM charged, over its rivals in PCs. Nevertheless, Lenovo at least enjoyed robust sales, whereas the computer firms discussed in subsection 3.1.2 did not even manage that.

3.1.2 The School-Based PC Firms: Founder, Tongfang, and Ziguang The two most prestigious Chinese universities, Peking and Tsinghua, founded three xiaoban qiye that were heavily involved in the PC industry. These three firms have several commonalities. First, they have seen their main computer businesses decline and rely primarily on state procurement. Second, they have diversified into many different areas related to the state. Third, they have not leveraged their links to their respective universities to create technologyintensive enterprises. The main differences between Founder and the two Tsinghua firms are Founder’s origin as an innovative firm and the greater policy burden the state has given Ziguang and Tongfang. Founder’s (Fangzheng) original technology innovation was a Chinese character printing system invented by Professor Wang Xuan of Peking University. The firm went into the printing business in 1988 and by 1995 dominated 75 percent of the market. While this market was state controlled (printing systems were sold mainly to the state-run media), Founder had to beat out established state enterprises to win business. However, by 1995, the state newspapers were only buying replacement systems. At the same time, Founder spotted a number of new state procurement opportunities. In 1994, the Three Golden Projects (the Golden Card Project for banks, the Golden Gate Project for customs operations, and the Golden Bridge Project for the telecommunications sector) were launched with Founder hired to do systems integration work. The very next year Founder started its own computer brand. By this point, Founder had already diversified, with thirty-four different subsidiaries. In 1996 Founder became a top ten Chinese PC vendor. The State Economic and Trade Commission chose Founder to participate in its 1997 plan to create Chinese Global Fortune 500 enterprises, through the Large-Scale Experimental Enterprise Group (Daxing Shidian Qiye Jituan) project (Lai 1997). The education system began a big drive to purchase PCs starting in 2000 so connections to the education system proved very useful to firms wanting to sell computers to universities and Founder, Tongfang, and Ziguang all benefited enormously (Interviews 27, 43, 91, 234). In 2002, a person close to Founder bragged to me that the firm was not worried about foreign PCs following China’s WTO entry because the Chinese state would take care of it (Interview 209). However, the good times have not lasted for Founder’s 78

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computer business. With its computer sales outside the state procurement channels flagging, Founder’s computers and peripherals business has seriously declined.25 In 2012 revenues in real terms (accounting for inflation) were lower than in 2003, when China’s PC market was much smaller. With the decline of its PC business, the Founder Group has expanded into healthcare, real estate, finance and commodities trading, and defense. This diversification strategy is not accidental as these sectors tend to be highly regulated and/or linked to state procurement. In January 2015, Chairman Wei Xin and two other top executives were taken into custody in a corruption case involving Founder’s securities arm (Caijing January 12, 2015). Ziguang26 started in 1988. Tsinghua University in 1997 cobbled together a bunch of non-educational units or nascent firms within the university and listed this amalgamation as Tongfang on the domestic stock market the same year. Ziguang began its notebook PC business in 1998 and became the third biggest producer by 2000. Tongfang concentrated in desktops. However, these firms just applied labels to machines designed and built by others (Interviews 206, 234, 235) and this remains true to this day.27 Both firms’ computer businesses have declined from their heyday with Ziguang’s computer-related revenues equivalent to only 4 percent of Lenovo’s revenues in 2013.28 Insiders and knowledgeable partners of both firms (Interviews 20, 21, 43, 234, 235) placed many of their firms’ problems squarely at the door of the management structure. Party officials of Tsinghua University, who had their own political missions, were placed in charge of managing these enterprises. The firms had to make policy-driven investments in poor, interior provinces and science park projects around the country on orders from Tsinghua and even the State Council, all of which hurt profitability (JJGC April 6, 2010; Interview 21). Nevertheless, both firms continue to seek out state-related businesses. Tongfang has warmly embraced the central government’s announcement of a big new initiative on smart cities (JJGC September 10, 2014). Despite all its difficulties in making its subsidiaries profitable (JJGC 1.14.2014), Ziguang has managed to set itself up as one of the key vehicles for China’s new stateled push in the IC sector (see Chapter 6) and has just acquired a 51 percent stake in HP’s H3C subsidiary, as HP hopes this JV will allow it to sell servers to

25 In 2012, computers and related products were still 64 percent of Founder Technology’s sales (Wright Investors’ Service, October 13, 2013), the subsidiary firm in charge of Founder’s PC business. 26 Ziguang Holding Company is now often referred to as Unigroup in English. 27 Interview with IT industry analysts on April 18, 2014. 28 Tongfang has several times the revenue of Ziguang (22 billion RMB in 2013), which is probably not surprising given its sprawling scope, with more than forty firms across thirteen different business areas.

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Chinese banks amidst the government’s push to rid the state banking system of foreign servers (Marbridge 5.19.2015).

3.1.3 Hybrid Comparison: Inventec While Lenovo is widely lauded as a Chinese high-tech champion given its large size and involvement in the computer business, a firm that has arguably done much more to develop local technological capabilities in China is the little-known Inventec. This firm operates in the unglamorous ODM business so consumers rarely have heard of it, even though the firm has embraced a China-based OS. Inventec’s Wen Shiren proclaimed in 2001 that the firm was embarking on a shuang-ta (twin or dual towers) policy placing its two critical corporate centers in Taipei and Shanghai’s Caohejing, where it began to build up its operations. Inventec also built up major R&D centers in Nanjing, Beijing, and Tianjin, and US utility patent data demonstrate these centers’ productivity. Despite Lenovo having revenues that as of 2013 are 250 percent of Inventec’s, between 2003 and 2013 Inventec produced 112 US utility patents using lead inventors based in China whereas Lenovo only produced 46 such patents. Tongfang and Ziguang had none and Founder had 21.

3.2 Telecommunications Hardware China has one of the largest telecommunication markets in the world and yet the list of formidable technology giants this large market has fostered begins and ends with Huawei. This section will examine China’s telecommunication infrastructure equipment and handsets, but will not delve into the telecommunications services because foreign-invested firms are not allowed to compete in that subsector. First, the section will overview infrastructure equipment, where Huawei received its start. Then, the focus will turn to Huawei as an exceptional case. Finally, the section will discuss the mobile handset subsector.

3.2.1 Telecommunications Infrastructure Equipment Telecommunications infrastructure equipment comprises the machines that form networks to allow telephones and mobile phones to function. Telecommunication service providers buy this infrastructure equipment to run their networks. In China, the telecommunication service providers are all stateowned firms. As of 1992, domestic Chinese firms held as little as 1.1 percent of the market in some telecommunications products, such as central office exchanges. A number of state-sponsored firms and Chinese majority JVs helped boost local production to 80 percent of the domestic market by 1997 80

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in certain areas, such as stored program control (SPC) switches, the primary fixed line switch. Behind this resurgence of Chinese telecommunications equipment production were state procurement and forced technology transfer by foreign partners in JVs (Shen 1999; Zhang and Igel 2001). The state placed tremendous pressure on MNCs and their JVs to localize their supply chains even in this period (Wolf 2012). In 1989 the state limited the number of JVs in switching equipment to three: Siemens, Alcatel (originally Belgian Telecom/ ITT), and NEC.29 The idea was that the state would play these MNCs from different countries off against each other (Harwit 2008). Along with the JVs, a number of local firms entered the marketplace during this period. Huawei, as a private firm, was far from the most prominent. That title would have gone to the Ministry of Post and Telecommunications’ (MPT) Posts and Telecommunications Industry Corporation (PTIC), which did not really perform well.30 Another firm that looked formidable on paper was Julong (Great Dragon) because this firm had PTIC, the military, and MEI as its major stakeholders. However, this number of major stakeholders and the fact that the firm essentially combined eight firms into one was problematic organizationally (Harwit 2008). Datang, a firm that came out of the Chinese Academy of Telecommunications Technology,31 also seemed well placed to compete. Finally, the Ministry of Aerospace set up ZTE in conjunction with the Shenzhen municipal government, although this firm did not enter the telecommunication equipment business until 1990. The firms which actually took off in the late 1990s and the first decade of the twenty-first century were Huawei and ZTE (see Table 3.5). Chinese firms had a window of opportunity during the Internet and telecommunications bubble that began in the late 1990s. MNCs simply did not have the capacity to meet all the large orders coming in from China in a timely manner. Local firms invested heavily in new capacity to meet these orders quickly— production increased between three- and four-fold—and resisted charging higher prices despite the lack of competition from MNCs. This reluctance to price gouge gained them loyalty from the Chinese telecommunication service firms (Wolf 2012). And yet Huawei and ZTE unquestionably made more of these opportunities than Datang and Julong, which is not so surprising. Alongside Julong’s management issues, Datang has always been the very epitome of the hidebound, slow-moving SOE even according to people close to the firm (Interviews 173, 322).

29

NEC’s JV started in 1990. It evolved into a holding company for various telecommunications-related firms called Putian (Potevio), which eventually absorbed what was left of Julong. 31 With the creation of the Ministry of Information Industry (MII) in 1998, Datang fell under its control. 30

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Paper Tigers, Hidden Dragons Table 3.5 China’s major telecommunications infrastructure vendors Firm

Start

Products

1997 Revenue

1997 Rank

2003 Revenue

2003 Rank

BISC JV (Siemens with MEI via Beijing affiliate)^^

1988

Fixed line; mixed form 2002

1988

5

N/A****

1993 1994^^^^

Mixed Fixed line

520 5,000

6 1

Negligible^ (bought out by Siemens: 62% ownership by early 2004) 2075* Negligible

Datang Julong (Great Dragon) Huawei Shanghai Bell JV^^^ (ITT/Alcatel with PITC and other state units)

1988 1983

Mixed Fixed line until 2001; 2001 onward mixed Mixed

4,189 4,561

3 2

31,712 14,350 (Bought out 50 +% by Alcatel in 2001)

1 3***

ZTE

1985

1997

4

17,036

2

4** N/A****

Sources: Compiled by author from Hoovers Online; Gartner/Dataquest; Zhang and Igel (2001); Harwit (2008). Notes: Revenue in RMB millions. * Datang’s 2002 revenue was used for 2003. ** Datang has been used to distribute Ericsson’s products and Ericsson sold 10.25 billion RMB worth of telecommunications products in China in 2003. Including Ericsson’s products, Datang ranked fourth. Without Ericsson’s products, Datang does not rank in the top ten. *** The figure represents the products of Alcatel. Before Shanghai Bell’s acquisition by Alcatel, Shanghai Bell had revenues that were only a quarter of ZTE’s revenues in 2001. **** These firms were not among the top ten largest vendors and no exact data were available. ^ BISC suffered badly in 2003 because Siemens cut off key components from the firm in 2003 when trying to force the Chinese side to sell Siemens a controlling share (Harwit 2008: 132). ^^ Now called Nokia Networks due to the Nokia and Siemens telecommunications equipment merger and then Nokia’s buyout of Siemens’ share. ^^^ Now called Alcatel-Lucent Shanghai Bell given the merger of Alcatel and Lucent. ^^^^ According to Harwit (2008: 123), the firm was actually created in 1995.

The relative decline of some domestic equipment vendors and the rise of others, such as Huawei and ZTE, points to some competition among domestic telecommunications providers. This competition has functioned on three fronts. Chinese telecommunication service providers in the recent past have switched from more expensive to less expensive equipment vendors (Zhang and Igel 2001; Wolf 2012). There has also been competition in creating new products, particularly wireless products and firms that could not generate new wireless products lost out. Moreover, these sources of competition took place in the context of a huge number of local firms entering this market. Some sources put the number of entrants at 200 (Fan 2011). Huawei and ZTE’s major domestic competitors lost out despite their right to sit on the same government review boards that tested and approved foreign telecommunications equipment for the Chinese market. Sitting on these boards, Huawei and ZTE learned how to copy foreign designs while testing and opening the equipment of foreign vendors as part of the approval 82

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process.32 Datang and Julong failed to make the most of the same opportunities for learning. In the early 1990s, Huawei was not yet a state-favored firm so it probably did not even have access to sit on such boards at that time. The best some of the other large firms could manage was to become subsidiaries or sales channels for foreign firms. Alcatel bought a controlling share in Shanghai Bell in 2001 and Siemens bought a controlling share in its JV, BISC, in 2004. While Datang was selling just a little over two billion RMB (the equivalent of USD 250 million at contemporary exchange rates) in equipment, it became a major sales partner for the much larger, more technologically sophisticated Ericsson, which had ten billion RMB in sales in China in 2003 (MFC Insight 2003). Datang also became the center of the Chinese government’s drive to create a new “Chinese” third generation (3G) telecommunications standard, TD-SCDMA, which was actually originally created in Europe by Siemens (EET 4.21.2003). Siemens and Datang worked on refining the specifications for the standard, for which Siemens had failed to win approval in Europe. The Chinese government also set up a series of collaborative efforts between Datang and other foreign firms anxious to gain access to the details of the new Chinese standard when and if it were to become a reality. However, Datang’s weak technological capabilities soon became evident and other domestic Chinese firms were able to barge into the collaborative foreign– domestic efforts designed by the state to support TD-SCDMA. For example, Huawei essentially hijacked COMMIT, a joint development program for TD-SCDMA involving Nokia and Texas Instruments, among others, and took over as the Chinese partner in place of Datang.33 ZTE and Huawei both continued to grow throughout the first decade of the twenty-first century to become major international firms (see Table 3.6). However, the firms have taken quite distinct paths. ZTE as befitting an SOE has remained much more dependent on the Chinese telecommunications market, which is a state-run oligopoly, and much more keen to remain in the good graces of the state in order to accrue further state largesse. In 2002 both firms were of nearly equal size and dependent on the Chinese marketplace. 32 This access to sit on these review boards was deemed to be a big boost for Huawei’s and ZTE’s ability to learn the technology according to interviews and a foreign telecom executive with whom I discussed this issue, in December 2002. The telecom executive was at a loss to explain why other domestic firms with the same rights to sit on the board were not able to capitalize on the opportunity. 33 COMMIT eventually failed. One interview subject working for one of the MNCs involved in COMMIT claimed that China Mobile, which was not happy about having the responsibility to support this standard on its third generation (3G) network, told the one VC interested in investing in COMMIT that China Mobile was not interested in TD-SCDMA. Such frankness immediately scared off the investor and not long after the MNCs abandoned this joint project. Consequently, the Ministry of Industry and Information Technology (MIIT), the successor ministry to MII, was greatly annoyed at China Mobile (Interview 440).

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Paper Tigers, Hidden Dragons Table 3.6 Global wireless infrastructure market share (revenue), 2002 and 2010–2013 (%)

Ericsson Huawei Nokia (NSN)* Alcatel-Lucent* ZTE Samsung Motorola NEC Fujitsu

2002

2010

2011

2012

2013

29.5 0.9 21.1 17.5 0.8 2.4 10 2.7 1.1

32.7 15.1 20.5 10.4 8.8 3.5 NA NA NA

35.1 16.2 20.9 10.1 7.6 3.3 NA NA NA

32.7 18.2 19.7 9.6 8.4 3.4 NA NA NA

30.2 21.2 16.2 10.2 9.1 5.5 NA NA NA

Sources: Gartner Dataquest and Jeffries. * For these vendors for 2002, the table combines their pre-merger revenues, e.g. Nokia and Siemens for Nokia (formerly NSN) and Alcatel and Lucent’s for Alcatel-Lucent. Nokia bought out Motorola’s infrastructure equipment arm in 2011, but Motorola’s small share is not included in Nokia’s 2010 figures

However, Huawei began to seek out international markets much earlier. Forty percent of its sales were overseas by 2004 and over half by 2005 (FT 11.30.2005). In contrast, ZTE still sold 85–88 percent of production domestically at that time. ZTE remains much more dependent on China with 46 percent of its sales there compared to one third for Huawei in 2011 (WSJ January 8, 2013).34 During the course of the first decade of the twenty-first century, Huawei rapidly outstripped ZTE in sales as well as internationalization. ZTE still lags far behind Huawei in terms of competing in the marketplace. ZTE can be said to be far less competitive in the open marketplace given its dependence on China’s state-controlled market. With China’s market declining as a share of the total global infrastructure market, ZTE suffered major losses in 2012 and operating losses in 2013 despite its state backing.35 ZTE itself and external analysts acknowledge that its path back to profitability runs through Chinese state procurement, and specifically the spending splurge on fourth generation (4G) networks by China Mobile (Su and Yang June 12, 2014; Meng et al. June 4, 2014), which will comprise approximately half of worldwide 4G spending during 2014–15 (FT 7.21.2014).36 The Chinese state clearly sets aside a

34 ZTE’s infrastructure equipment seems to have had a majority of sales in China in 2012 and 2013 (estimate made in November 2013), which represents a retreat back to the China market from 46 percent of revenue from China sales in 2011 (Gai et al. 2013). 35 ZTE was only profitable in 2013 because of non-operating income. It still had a negative 2 percent operating profit margin (Grinnan 2014: 14). ZTE not only benefits from the typical low (even negative real) interest rates enjoyed by state-backed firms, but the firm has received huge amounts of financial backing to sell into developing world markets, such as Africa (Sanderson and Forsythe 2013; WSJ January 7, 2014). The growing number of Chinese state export finance institutions have provided USD 670 billion in financing just in 2013–14, which is larger than the US Ex-Im Bank has provided in its entire history since the 1930s (FT 10.20.2014). Huawei has also received such backing, but its total sales abroad dwarf ZTE’s. 36 One source projected that the spending drive in 2014 and 2015 would include China Telecom and China Unicom (Gai et al. 2013).

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significant portion of state procurement for ZTE and Huawei, and gives ZTE, despite being smaller than Huawei, as large or larger a slice. For 2013’s China Mobile 4G tender, ZTE and Huawei each won 26 percent.37 Under threat of European sanctions, Ericsson, Nokia, and Alcatel-Lucent Shanghai Bell were awarded 11 percent each (FT March 2, 2014).38 For the large China Mobile 4G tender in 2014, ZTE actually won more than Huawei, 34 percent to 31 percent (Marbridge 5.23.2014). The problem for ZTE is that this 4G splurge in China will end in 2015 and the Chinese market is projected to decline from a peak of nearly 20 percent in 2014 to 16 percent in 2016 and level off thereafter, which is similar to the Chinese share of the global market when ZTE got into trouble in 2011–12 (Grinnan 2014). ZTE not only remains dependent on state procurement in China, the firm also sells less valuable products than Huawei. In 2013, Huawei wireless infrastructure products have a price that is 91.77 percent of those of the average of the major telecommunications firms, while ZTE’s lag far behind at 74.6 percent, the worst of all the major firms.39 This stalled catch-up to the technology frontier combined with ZTE’s dependence on China’s state-led market suggests that ZTE’s upgrading has stagnated. From the beginning, ZTE has always been a laggard compared to Huawei in terms of its commitment to technological learning and innovation. To give one example, Huawei and ZTE both had a relationship with a Taiwanese networking equipment ODM in early 2000s, but they approached the relationship very differently. ZTE was passive, content to slap its name on a product designed and manufactured by the Taiwanese firm. In contrast, Huawei also tried to outsource equipment from a Taiwanese ODM, although the ODM quickly terminated the agreement because it felt Huawei’s real goal was to steal technology given Huawei’s unceasing demands for access (Interviews 81, 198). Testimony from internal firm sources and key suppliers also pointed to ZTE’s limited commitment to pursue technological upgrading in an aggressive way (Interviews 213, 155). Another supplier to both Huawei and ZTE testified in 2004 that it was obvious that Huawei was a much more efficient, streamlined organization. ZTE functioned like a typical SOE (Interview 291). When it comes to actual innovation, ZTE is far behind. ZTE produced less than 9 percent of Huawei’s China-based US utility lead inventor patents

37 Datang won 9 percent and Putian and two other small players each won 2 percent (Marbridge 3.17.2014). 38 ZTE had the highest share of optical equipment procurement for 2013. Ciena and Alcatel were neck-and-neck for second and third place, with Huawei in fourth. Only two Chinese vendors serve this market (Gai et al. 2013). 39 Calculated by the author based on data available from equity research firm, Jeffries (Meng et al. May 28, 2014).

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between 2003 and 2011. In fact, ZTE created just a tad more such patents than Nokia produced in China (70 to 63) despite China being ZTE’s largest market and home base. The results are unimpressive given that ZTE has spent over USD 1 billion per annum on R&D in recent years.

3.2.2 The Huawei Exception Having started out on the political periphery in its early days, Huawei as a private firm had to find ways to expand its share of the market without state support. Huawei had to borrow from SOEs at high interest rates because it could not get loans from the state banks (Ahrens 2013). According to Cheng and Liu (2003), Huawei set up JVs with local post and telecommunication bureaus in the 1990s partly to collect funds from these bureaus which became investors. At the same time, Huawei returned “dividends” to the customers and local government officials who were investors in these JVs, which essentially amounted to providing bribes to capture the local telecommunications market over which these officials had a large amount of decision-making power. Consequently, if Cheng and Liu are correct,40 it was not an accident that Huawei’s initial strength was in peripheral areas in the interior. Similar to Lenovo and Founder’s experiences, success brought state attention and emoluments to Huawei. In 1994, as one of the first signs of the state’s growing recognition of the company, Huawei’s founder, Ren Zhengfei, met President Jiang Zemin. By 1996, Huawei received the imprimatur of state approval when two high-level leaders, Wu Bangguo and Liu Haiqing, came to visit its headquarters in Shenzhen (Ahrens 2013). Despite being a private company, Huawei insiders admit it receives state backing. Huawei’s founder, Ren Zhengfei, himself has in the past emphasized Huawei’s connections to the state as a competitive advantage for the firm. As he put it, albeit somewhat obliquely, “The difference between Huawei and Western firms is simply that we at every level of management are close to our customers” (Jiang 2003, author’s translation). Until Huawei’s success in overseas markets, its customers of course were overwhelmingly Chinese government-owned firms.41 Ren has stressed the crucial role of government support in the face of large foreign competitors: “If it were not for the 40 In support of their claims, Harwit (2008: 128–9) cites Li Sun, “Huawei: Tulang Xiang Shizi de Yanjiang” [Huawei: The Evolution from Wolf to Lion], IT Jingji Shijie [CEO and CIO information Times], 10 (2002): 50–62. 41 In commenting on Ren’s statement, Jiang explicitly states that customers means local units of the state-owned telecommunication service providers (Jiang 2003: 119). In reference to Ren Zhengfei’s remark, Jiang Ruxiang also notes the crucial government role for many domestic firms: “This kind of philosophy of seeking to survive in this tiny fissure [of opportunity] really is the situation of almost all domestic firms, they face formidable [foreign] competitors, but they can also from ‘government protection’ receive a huge advantage” (Jiang 2003: 120).

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protection through the national government’s policy, then [our firm] would have been easily destroyed” (Jiang 2003). One cannot ascribe Huawei’s success simply to receiving state favor because Huawei was not unique in receiving state favor nor did the firm receive more state favor than others (Zhang and Igel 2001; MFC Insight 2003; Harwit 2008; Wolf 2012). The most damning piece of evidence against any supposed unique position of privilege for Huawei is from Huawei’s state competitors. One would think, particularly in the context of particularistic competition, that Huawei’s competitors would complain bitterly about Huawei’s supposed privileged position if the firm had one. However, the state-linked competitors I talked to did not think Huawei had an upper hand in securing government procurement. This is not to say that they denied that government support was critical, it was just that they did not think the government favored certain major domestic firms over others as they all were equal beneficiaries of government support (Interviews 128, 155, 173). In the past, Huawei had a bad reputation for alleged intellectual property (IP) infringement and lack of innovation. For example, Huawei illegally photographed the internal design of Fujitsu’s equipment at international trade shows and Cisco successfully sued Huawei for copyright infringement, which was later settled out of court with the help of Huawei’s ally, 3Com. A number of returnee engineers coming back to China expressed how unimpressed they were with Huawei. One returnee with years of experience in IC design disparaged Huawei’s early efforts at advanced mixed signal design saying, “Sooner or later Huawei’s efforts at mixed signal will fail” (Interview 136). He went on to note that many major telecommunications firms had retreated from making their own ICs and predicted, “If these big boys cannot support IC divisions, how can these second class Chinese firms support them? IC development—the Chinese have not realized how hard ICs are” (Interview 136). Flash forward twelve years. Huawei’s IC design division, Hisilicon, stands out as the one domestic design outfit that has relatively sophisticated technology and supplies most of Huawei’s own baseband chips for its mobile phone line. Huawei has sold into half of the European 4G networks rather than selling just into less demanding and lower margin developing world markets as ZTE had done. Huawei has far more US utility China-based lead inventor patents than any other domestic firm in China. What has made Huawei different from the other Chinese national champions? It could not be just its origin in starting out on the periphery. After all, Lenovo and, to a lesser extent, Founder were originally outside the networks of state support, but they soon began to stagnate under the state’s embrace. The lack of direct state ownership in Huawei does not explain much either because other private technology firms, such as Stone, did not succeed, and even 87

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Lenovo, while owned by CAS, basically gave Liu Chuanzhi free rein to run the firm. This subsection will point to several facets that aided Huawei’s success, but recognizes that these are but partial explanations. This book acknowledges that Huawei is the exceptional case of a state-favored firm that has apparently not succumbed to state blandishments in a manner that would undermine its capabilities to pursue technological development. With thousands of domestic firms involved in its technology sector, and dozens, if not hundreds, of relatively large firms, China was bound to have an exceptional firm that bucked these institutional constraints. The real question is not why Huawei emerged, but why China doesn’t have a dozen Huaweis. After all, thirty years into Korea’s industrial take-off, Korea already boasted two firms, Samsung and Hyundai, that had taken the global technological lead in memory semiconductors (Mathews and Cho 2000) in an economy that is much smaller than China’s today. If Korea could create several technology titans, arguably China should boast many more such success stories. The answer of course is that China’s institutional arrangements have severely constrained and distorted the development of such firms. A caveat is in order for all this praise for Huawei. This firm has not been publicly listed and until the last few years has not been forthcoming about its internal operations. Financial data from listed Chinese companies are somewhat unreliable. With unlisted, closely controlled Huawei, the financial opacity is heightened. Furthermore, while the share rights are famously spread among Huawei’s employees, the control rights, as far as anyone can tell, remain in the hands of Ren Zhengfei, his daughter, and his close associates. With such a closed group of insiders, the chance of them going down the wrong path given the lack of scrutiny is relatively high despite their past track record of making all the right moves. Huawei looks like the next Samsung Electronics, but there is the possibility that it will turn out to be the next Daewoo, a firm now remembered more for its dramatic demise than for its prior decades-long rapid growth. Huawei’s strengths appear to rest on three things: a commitment to R&D beyond what the state was willing to support, seeking out competition in new markets, and its unique internal human resource management practices that have elicited strong commitment and high performance from its workforce. From its earliest days, the firm was willing to funnel a large portion of its revenues back into R&D (Ahrens 2013), investing no less than 10 percent of annual revenue in R&D (Zhang and Wu 2012).42 Moreover, the firm has pursued technologies that clearly made sense in terms of the market, but did 42 It must be noted that this rule does not always hold. In 2010, Huawei’s R&D fell to 9.7 percent of revenue (Tsai and Lu April 25, 2014).

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not make sense if the goal was simply to take advantage of China’s state-run telecommunications equipment market. Simply put, Huawei did not allow the state to undermine or distort its technological learning mission. For example, Huawei made a specific commitment to developing 3G WCDMA (Wideband Code Division Multiple Access) technology in 2002 even though the Chinese state kept delaying 3G rollout. With a distinct lack of enthusiasm from the Chinese state, Huawei had to undertake such R&D all on its own and spent 6 billion RMB on this research. Huawei actually suffered losses for the first time in 2002 because of this bold move, but it paid off in terms of Huawei being forced to sell this 3G equipment internationally. Its first customer was a small Spanish telecommunications firm.43 Huawei also never paid much heed to TD-SCDMA (Time Division Synchronous Code Division Multiple Access), the 3G standard the Chinese government was pushing. Datang was heavily investing in this standard and ZTE was also more proactive in promoting it than Huawei (Interviews 376, 458, 475).44 The lack of attention of state diktats on R&D goes hand-in-hand with Huawei’s earlier and continued propensity discussed before to seek out new markets and consequently foreign competition abroad. As for Huawei’s human resource management skills, the firm has managed to encourage and retain an enormous and skilled workforce including over ten thousand PhDs.45 No other large Chinese company can compare. From the late 1990s, Huawei has employed Hay and subsequently IBM to help it design and implement its human resource management and R&D management processes, respectively (Zhang and Wu 2012). However, more than merely implementing cutting-edge practices, Huawei has inspired its employees to a high level of performance and commitment to the firm.46 Huawei’s 1997 Basic Law, which was written through extensive consultation with staff throughout the company, encapsulates the goals and the spirit of the firm (Cheng and Liu 2003; Tian and Wu 2012; Zhang and Wu 2012). Ren Zhengfei has successfully invoked corporate crises time and again to push his workforce and eliminate any sense of complacency despite Huawei’s quite consistent record of growth and success (Hawes and Chew 2011). Although Huawei has shied away from using the fierce moniker “wolf culture” (see footnote 46) to describe its

43 This case is from a speech given by Tian Tao, a long serving advisor to Ren Zhengfei, at Zhejiang University on July 1, 2014, entitled “Huawei xiang Zhongwai Jundui Xuedao le Shenme” [What has Huawei Learned from Chinese and Foreign Militaries?]. 44 Additional interview on June 19, 2013, with an interlocutor who had been involved with several state IC firms and telecommunications firms. 45 Tian, July 1, 2014, speech. 46 Huawei’s culture was described as “wolf culture” due to its collective and relentless pursuit of corporate goals in competition against bigger firms, but the firm has moved away from using this terminology since a famous article in 2002 celebrated Huawei’s wolf culture against the MNC lions and the JV leopards (Tian and Wu 2012: 19–21).

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corporate culture over the last dozen years, Huawei’s senior advisor, Tian Tao, did proudly note in 2014 that Baidu had tried to adopt Huawei’s “wolf culture” but failed.47 There is a dark side of Huawei’s competitiveness now that it has strong links to the state. Huawei has been able to use its political clout to close off competition from new entrants and this behavior explains the relative absence of hybrid firms in the telecommunications infrastructure space in China. The one major hybrid entrant into mainstream telecommunications equipment was Harbour Networks in 2000. From Huawei’s pint of view, this firm was an immense threat given that former Huawei vice president, Li Yinan, recruited away Huawei personnel with promises of stock market riches. Harbour Networks also began competing in Huawei’s main markets with equipment that looked suspiciously like Huawei’s. Equally worrisome was the foreign VC backing that provided Harbour Networks with financial support (Tian and Wu 2012). From the point of view of budding entrepreneurs and venture capitalists alike, what happened next provided both a warning and a lesson. There are two versions of the events. Huawei either lobbied the state in order to have Chinese telecommunications service firms stop buying from Harbour Networks or severely undercut Harbour Networks’ prices with the help of soft loans from state banks. Given Harbour Networks’ FIE status, it probably was not a difficult sales pitch to make to state officials to back Huawei against the hybrid interloper. In any event, Harbour Networks was destroyed and foreign venture capitalists and budding telecommunications equipment entrepreneurs learned not to try their luck in this mainstream market again (Interviews 318, 337). Telecommunications infrastructure equipment start-ups, such as New Rock and Bodatong, could only get VC backing if they had niche strategies. Even prior to Harbour Networks, the main hybrid success story in this subsector was UT Starcom, which successfully won over the niche PHS (Personal Handy-phone System) market which the major state firms ignored.

3.2.3 Mobile Handsets MNCs dominated China’s emerging mobile handset market for a number of years. First, Motorola was the dominant player and then Nokia took over. In 2003, local brands managed to capture more than half of the market for the first time, but lost that majority the following year, falling to 40 percent of the market in 2005 (Li and Kozhikode 2008). This early peak coincided with the success of domestic Bird (Bodao), a firm that originated as a Ningbo 47

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Tian speech, July 1, 2014.

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township and village enterprise (TVE) but was brought under Putian. Another firm that did well in this early period was the hybrid, Techfaith, which now concentrates on niche “ruggedized” smartphones and online games. Following this early surge by domestic phone makers, there was the phenomenon of shan zhai (literally “mountain fortress” but with the connotation of being a bandit hold) phone makers. These unlicensed firms generally copied the look of established brands and relied on complete reference designs, even assembly kits, from their main chip vendors, such as Mediatek and Spreadtrum. While much was made of these firms at the time, none of them were capable of competing as branded makers with their own designs with the exception of Tianyu (EET 6.14.2010). Tianyu is but a small player in China’s market today. Lenovo also attempted to enter the cellular phone market. In 2002, Lenovo acquired a 60 percent stake in a JV with Xoceco48 (Xia Hua) in Fujian because Xoceco had a license to sell mobile handsets. Lenovo eventually purchased the entire entity in 2005. Despite the hoopla surrounding Lenovo’s entry into the handset business, Lenovo had a very weak R&D team in mobile handsets (Interviews 280, 304, 309) and sales were not very good until the last several years. Samsung took over from Nokia as the largest handset seller in 2012, but by that point Chinese phones controlled the bulk of the market (Marbridge 7.3.2012). Lenovo, after flailing about for many years in this market with only 4.72 percent of the market, had improved by 2011 (JJGC 8.9.2012). Huawei, ZTE, Xiaomi, and Yulong’s Coolpad have also done well in recent years as China’s smartphone market boomed, but there are now signs of saturation (WSJ 8.13.2015). In sad contrast to these firms, many domestic Chinese firms, including those with significant state backing, have failed to make headway in China’s booming mobile market over the last decade. This includes the giant state conglomerate, CEC, Ziguang’s Unis Mobile and TCL, even though the latter bought Alcatel’s handset division. Even the successful firms find themselves caught in a low-price trap. While they all have tried to compete on xing jia bi (good functionality for the price), this relatively low price for adequate functionality has led to very little in the way of profits. As the head of ZTE’s handset unit, Zeng Xuezhong, put it, “To tell the truth, even though we of course very much would like to sell at high prices, but the value of domestic brands simply still does not support such high prices” (JJGC 4.29.2014). Ren Zhengfei himself came out and criticized the idea that e-commerce channels and other things could save this “hightech” market: “You all have said that you want to sell 20 million handsets and

48

The English name is an abbreviation for Xiamen Overseas Chinese Electronics Corporation.

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2000 RMB+

Apple Samsung Huawei ZTE Lenovo Coolpad Xiaomi

100 30 20 15 10 5 0

1000–2000 RMB 0 45 40 30 20 10 60

1000 RMB> 0 25 40 55 70 85 40

Source: Barclays, June 11, 2014. Note: MNCs in bold.

make 100 million USD in profits, but that is only 30 Chinese yuan per phone, how can this count as high-tech and high-end.” He concluded with instructions for Huawei’s mobile unit: “From now on, when reporting just say how much money can be made. Unit sales are for making profits, not the object of the fight” (JJGC 4.29.2014). The results thus far have not been encouraging as Apple and Samsung have completely dominated the profits of the industry, even though, in terms of total unit sales, they are less than a majority. In smartphones, where the profits are, and where the Chinese firms are trying to compete their way to profitability, Apple and Samsung have taken between 90 and more than 100 percent of the profits in recent years (in the latter case of more than 100 percent of the profits, the other firms in total are racking up losses) (FT 1.25.2013; WSJ 7.13.2015). Chinese competitors are putting the squeeze on Samsung, but are only taking market share from Samsung at the lower end. Samsung’s mobile profits have tumbled along with market share, but Apple’s pressure at the high-end of the market is the force behind this profitability squeeze (FT October 7, 2014). If one looks at the segments where their phones are sold, Apple and Samsung are clearly concentrated in the high-end and even the best local firms are not (see Table 3.7). While Lenovo’s recent purchase of Motorola Mobility makes sense as one way out of this predicament, it is not clear if it will be a success since Motorola today only has good market visibility in the United States and Latin America.49 Much more promising are the hybrid, Xiaomi, which is the new market share leader in China’s smartphone market (EET 5.18.2015), or possibly Huawei, because they have potential strategies for sustainable profits. Xiaomi sells its smartphones at relatively low cost so it appears to be yet another Chinese phone maker not making any money. However, Xiaomi’s strategy is to sell

49 And Lenovo Mobile did badly enough in the first half of 2015 that its CEO resigned and layoffs occurred (WSJ June 2, 2015; EET 8.15.2015).

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value-added services, such as apps and games, to its mobile phone users and makes money this way (NYT 7.13.2014). To help with its internationalization, Xiaomi has recruited former Google executive, Hugo Barra. Huawei may also have an alternative way to success. Rather than trying to mimic Xiaomi by going the apps and other value-added services route, Huawei is trying to find a way to sustainable success (i.e. profits) in the handset business by sticking close to its core competence in hardware. Huawei’s chip design subsidiary, Hisilicon, makes many of the baseband processors that go into Huawei’s mobile phones. This in-sourcing potentially can save Huawei lots of money. For example, for the iPhone 6, the baseband comprised 11.3 percent of the total cost.50 There are, however, two caveats. First, Hisilicon basically sells only to Huawei, so we have no idea really what Hisilicon’s own cost structure is. We thus do not know how much savings is realized by insourcing. Second, we do not know if Huawei is sacrificing performance by insourcing its chips.

3.3 Conclusion Mao gong ji proved to be more of a slogan than an actual trajectory for China’s national champions. In principle, there is nothing wrong with trying to build technical competencies on the back of manufacturing, and Huawei took just this route. Many hybrids concentrate on design, a form of ji, without even bothering with manufacturing, proving there are multiple routes to ji. The main roadblock for China’s state-favored firms is not the route per se, but state beneficence that unintentionally sidetracks firms from the continued pursuit of ji. Having examined China’s national champions, let us now turn in Chapter 4 to the R&D activities of the hybrids and MNCs in China.

50 Author’s calculation based on EE Times’ estimates of the total cost of the iPhone 6 (EET 9.22.2014).

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4 State-Driven Technology Commercialization versus the Globalization of R&D

This chapter examines the Chinese state’s initiatives to spur upgrading through grants to domestic firms and juxtaposes this problematic effort with the burgeoning R&D activities of FIEs. Observers have noted multinationals’ movement of R&D activities to the developing world and hailed it as the globalization of R&D (Reddy 2000). However, as this chapter will show, FIEs vary in their behavior: hybrids embrace China as the center of their R&D efforts while MNCs adopt a more diffident approach. The first section will examine the state’s grant system and its problems. The second section will look at the R&D activities of hybrids and MNCs in China. The third section will use patent data to provide evidence of the superior performance of hybrid firms over MNCs and MNCs over domestic firms.

4.1 Government Grant Programs to Technological Capabilities of Firms Beyond high-tech zones and venture capital, the Chinese government has also tried to provide financial support to firms to boost their internal technological capabilities. This section will first describe some of these programs and then delineate the significant problems with how these programs support the commercialization of technology and the technology endeavors of firms.

4.1.1 Programs The Ministry of Science and Technology (MOST) has been at the center of many programs to promote technological capabilities within firms. This is not to suggest that MOST is an extremely powerful ministry. Many of the decisions about macro-level prioritization of programs, financial control, and

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strategic directions of China’s science and technology (S&T) policy come from elsewhere within the Chinese state, such as the National Development and Reform Commission (NDRC) and the Ministry of Finance (MOF). Nevertheless, the main S&T programs relevant to firms have been MOST’s Key Technologies Program, the 863 Program, and the Torch Program, although the latter originally focused more on investing in the infrastructure to induce firms to be innovative, such as investment in incubators and high-tech zones.1 The Key Technologies R&D Program2 was created in 1982 to aid the technical needs of industry and agriculture, but today it focuses on an array of sectors including IT and biotechnology, with an emphasis on funding research that encourages collaboration among universities, industry, and state research institutes. The 863 Program is the prime program targeting cutting-edge technology and arose out of the concerns of elite Chinese scientists that China’s S&T policies were failing to foster technology catch-up. These scientists3 petitioned Deng Xiaoping in March 1986 for a new program and with Deng’s immediate endorsement, the plan was formally approved in October. Although the policy was not originally geared towards supporting research in commercial firms, there has been a shift towards supporting research within companies. The 863 Program has always prioritized high-technology sectors, including IT and biotechnology, and new priority sectors have been added over time.4 MOST has administered the program except for the space and laser parts, which have been administered through State Administration for Science, Technology and Industry for National Defense (SASTIND) and its bureaucratic predecessor, the Commission on Science, Technology and Industry for National Defense (COSTIND). For both the Key Technologies Program and the 863 Program, direct central government funding is mixed with funding from other sources, much of which is also of government origin, e.g. local government funding and state 1 Chinese Academy of Sciences (CAS)’ Knowledge Innovation Program has been a major attempt to reform and revive CAS’ research institutes (Suttmeier et al. 2006), but only indirectly impacts firms, principally the firms connected to CAS’ various institutes. Military research funding through the State Administration for Science, Technology and Industry for National Defense (SASTIND) tends to go to defense contractors, including China Electronics Technology Corporation (CETC), a firm which aims at civil-military technology integration. See Cheung (2009) for discussion of military R&D by CETC. 2 Prior to 2005, this program was referred to as the Guojia Keji Gongguan Jihua or gongguan for short, but with the advent of the Medium and Long-Term Plan for Science and Technology (MLP) in 2006, the name of this program was changed to Guojia Keji Zhicheng Jihua or zhicheng for short. 3 The four prominent scientists who jointly petitioned Deng were Chen Fangyun, Wang Daheng, Wang Ganchang, and Yang Jiachi. 4 The original seven sectors were automation, biotechnology, energy, IT, lasers, new materials, and space technology. Two more sectors, ocean and marine technology and environmental technology, were added in the 1990s.

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bank loans at preferential rates. Thus, even as the direct central government funding has risen for these activities, the programs have also benefited from further funding beyond MOST. The Torch Plan was originally the most explicitly oriented towards the commercialization and industrial application of R&D.5 However, unlike the Key Technology Program and 863, Torch’s central government funding has actually stagnated in recent years.6 Demonstrating Torch’s declining role, the key slogan of MOST’s prioritization of S&T is “3+2” with the three referring to the three major programs (Key Technology Program, the 863 Program, and the 973 Program) and the two referring to two areas of infrastructure construction: S&T Infrastructure and S&T Industrialization Environment, under which Torch and many other programs were subsumed (Benner et al. 2012). Another major program is the 973 Program7 or National Key Basic Research Program (Guojia Zhongdian Jichu Yanjiu Fazhan Jihua), but this program is focused on basic science so that most of its research is conducted in universities and research institutes rather than in firms. In 2012, R&D institutes spent 930 million RMB of the 973 Program’s funds, universities spent 1.8 billion RMB, and enterprises spent only 150 million RMB. In contrast, under the 863 Program, enterprises spent 8.1 billion RMB, universities spent 2.86 billion RMB, and R&D institutes spent 1.07 billion RMB. Similarly, for the Key Technologies Program, enterprises spent 5.66 billion, universities spent 1.45 billion RMB, and R&D institutes spent 1 billion RMB.8 In addition to MOST, significant amounts of funding for high-technology research come from the Ministry of Industry and Information Technology (MIIT). The original plan for the technology zhongda zhuangxiang9 (“megaprojects”) of the Medium and Long-Term Plan for Science and Technology 2006–20 (hereafter MLP) reveals the obvious involvement of bureaucracies beyond MOST.10 NDRC and MOF had important oversight roles and MIIT was in charge of the IT megaproject.

5 Albeit commercialization via supporting development zones and other organizationalcum-infrastructural efforts. 6 The Torch Program’s government funding appears to be mainly from local governments now. In 2012, the central government provided 220 million RMB but total government funding for the program was 1.97 billion RMB (2013 Zhongguo Keji Tongji Nianjian [2013 China Statistical Yearbook on Science and Technology]: 164 and 174). 7 Like the 863 Program, the 973 Program’s numerical name indicates the date it was first broached. In this case, scientists proposed the program in the Chinese People’s Political Consultative Congress in March 1997 and the program was launched in 1998. 8 2013 Zhongguo Keji Tongji Nianjian (2013 China Statistical Yearbook on Science and Technology): 170. 9 These projects have been referred to as megaprojects and mega-engineering projects in English, but their official translation is National S&T Major Projects (Li 2009: 7). 10 The 16 proposed megaprojects are in the following areas: (1) CNC machine tool and advanced manufacturing; (2) control and treatment of major diseases including AIDS and hepatitis; (3) core electronic components, including software and chip design; (4) advanced IC manufacturing;

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Unlike Torch’s stagnant budgets, most R&D programs have seen significant budgetary increases over the past decade because of the MLP. There has been an enormous increase in government S&T spending from 168 billion RMB in 2006 to 560 billion RMB in 2012. The result is an accumulated 2.4 trillion RMB in government S&T spending over those seven years (XSJ 10.22.2014). This increase in spending, moreover, does not take full account of the follow-on megaprojects, many of which have just begun or have not yet started. Potentially even more important for future increases in funding is the Strategic Emerging Industries (SEI) initiative announced in November 2009. Best conceived as an addition to the MLP, this initiative identified seven sectors11 that China would promote in order to leapfrog to the technological frontier and thereby drive China’s overall economic and technological development. The program is certainly well funded. Reports on future spending for this initiative have ranged anywhere from 4 to 14 trillion RMB, and the SEI has basically subsumed the megaprojects since the October 2010 government decision that the megaprojects would “drive” the implementation of the SEI initiative. The SEI initiative also shows how politically weak MOST is compared to the NDRC and MIIT. The latter two ministries have split responsibility for overseeing the policies for these seven sectors. NDRC will govern clean energy technology, biotechnology, and alternative energy and MIIT is responsible for the other four (J. McGregor 2012).

4.1.2 Problems of China’s S&T Funding There are two systemic problems that limit the positive impact of China’s policies for improving firms’ technological capabilities. The first is the neglect of support for diffusion and institution-building as part of overall funding. The second is the waste, ineffectiveness, and corruption involved in the allotting of research funding. The recent increases in funding may have actually exacerbated these problems. One issue is whether the government’s priorities support China’s long-term technological development. There is a strong bias within China’s S&T funding

(5) pharmaceutical development; (6) genetically modified organisms; (7) high-definition earth observation systems; (8) advanced nuclear reactors; (9) large aircraft; (10) large-scale gas and oil exploration; (11) manned space exploration; (12) next generation broadband wireless; (13) water pollution control and treatment; and three projects that are classified (Li 2009; Springut et al. 2011). 11 The seven sectors ranked in descending order of importance are: (1) Clean Energy Technology; (2) Next Generation IT; (3) Biotechnology; (4) High-end Equipment Manufacturing; (5) Alternative Energy; (6) New Materials; and (7) Clean Energy Vehicles and under these seven sectors are 37 subsectors (J. McGregor 2012: 36–7).

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system towards mission-oriented and excellence-oriented R&D12 and away from programs that could promote diffusion of technology, such as programs like Torch that invest in the wider S&T infrastructure. Benner and his colleagues (2012) note that such a bias is common in many S&T systems. However, such an emphasis is particularly ill suited to the needs of a developing country like China where knowledge diffusion should take precedence over knowledge generation and where the capital markets are too undeveloped to foster the commercialization of knowledge. Others criticize the lack of focus on institutional development even as S&T investments have rapidly increased (Gu and Lundvall 2006; Zhao et al. 2010). The megaprojects and SEI seem to continue this problematic bias on mission-oriented projects. A fundamental problem with the MLP and general increase in formal government S&T spending is the inability to monitor the increased funds. In discussing the newly unveiled MLP in a presentation in New York on July 26, 2006, MOST Vice Minister Shang Yong when asked conceded that there were no new procedures in place to vet and manage the enormous increase in funding that the MLP envisioned. The lack of new procedures to evaluate the spending helps to explain the shocking misuse of funds that MOST Minister Wan Gang publicly uncovered in October 2013 when he admitted his frustration and disgust with the level of malfeasance in S&T spending. He announced that only 40 percent of the funds were actually spent on the S&T projects for which they were granted (Qianjiang Wanbao 10.14.2014). Even before Minister Wan Gang’s public criticism of MOST’s internal financial controls, there were strong indications that the state leaders in charge of S&T knew this was a major problem. The 2012 National Conference on Science, Technology and Innovation called for the separation of the funding, research, and performance evaluation organizations in order to create better checks and balances and for greater transparency in the awards system. This conference also led to the creation of a new Leading Group of State Scientific and Technological Reform and Innovation System Construction (LGSSTRISC) in July 2012, principally because both the existing Leading Group on Science, Technology and Education (LGTSE) and MOST have failed to coordinate S&T policy effectively across various government units (Cao et al. 2013).13

12 Beardson (2013) makes a similar claim about the problematic mission-orientation, alluding to the military origins of China’s S&T policy in line with Feigenbaum (2003). 13 My contacts in MOST believe the ministry has relatively weak influence in coordinating or even setting national policy (especially policy for commercialization of technology rather than basic science) compared to the other ministries and government units involved in technology policy, such as MIIT and NDRC. Similarly, when it comes to technology-cum-industrial policy, Heilmann and Shih (2013) place the NDRC and State Council front and center and consider MOST marginal. Johnson and Kennedy (2015) argue that the CCP itself is supplanting state organs in many areas of policymaking and implementation.

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Going back to before the MLP, the practices of reviewing and allocating of grants were and continue to be highly problematic. Across the ministries, there is a bias towards funding established, connected researchers (Shi and Rao 2010). In many cases, researchers with sufficient guanxi do not even have to submit formal applications for review (Cao et al. 2013). Another clever and common way to skew the distribution of funds is to set the terms of grants so narrowly that certain intended recipients are destined to win them. Compounding this, the large-scale “mega” science grants have their requirements set annually, which opens the door to picking winners through narrow requirements (Shi and Rao 2010). Scientists-cum-administrators also stand to gain from their positions, both in terms of grants received and the scope they have to influence the review process for others. Collusion between scientists on review committees and the bureaucrats who appoint them is widespread. Unsurprisingly, corruption of the grant process is not uncommon (Shi and Rao 2010; Cao et al. 2013). The corruption, collusion, and other types of misallocation of funds that occur in the science grant process are only amplified for those grants geared towards commercializable technologies. In a conversation with me in 2011, a contact of mine, who had worked within the central government and regional governments’ S&T apparatus and had served on an array of review committees, staunchly defended the review process for basic science grants. He launched a broadside against the complaints that Shi Yigong and Rao Yi, the deans of the life science schools of Peking University and Tsinghua, respectively, had published in Science in 2010 about the misallocation of science funding. My contact claimed that many of Rao’s perceptions came from Rao’s own inability to readapt to the Chinese environment after returning from abroad, and, most importantly, to mitigate the jealousy his colleagues felt towards his position. He even said that the review process had improved in recent years for basic science research. However, when I asked him about the review process of applied research grants given to firms, he laughed and admitted that review processes for commercially oriented, applied technology grants, which he had also been involved with over the years, were still riddled with vetting problems and had always been more problematic than those for basic science. In 2013, we revisited this topic and he said he had to revise his previous judgments. While the applied technology grant review process had been, and remained deeply problematic, the basic science grants in recent years had become increasingly riddled with corruption given the increasing avalanche of funds.14 One entrepreneur echoed these sentiments telling me that commercial technology grants are “a huge opportunity for corruption because they [officials] do not have any standards” (Interview 442).

14

This conversation took place on December 12, 2013.

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Another worrisome signal that the commercial technology grant process has not been run in a very professional manner is that I inadvertently, albeit only indirectly, became an arbiter in the applied technology grant process. In 2004, a journalist at a major Western newspaper contacted me for some recommendations for promising semiconductor start-ups to interview. In 2006, I ran into the CEO of one of the firms mentioned in the article and he began to thank me profusely. Noticing my confusion, he explained that the journalist had told him that I had suggested interviewing the firm and the firm ended up being mentioned in a published article. It wasn’t just the mere publicity that the CEO was grateful for. According to the CEO, solely as a result of appearing in this prominent newspaper’s article, one of the ministries had decided that the company was worthy of a major grant to develop a mobile handset-related chip technology. The decision to base funding on a newspaper article was not a wise one. Much had transpired between my suggesting this firm to the journalist and the publication of the article. The core technical team of the semiconductor start-up (comprised of returnees and ethnic Chinese technologists located abroad) quit the firm leaving behind only the CEO, who did not have the requisite semiconductor design background, and inexperienced local staff. Despite the gutting of the firm’s technical core, the government still awarded the firm the first of what turned out to be a series of grants in the same mobilerelated semiconductor technology even though these grants never led to a successful commercial product launch.15 Of course, it could have been worse. The ambitious CEO in this case was at least honest. Even though ultimately unsuccessful, he at least did not engage in the corrupt machinations concerning grants that other semiconductor entrepreneurs have (see Chapter 6). The inefficient and even corrupt grant process has a bias towards supporting domestic firms, which further amplifies the inefficacy of the research grant system. Steering most of the S&T grants to domestic firms only lowers the effective impact of the grants. While S&T funding had always had the objective of upgrading the capabilities of domestic firms, the MLP and the subsequent SEI initiative signaled a sharper turn towards using S&T policies to support and nurture the capabilities of domestic firms rather than support S&T activities in China irrespective of ownership (J. McGregor 2012). Interview subjects testified that the government, including local government 15 A competitor in the same technology area confirmed that the firm over the subsequent years had received a number of grants in this area but had not been commercially successfully and was in danger of closing (Interview 402). Indeed, as the offices of the two firms were in the same building, I checked at the office of the firm mentioned in the article after the interview with the competitor. The office was dark and empty even though it was during business hours. The firm’s ultimate failure to successfully commercialize technology in this area was later confirmed by the CEO in an interview in 2012 (Interview 498). Another interview subject confirmed the story about the core technical team leaving (Interview 387).

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officials that previously had a willingness to provide S&T funding in their pursuit of zhaoshang yinzi, had an increasing bias towards domestic firms (Interviews 441, 442, 456). However, this bias goes further back than the MLP. The origins of the S&T push from the 1980s onward were motivated by classic techno-nationalist concerns that put a priority on domestic control of these capabilities (cf. Feigenbaum 2003; Beardson 2013). The Chinese government’s interest in pursuing dual-use (civilian and military) technologies has meant that a significant portion of S&T spending, perhaps as high as 28 percent (Cheung 2010), went to such projects. Given the military implications of some of these projects, these grants obviously were not going to be given to foreign firms (Cheung 2009). Long before the formulation of the MLP, officials in the S&T policy apparatus across ministries and local governments also emphasized to me the priority placed on capability-building in domestic firms (Interviews 42, 61, 65, 74, 96, 97).

4.2 Hybrid and MNC R&D in China The globalization of R&D literature (cf. Dalton et al. 1999; Reddy 2000; Chen 2004) recognizes that foreign firms have begun to invest in knowledgegeneration activities in far-flung locations away from their home markets. The development of R&D efforts by MNCs in China fits this global pattern. There are both demand factors pushing MNCs to locate R&D in developing countries and supply factors pulling the MNCs to certain locations.16 MNCs generally did not really begin to pursue any significant R&D efforts in China until the end of the 1990s even though “show” R&D centers and donations of equipment to local universities (often under the name of a company-sponsored university “lab”) were already common (Walsh 2003). Even with greater MNC activity, there has been persistent reluctance on the part of MNCs to commit significant resources in China (Quan and Chesbrough 2010) even as some ECE firms, particularly Taiwanese ones (Chen 2004), have been more active in pursuing R&D in China. On the face of it, the fact that hybrids have outperformed MNCs as well as the local firms is still surprising. Hybrid firms have everything stacked against them. They are generally small start-ups, and even established ECE hybrids tend to be smaller and less technology-intensive than their major MNC rivals in the same product segments. How can we explain the hybrids’ remarkable success against the odds? My interviews revealed a strong commitment by

16

This section excludes discussion of semiconductor-focused firms covered in Chapters 5 and 6.

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hybrids to place their core technology activities in China. In effect, hybrids treat China as their home base and exhibit the same positive bias towards it that MNCs often have for their home economies. This commitment, undiluted by the soft budget constraints swaddling state-favored domestic firms, explains the hybrids’ success. While MNCs’ wariness of China’s intellectual property rights (IPR) regime has lessened, concerns persist and MNCs adapt their R&D strategies accordingly. Building on the work of Walsh and others, Quan and Chesbrough (2010) documented how MNCs have cleverly broken the R&D process into discrete segments so the R&D staff in China either do not have a full picture of the R&D flow or are relegated to relatively routine, technologically unsophisticated tasks. Both methods ensure that IP does not leak out of the MNCs, but it also ensures that MNCs are not fully utilizing China’s S&T resources. Hybrids approach this issue quite differently, viewing the issue as a problem to manage rather than one to avoid by eschewing the placement of valuable R&D activities in China. Moreover, they regard themselves as having an advantage in navigating the Chinese IPR environment, either due to their deep cultural understanding of China due to shared ethnic ties or because many entrepreneurs dealt with similar issues in the past when operating in the ECEs when they were still developing economies. Even for hybrids that are created overseas initially, the typical route is to shift the locus of firm activity to China. For example, one niche telecommunications equipment provider started with six experienced engineers, created a prototype, and moved the entire operations to Shanghai within a year of its founding in 2002. What is now left in the United States is a “shell” company as the entire staff, comprised mostly of R&D engineers, is based in Shanghai. One hybrid17 embracing the “twin towers” approach discussed in Chapters 1 and 3, has placed all of its software development (approximately half of its R&D workforce) in China. The firm began building up its R&D team to do notebook design in Shanghai three years prior to Lenovo’s ability to design notebooks via its IBM acquisition. Another ECE hybrid18 has two major R&D centers, one each in Taiwan and Shanghai, but the Shanghai research team has PhDs comprising half of the team whereas in Taiwan PhDs make up just 10 percent. MNCs’ operations have evolved as their fears of IPR have somewhat lessened over time.19 They have invested more resources and placed a greater priority on R&D in China than in the past. And yet, the emphasis for MNCs is one characterized by caution. They still view China as one possible source of

17

A top ten manufacturer from Taiwan according to Tianxia’s 2014 Top 2000 Ranking. A top twenty manufacturer from Taiwan (Tianxia 2014). 19 Booz (2013) and speech by former head of Philips R&D in China, Frans Greidanus, on November 12, 2013. 18

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resources their respective firms can use rather than having a deep commitment to developing their core competencies in China. Thus, foreign firms look at China’s human resources and see bottlenecks or insufficiently trained workers. For example, even in one of the MNCs most committed to R&D in China (and a global top ten IT firm), the head of their large R&D center dismissed many of the firm’s original workers as inadequate by saying, “Don’t ask how good they are, but how bad” (Interview 312). In order to manage the perceived deficiencies in the labor market, this firm instituted a highly competitive internship program through which they selected the cream of the crop as their future employees. From the perspective of the hybrid networking equipment maker referenced above and other hybrids, the MNCs have gotten their approach to talent all wrong. Rather than coming to China to find ready-to-use researchers, hybrids approach the labor pool with the idea of cultivating talent. This commitment works both ways. Local engineers often regard “local” firms, including hybrids,20 as more desirable employers. While former head of Philip’s Chinese R&D operations, Frans Greidanus, bemoaned the lack of local talent as the real bottleneck to Philips’ R&D operations in China, he readily admitted that the best talent goes to local firms.21 This is in line with the findings of Booz’s 2013 survey on R&D in China. He further conceded that there was lots of turnover and that people sought new experiences. What Greidanus did not do is further explore why they chose local firms over the MNCs in general. Equally telling, a global top ten telecommunications firm stated that it did not have staff turnover problems because unlike other MNC R&D centers it did not do “dull” research. The manger went on to say that “in China firms22 usually do blue sky or near product research” (Interview 440). In this manager’s mind, blue sky23 research would not retain people who wanted to be doing advanced, commercial R&D that at the end of the day would still be applied in a product relatively soon rather than decades after the research. While blue sky research sounds advanced, one of the largest IT firms in the world approached R&D in China explicitly with the idea of conducting basic science research: such research would be far removed from the commercializable IP the firm would want to protect. The firm first started a blue sky, pure science lab in 1995 and then initiated an R&D center in 1999. However, the R&D center limited its activities to design rather than more challenging and 20 Here hybrids may be somewhat more or less “local” in the estimation of local engineering workforces. China-based hybrids are regarded as “more” local and ECE-founded firms that have embraced the “twin towers” strategy are viewed as a bit less “local,” according to my interviews. 21 From the context of Greidanus’ speech on November 12, 2013, at Zhejiang University, it is clear that he was including many hybrids in his category of “local” companies. 22 In the context of the interview it was clear that by “firms” the interlocutor meant MNCs. 23 In this context, blue sky research is exploratory scientific research far removed from any nearterm practical application.

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sophisticated product architecture and thus did not hire PhDs. One manager overseeing teams in Beijing and elsewhere in the world stated bluntly that product management and architecture remained firmly in the United States. The local R&D center in China just took the design from testing to service (within wider software platforms) without any wider knowledge of the platform of products where a PhD would be required (Interviews 208, 263). This approach typifies the segmentation of R&D discussed by Quan and Chesbrough. In total, I obtained information through interviews on the R&D operations of 36 IT industry FIEs, which included ten hybrids and 26 MNCs. Among these 36 firms were 14 top twenty global IT firms in terms of revenue, three others were top ten global telecommunications firms, another two were global top ten computer firms, and another was a top three global software firm in 2003 (OECD 2004), which is the starting year for the patent data presented in the section 4.3. Another interviewed firm that did not exist in 2003 became a global top ten IT company. All of these large firms except one were MNCs rather than hybrids. From the interview data, I classified the firms’ R&D activities using a modified version of the Amsden-Tschang R&D typology (Amsden and Tschang 2003) in descending order from the most technically sophisticated basic research (stage 1) through applied research (stage 2) and detailed design (stage 3) to final development (stage 4). The interviewed MNCs’ activities generally have focused their activities in stages 3 and 4 while the hybrids all had some presence of stage 1 and/or stage 2 activities. One obviously can object that these interviews were not randomly selected and may not be representative of the IT industry or industry more widely. In order to assess the entire population of IT firms’ propensity for undertaking technological development activities in China, we will now turn to patent data.

4.3 Patent Data To demonstrate that hybrids outperform the MNCs and domestic Chinese firms in promoting technological development, this section examines US utility patent data from China. US utility patents are a relatively good standard for technological innovation (Fu and Yang 2009) because the United States is still the world’s largest and one of the most sophisticated technology markets and, unlike China, has an effective legal mechanism to protect the property rights that patents confer. Given that China’s patenting system also has severe technical problems in terms of vetting patent applications, US utility patents provide a much more accurate account of actual technological development than Chinese patents (Sun 2002). Additionally, the US Patent and Trademark Office (USPTO) records the location of the lead inventor of each patent. Lead 104

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inventors are the inventors credited with contributing the most to creating a particular patented technology. Thus, these lead inventor patents reflect the center of R&D activity for a given patent. The significance of the lead inventor and the fact that these data represent patenting across all industries makes these data very useful for testing the claims of this book.24 In contrast to US utility patents, China’s domestic patents often have little connection to innovation. China offers three types of patents: design, utility, and invention. Here utility and invention are the pertinent categories because these are the patents related to technical breakthroughs and improvements. However, Chinese utility patents differ greatly from US utility patents as they are essentially granted without an internal review process by the Chinese government, the idea being that this would balance the playing field in IP protection for SMEs. Unfortunately, anyone can apply for these patents. And they do apply because the Chinese state offers all sorts of incentives for firms and individuals, typically academics, to patent even if the patents are worthless.25 What is worse is that the lower quality, even often junk quality, utility patents are projected to grow proportionally larger vis-à-vis the inventor patents (Moga 2012). Although Chinese invention patents at least require a vetting of the patent application, irrational application incentives are in place for Chinese invention patents as well. The National Patent Development Strategy 2011–20 called for an increase from 1.2 million patents filed in 2010 to 2 million by 2015.26 The goal was reached three years early. Local governments also have many different promotional policies for promoting patents in their jurisdictions.27 Prud’homme (2012) found that 150 local patent targets were set by municipal and provincial governments, and patent applications are one of the criteria by which the central government judges its SOE managers. Local and central government incentives and subsidies run from paying for the patent application fees to tax breaks (Bound et al. 2013). Li’s (2012) research demonstrates that these government promotional policies have been the primary 24 The lead inventor data from the USPTO are limited to actively patenting firms (defined as firms that patent five patents within a given time frame, which is typically five years). While this definition eliminates some patents, I went through two years of USPTO utility patent data (2008 to 2009) using the Matheo patent analysis software in order to see if there were major differences in the total number of China lead inventor patents with or without this active patenting definition. I found an additional 46 lead inventor patents for hybrids, 59 for MNCs, and 51 for domestic firms. Using the active patenting criterion in total for these years, there were 1,139 for hybrids, 767 for MNCs, and 250 for domestic firms. The additional patents did not significantly alter the results. 25 Huang and Wu (2012) find that Chinese academics file nanotechnology patents for career advancement with almost half making no plans to otherwise utilize the patents. 26 The translation of the State Intellectual Property Office’s (SIPO) National Patent Development Plan is available at , downloaded on September 29, 2014. 27 Moga (2012: 18) has a list of various subsidies for filing and attorney fees offered by a number of provincial-level jurisdictions.

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drivers of China’s domestic patent explosion. Approximately 80 percent of Chinese SMEs are under the mistaken impression they need a patent to operate in a given industry. Moreover, the state has provided SMEs with over 10 billion RMB since 1999 both as rewards for and incentives to patent (Moga 2012). The net result is that China has witnessed an explosion of patents, including inventor patents, with little indication that this has enhanced technological development. Not surprisingly, Chinese firms often let their patents, even inventor patents, lapse. While inventor patents filed by Chinese are maintained for an average of five to 6.9 years, foreigners who file in China tend to maintain their patents for nine to 10.3 years on average.28 Even the 2013 implementation directive for the 2012 National Intellectual Property Strategy acknowledges the need for less quantity and more quality in China’s policy (Bound et al. 2013).29 By point of contrast, US and German patents tend to be maintained for 12 years and Japanese patents for 17 (Prud’homme 2012). In 2011, Mao Jinsheng, head of research at the State Intellectual Property Office (SIPO), China’s patent office, admitted that despite China’s surging domestic patent applications, patent quality remained a concern.30 Another report led by a scholar related to SIPO found the quality of Chinese invention patents below those of developed countries and noted that one of the contributing factors to the low quality was the subsidization of invention patent applications (Gao et al. 2011). There has also been a substantial state push for firms to file patents abroad. The National Patent Development Strategy for 2011–20 calls for a doubling of patent applications filed abroad and offers incentives to support this push. Subsidizing or even paying the full cost for foreign applications certainly lowers the threshold for local firms to file overseas. Similar to Li’s (2012) work on domestic patents, Hu (2010) recognizes policy inducements as one of the factors behind the surge in foreign patents from China. With subsidies to encourage foreign patenting available to them, Chinese firms actually have lower cost barriers to filing compared to foreign firms without such

28 Both of these averages are relative to a full twenty years of protection available for Chinese invention patents. The higher figures are from Bound et al. (2013) and the lower figures from Gao et al. (2011) where they also claim that only 4.6 percent of the invention patents were maintained for more than ten years. 29 The Promotion Plan for the Implementation of the National Intellectual Property Strategy in 2013 is available at , downloaded on September 30, 2014. 30 James Ockenden, “China must boost patent quality, protection and use, says IP boss,” Blueskies China, December 5, 2011. , downloaded on October 3, 2014.

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subsidies.31 For example, one large Taiwanese IT firm told me that his firm began to vet more carefully what patent applications its employees sent to the United States because they only wanted to pay the high application cost for valuable patents (Interview 281). In light of the criticisms of the quality of even China’s invention patents, this price difference between American and Chinese patent applications probably reveals a gap in inherent value between the two. Even if some state R&D subsidies do go to foreign and hybrid firms, the data from MOST suggest these subsidies are a very small amount of the whole. In 2000, 99.5 percent of direct government R&D support funds went to domestic firms, and 0.25 percent went each to ECE firms, which we will use as a proxy for hybrids, and non-ECE foreign firms, which we will use as a proxy for MNCs, respectively. For 2009, 86.8 percent of government subsidies for R&D went to domestic firms, 5.9 percent went to ECE firms, and 7.3 percent went to non-ECE foreign firms. For 2011, the figures were 86.6 percent, 5.7 percent, and 7.7 percent, respectively.32 Turning to the US utility patent data on China-based lead inventor utility patents, we find the hybrids consistently produced the most overall patents, the MNCs came in second, and the domestic firms did the worst. In other words, in patents where China-based researchers were contributing the most to the patent technology, hybrids were far ahead. When fast moving, technology-intensive, classic high-technology sectors were examined separately (here IT and bio-pharmaceuticals broadly defined were used as the hightechnology sectors), the patterns were even more pronounced in favor of hybrids and, secondarily, multinationals (Figure 4.1).33 As Chapter 7 will explain, hybrids work best in such classic high-technology sectors, and thus it is not surprising that their relative success in these sectors is even more pronounced. The poor performance of the domestic firms looks even more dismal when one considers that 57 percent of the domestic firms’ lead inventor patents came from one firm, Huawei. One could think that these patent patterns were simply driven by differences in R&D expenditures or fixed asset investment. However, domestic firms have invested far more in R&D and fixed asset investment in China than MNCs or hybrids. Furthermore, hybrids have invested the least in R&D (see Table 4.1). The R&D and investment figures almost certainly overstate the

31 Prud-homme (2012: 52) makes a related point by pointing out how poorly SOEs in generally perform in terms of patenting within China given the tremendous amount of direct and indirect subsidies they receive. 32 These figures are from MOST’s Zhongguo Kexue Jishu Zhibiao [China Science and Technology Indicators] 2002, 2010, and 2012, respectively. 33 It should be noted that IT and bio-pharmaceuticals typically account for 70 percent of all patents (Walsh 2003).

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Paper Tigers, Hidden Dragons 3500 3000 2500 2000 1500 1000 500 0 2003–2007

2007–2011 Hybrids

03–07 Tech MNCs

07–11 Tech

Domestic

Figure 4.1 US utility lead inventor patents by firm type Source: Author’s calculations based on United States Patent and Trademark Office’s Patent Technology Monitoring Team data. Notes: Patents for 2007 appearing in the 2003–2007 data were not included in the 2007–2011 data. The two “Tech” categories included all patents that were assigned to companies active in the IT and bio-pharmaceutical categories, broadly defined.

Table 4.1 Fixed asset investments and R&D by firm type (%) Investment category Fixed asset investment (2000) Fixed asset investment (2003) Fixed asset investment (2009) Fixed asset investment (2011) R&D (2000) R&D (2004) R&D (2009) R&D (2011)

Hybrids

MNCs

Domestic firms

4.8 5.3 3.2 3.0 8.3 8.0 9.7 9.3

3.2 3.5 3.7 3.0 12.1 19.1 16.7 15.7

92.0 91.2 93.1 94.0 79.5 72.9 73.6 75.0

Source: Author’s calculations based on MOST’s Kexue Jishu Zhibiao (2002, 2006, 2010, 2012); Naughton (2007: 413); Brandt and Rawski (2008: 354–5); and Chinese National Statistical Bureau’s National Statistical Yearbook (2010, 2012).

share of hybrids and MNCs because the figures are based on the official registration of the firms and as Yasheng Huang (2003, 2008) and others have shown, many firms in the past claimed to be foreign when they were in fact domestic firms. The statistics also likely overstate the R&D spending and, especially, the investment of the hybrids vis-à-vis the MNCs because the data used in Table 4.1 took the ECE data as a proxy for the hybrids and classified all other foreign investment and R&D as MNCs. We do know that many ECE firms 108

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have not embraced the China-based operational strategy and thus such firms are MNCs. Offsetting this inflation of the hybrid category is the fact that much investment for hybrids comes from places other than the ECEs. There are important sectoral differences. The domestic firms did better in the mature technology sectors (derived by subtracting the high-technology patents from the total patents) than the MNCs and hybrids. In 2003 to 2007, the domestic firms had 90 mature technology patents to 46 for MNCs and only 18 for hybrids. In 2007 to 2011, there were 260 mature technology patents for domestic firms versus 85 for MNCs and 37 for hybrids. This finding fits this book’s prediction (discussed in detail in Chapter 7) that the hybrids do best in high-technology sectors, and also conforms to the findings of Brandt and Thun (2010) who found domestic firms are better able to compete against MNCs in mature, medium-technology sectors. However, given the much larger amounts spent on R&D by domestic firms, their greater share of mature technology patents is still disproportionately small controlling for their greater R&D and fixed asset investment. After all, in terms of R&D, the domestic should have had approximately eight or nine times the output of the hybrids.34 Therefore, it probably is more accurate to say that the performance gap between the hybrids and MNCs, on the one hand, and the domestic firms is reduced in mature technologies, but that the MNCs and hybrids still slightly outperform domestic firms in mature technology patenting when one controls for the R&D investment input. In any case, domestic firms dramatically underperform hybrids and MNCs in their overall patent output and high-technology patent output despite state support for R&D and patenting. Given their large share of R&D investment and fixed asset investment, even if the domestic firms accounted for 50 or even 70 percent of the total lead inventor patents, they would be underperforming. While MNCs may still be drawing on large offshore capabilities and human resources when creating their China-led utility patents, hybrids have much less impressive offshore resources to draw upon, which makes their onshore performance that much more impressive.

34

If one takes the narrowest gap in R&D (2009) and multiplies 7.59 (the ratio of domestic to hybrid R&D) by the number of hybrid mature technology patents for 2007–2011, one still gets 280 patents, i.e. more patents than the domestic firms produced.

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Part III The Integrated Circuit Industry

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Introduction to Part III

Almost three years after my 1998 visit to the failed state-backed champion, Huajing, in Wuxi, I visited a respected fab1 manager who had worked for US fabs and TSMC before moving to China to pursue his lifelong dream of bringing technology to China. He was working out of a prefabricated office surrounded by fields of mud and a very large hole out of which were rising some girders serving as hopeful hints of the possibility of a building. Despite these bleak surroundings, the site was bustling with activity. The international team recruited to create the new pureplay foundry, SMIC, was an impressive one including engineers from TSMC and UMC, the two largest pureplay foundries in the world, as well as prominent integrated device manufacturers (IDMs), such as Texas Instruments (TI). The firm did not yet have a fab, but they had a viable strategy and the team to execute it. These two features put them two moves ahead of the Project 908 firm, Huajing. Clearly, China’s silicon fortunes had taken a turn for the better. The following year I went back with some MIT electrical engineering professors to see SMIC’s fab in operation. The electrical engineers were clearly impressed and complimented the fab manager on his success. The engineers had started the trip pessimistic about China’s prospects, but the visits to SMIC and other firms changed their minds. Part III of this book is the story of China’s silicon success. I chose to study the microelectronics (meaning semiconductors or, even more colloquially, computer chips) sector because microelectronics is commonly seen as one of value centers and technology drivers of IT (Macher et al. 1999). The subsectors of semiconductors examined are fabrication (chipmaking) and design. The sophisticated technology needed for semiconductor production makes this segment of IT a good critical case for exploring routes to technological upgrading, because many assume MNCs are either

1

A fab is a fabrication facility (manufacturing plant for chip-making).

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unwilling or unable to transfer the most sophisticated technologies to host countries (Song 1998). If such firms are fostering technological upgrading in the advanced technology of microelectronics, then such firms may be even more willing and capable to upgrade in other areas in the IT industry in China. Part III will examine the more technology-intensive segments of the semiconductor production chain, design and fabrication. Part III will not examine the assembly and testing of integrated circuits ICs, often referred to as the backend of the IC production chain, because the backend is less technologically intensive and is not the core technology and value creation center of the semiconductor production chain.2 Historically, the developing world has had assembly and testing operations due to the labor-intensive nature of the work, and these operations did not necessarily lead to the development of the more technologically sophisticated frontend skills of design and fabrication.

The Structure of the Integrated Circuit Industry The semiconductor value chain is broken down into three large blocks of activities (excluding marketing and distribution): design, fabrication, and assembly & testing (Figure III.1). The design stage is the execution of a design idea into code (typically a GDSII file) that serves as the blueprint for the IC in the fabrication stage. The design stage itself consists of a number of discrete steps that will be discussed in greater detail in Chapter 6. The fabrication stage takes the code and, according to the code, inscribes circuitry onto physical material (typically a type of silicon) using lithography and treats the physical material with chemicals. The result of this fabrication process is the IC, but the IC is not yet complete. In the final stage, the IC undergoes: (1) assembly of its packaging that protects it and allows it to connect to other electronic components and devices and (2) testing to see if it works properly. There is significant know-how at the interface of the design functions and the wafer fab functions. The IC fabrication process and resulting device specifications are captured in a sophisticated set of models that are provided by wafer foundries. These models encapsulate the detailed physics of the transistors so that the designers can simulate the operation of the circuit before fabrication. Successful wafer foundries have considerable expertise in making

2 My discussions with Intel employees in March of 2004 reconfirmed this notion of the noncritical nature of the backend.

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Introduction to Part III

Design

Fabrication

• From idea to GDSII file • Discrete stages of design

• Integrated circuits created on silicon wafers

• Key input: intellectual property

• Key input: capital equipment

Assembly and Testing • Relatively low technology intensity

Figure III.1 Integrated circuit value chain

this interface user-friendly with the aid of web-based tools for easy information transfer. Traditionally, vertically integrated firms called integrated device manufacturers (IDMs) dominated the IC industry. IDMs perform all three functions though they often outsource assembly and testing operations. Today, many IDMs are following a fab-light strategy utilizing less internal chip-making capacity that follows the progressive abandonment of in-house assembly and test operations. In place of IDMs, the industry has witnessed the rise of dedicated design firms and dedicated fabrication firms (pureplay foundries) over the last twenty-five years (Hurtarte et al. 2007). There are two types of dedicated design firms: fabless design houses that design and market their own chips, and design service firms that undertake part or the whole design process for other firms. Foundries typically have large R&D departments for process technology and also capture value by being more efficient in fabrication due to their focus and flexibility. They compete by offering, multiple processes and multiple products in the same fabrication facilities and even on the same wafer in the case of multi-product wafer (MPW) production. Foundries also compete on the service elements of fabrication by trying to provide ever more detailed information about the timing and quality of production to their customers via the Internet. At the leading foundries, customers can receive real-time data on their wafers as they are being fabricated. The need for a design firm to reveal IP to foundries in order for the foundry to be able to fabricate the chips 115

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necessitates that foundries strive to protect customer IP in order to keep clients and attract new ones.3 The Chinese state has not been unaware of the changes in this industry. As will be seen in the next two chapters, the Chinese state has had policies promoting both new types of firms (fabless design houses and foundries) as well as IDMs.

3

116

The preceding three paragraphs draw on Fuller et al. (2013).

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5 IC Fabrication

5.1 Introduction China’s semiconductor industry can be said to have started in 1956 when China’s first transistor was created (Dewey Ballantine 2003, hereafter referred to as DB 2003). Others date the start of China’s semiconductor industry to 1965 when China created its first integrated circuit only seven years after the ICs were invented in the United States by Texas Instruments (TI) and Fairchild. When the Chinese Academy of Science (CAS) started its IC research in 1965, China was far ahead of Taiwan and Korea in ICs as neither of these economies had any IC industry to speak of (DYBG 2002, No. 11). This period of self-reliance (ziligengsheng) lasted well into the era of economic reforms with the first major effort to improve China’s commercial fabrication technology starting in 1991 with the 908 Project. This chapter covers the IC fabrication sector where Chinese state industrial policy has in recent decades tried to build competitive local champions using SOEs without much success. In light of this lack of success, the state has turned to encroaching upon successful hybrid firms—a variation on the guojin mintui (“the state advances, the private sector retreats”) phenomenon. Recently, a similar impingement appears to have begun in the design sector (see Chapter 6).

5.1.1 Technical Note Before we begin the account of fabrication in China, a technical note is in order. IC fabrication process technology is most typically measured in the width of lithography used to etch the circuits onto silicon with the lithography becoming finer and finer so the widths shrink. In the 1990s, the lithography widths were typically measured in microns, but as they grew smaller, the industry began to discuss them in nanometers. One micron is the equivalent of 1000 nanometers so 0.18 microns is the same size as 180 nm.

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The key thing to remember is that the smaller the size ceteris paribus the more advanced the process technology. Fabs are also measured in terms of the size of the wafers that are processed. Newer generations of fabs can process larger wafers and thus can create more chips per wafer processed. The current generation is 300-mm (or 12-inch) and the preceding generation was 200-mm (or 8-inch).

5.2 State Projects While the Chinese state attempted a series of grand projects to leapfrog into the silicon age, its plans were burdened from the beginning by being attached to SOEs and the managerial and production inefficiencies associated with such firms. These firms, furthermore, were blessed and cursed by state beneficence. With assured state support, these firms were able to enter more advanced semiconductor manufacturing, but the state support undermined the financial discipline that could have forced the firms to hone their competitive advantages. Instead, these firms were either late in achieving the goals set for them, dependent on their foreign partners for technology, or both.

5.2.1 The Chinese IC Industry’s Huangpu Academy: Huajing and the 908 Project The Huajing Group was originally Wuxi Factory No. 742, established in 1960. The factory has been hailed as the “Huangpu Military Academy of China’s semiconductor industry,” referring to the famed KMT1 military academy in Guangzhou that trained many of the military cadres of both the KMT and CCP. The factory did indeed train much of the early personnel of China’s fledgling semiconductor industry, and, as Chinese semiconductor engineers of a certain age never tire of reminding people, in the early 1960s China’s semiconductor technology was at least as sophisticated as Japan’s. Despite these prestigious origins, Huajing was the main failure at the center of the state’s semiconductor industrial policy in the 1990s. In preparation for the Eighth Five-Year Plan (FYP) (1991–5), the Huajing Group was selected to be the vehicle for a project to lift China’s semiconductor manufacturing up to 150-mm wafer technology, which was the largest wafer size at that time. The government decided upon the plan in August of 1990 so the plan was dubbed the 908 Project. The government spent 2 billion RMB to complete the modest goals of the project to build a 150-mm fab with 0.8 to 1 KMT is the abbreviation for the Wade-Giles romanization of the Chinese name of the Nationalist Party that ruled China prior to the CCP takeover.

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1.2-micron process technology (which, even at the time, was not the technological frontier in process technology), for a moderate monthly output of 12,000 wafers (DYBG 2002, No. 14). Despite the modesty of the goals, the project took eight years to complete, and when it was finished, the fab remained virtually empty as Huajing had no idea how to operate the fab as a commercial enterprise. The resulting problems from this long delay in ramping up the project were manifold. By the time the plant came on line, the technology was very backward as 200-mm fabs were already mainstream. The capacity was also quite small so it was hard to earn back the initial investment. According to a MOST report, massive losses hindered the advance of the entire Huajing Group (DYBG 2002, No. 14). The primary foreign partner for the technology transfer was Lucent Technologies. Lucent was very eager to sell more telecommunications infrastructure equipment in China and participating in this technology transfer project seemed to be a good way to curry favor with the Chinese state. Lucent not only provided process technology, but also provided a design library so Huajing could design its own products. Lucent did not take a stake in the firm nor promise to be a major customer. Unfortunately, even with Lucent’s help, things did not go as planned. Engineering professors from MIT who visited in January of 1998 reported that the firm’s own engineers had no idea what products to design despite access to the design library. The fab was essentially empty because there were no products to produce. In the summer of 1998, a Lucent employee heavily involved in the technology transfer reported much the same dilemma (Interview July 11, 1998). Happily, there was already a glimmer of hope for the fabrication operation. Central Semiconductor Manufacturing Corporation (CSMC), a Hong Kongregistered firm with strong links to Mosel-Vitelic, a Taiwanese semiconductor firm, proposed to rent the fab in order to use it as a foundry for low-end products in line with the fab’s backward technology. Huajing agreed to this proposal in 1998 and operations commenced. In 1999, CSMC took formal ownership of the fab through the establishment of CSMC-HJ, a 51 percent CSMC owned joint venture. By 2002, CSMC had taken control of another fab line, a 125-mm (5-inch) line, from Huajing (according to company materials given to the author in July 2002). A planned national champion had become a subsidiary of a hybrid FIE. This was hardly what the central state, especially the technocrats at Ministry of Electronics Industry (MEI), had envisaged when they embarked on the 908 Project back in 1990. What happened to the design library Huajing received from Lucent? Later evidence bears out the early pessimistic reports from the MIT engineers and the Lucent employee that the design library was never effectively used to 119

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design products. Huajing Group has a wide array of low-end products, but these are all very low-end and low-profit items. Huajing’s well-known and relatively large (by Chinese industry standards) design house, Semico (Xike), has been regarded as a typical reverse engineering design house among technology people familiar with the Chinese industry (Interviews July 11, 1998; 253, 299). In 2002, China Resources, a Hong Kong red chip,2 bought a controlling share of Semico. Huajing also did not contribute much to diffusing technology in China. A former Huajing employee, who subsequently received training abroad in a large IDM, remarked in 2004 that a lot of Huajing’s designers had left the firm to set up their own fabless design companies in Wuxi, but these engineers were just doing the same thing they did ten years ago, reverse engineering of low-end designs. He was emphatic that there was no way these ex-Huajing employees could do contemporary, large-scale design known as System-on-aChip (SoC), where many functions are integrated into the chip design requiring very large and complicated designs (Interview 299). In short, Huajing did not manage to make much of the resources that Lucent gave the firm, and many of these assets eventually left Huajing’s control. On top of which, Huajing also failed to diffuse technology to others. From the Chinese state’s techno-nationalist perspective, the failure of Huajing was two-fold: (1) Chinese-controlled technology did not get much closer to the technological frontier in the IC industry and (2) the selected national champion was not strengthened. However, this study does not denigrate the transfer of assets to foreign control if foreign control enhances the capabilities of Chinese or the industrial infrastructure in China. On these grounds, the 908 Plan via CSMC was a modest success albeit not in the way envisioned by the government. The takeover of two fabs by CSMC while using the same engineers that were originally in Huajing offered these engineers the opportunity to learn how to operate more efficiently and familiarize themselves with the foundry business, albeit with relatively backward process technology. As one former Mosel-Vitelic and CSMC manager observed, CSMC used the same engineers from Huajing, but they were under better management (Interview July 11, 1998). The hybrid, CSMC,3 pushed China’s fabrication closer to the international technology frontier, but in a rather modest way. A fab with old process 2 Red chips are Hong Kong-listed firms with links to the Chinese government. China Resources is linked to the Ministry of Commerce (MOC). 3 Why was CSMC a hybrid FIE rather than an MNC? CSMC was a hybrid FIE because the firm clearly was conducting a China-based operational strategy on the two criteria outlined in the Introduction: self-described strategy and functional headquarters. CSMC explicitly proclaimed its desire to serve the growing manufacturing base of China. All of the firm’s fabs were in China. Examining the balance of operations, the firm’s operational resources were based almost entirely in the PRC despite registration in Hong Kong. Outside of China, CSMC had only sales offices.

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technologies, such as Huajing’s 908 fab, would only attract an investor who was seeking to do low-end fabrication. Thus, Huajing attracted the start-up, CSMC, to start a foundry business rather than a top-tier foundry. Nevertheless, CSMC did at least manage to come up with a business plan that filled the fab with orders and taught Chinese engineers how to run a foundry business using a 150-mm wafer line. Only with the arrival of CSMC did the fab begin to function as a commercial enterprise and the fab was one of China’s first two 150-mm fabs. Hybrid CSMC accomplished embedded technological upgrading where the domestic champion, Huajing, could not. CSMC was the first foundry in China with a 150-mm, 0.8 to 1.2-micron fab that competed in the open marketplace. The technology was ten years behind the technology frontier in 1998, but this gap was smaller than the gap between China and the global frontier prior to CSMC (see Table 5.1). The process technology employed at CSMC was embedded in the local environment because local engineers ran the process with only a handful of Taiwanese executives in the firm at any one time. After 1998, CSMC maintained its strategy of being a low-cost fab following approximately ten years behind the technology frontier. Furthermore, the firm has not grown substantially after its initial growth spurt. Revenues have stayed below USD 200 million for the past decade.4 Like other firms, CSMC became a victim of state encroachment. The red chip China Resources Holdings was originally a minority shareholder and became the majority shareholder in 2006. CSMC and China Resources’ CR Logic were amalgamated in January 2008. Takeover by those connected to the Chinese state had its financial benefits. Due to its government connections, the firm received a USD 200 million bailout from the government during the severe downturn that accompanied the onset of the global financial crisis (FT 2.8.2009). Of course, the use of government funding to save a technologically backward firm is questionable on technological development policy grounds. By contrast, Taiwan cut off tax incentives for similar trailing-edge fabs in 2000.5 One positive, unintended consequence of the failure of Huajing’s fab and the subsequent takeover of operations by the hybrid CSMC was the gradual inflow of talent from Taiwan. Nasa Tsai (Cai Nanxiong), one-time president and chairman of Grace Semiconductor, came to China via CSMC. Tony Liu (Liu Youhai), later CEO of Advanced Semiconductor Manufacturing 4 As China Resources Microelectronics Holdings bought out CSMC, this statement about revenues refers only to the foundry business, the original CSMC, within the larger holding company through 2011 (PWC 2012). 5 It should be noted that Taiwan cut off tax breaks for 150-mm fabs in 2000 because they were deemed too out-of-date to merit support. CSMC still had such old fabs when it was bailed out in 2009.

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Paper Tigers, Hidden Dragons Table 5.1 China’s gap with leading international IC fabrication Year

China (embedded)

1979 1986 1995 1998 2003 2012

25- to 30-mm wafers 5-microns technology 3-microns 0.8-microns (CSMC) 0.13-microns logic (SMIC) 40-nm logic (SMIC)

Years behind 16 14 19 10 1–2 1–2

Sources: Mathews and Cho (2000); GAO (2002); Dewey Ballantine (2003); ITRS; Cash Research 2004.

Corporation (ASMC), also spent time at CSMC before moving on to head ASMC. As for locals, many moved on to other firms after receiving some training in conjunction with CSMC.

5.2.2 The Big Statist Push: Huahong and the 909 Project With the advent of the Ninth FYP (1996–2000), the Chinese government embarked on a second major effort to catch up to the technological frontier, dubbed the 909 Project as it followed the 908 Project. The Ministry of Information Industry (MII)6 and Shanghai Municipality created the Huahong7 Group with shares distributed between the two government entities in a 60:40 split. Huahong was charged with the task of being the Chinese SOE that would hold a majority share in the 200-mm JV fab that was the centerpiece of the project. Then, NEC was selected as the JV partner and technology source. For the JV, Huahong NEC (HHNEC), Huahong put up USD 500 million for 71.4 percent of the equity and NEC put up USD 200 million for 28.6 percent of the equity. In 2002, HHNEC already had a staff of 800 (DYBG 2002, No. 11). The goal was to create a commercial 200-mm fab with 0.5-micron technology.8 NEC was to run the fab for the first five years and then turn it over to Chinese management. Some central government bureaucrats argued that this was a sweet deal for NEC since they could control a 200-mm fab for five years for USD 200 million, a fraction of the cost of such a fab (Interview 65). The 909 Project was expensive. The total expenditure was 10 billion RMB (USD 1.25 billion in contemporary prices), or three times what Taiwan spent during its whole ramp-up stage for its IC fabrication; Huahong could have

6 MII was created from merging the Ministry of Electronics Industry (MEI) and the Ministry of Posts and Telecommunications (MPT) in 1998. MII’s China Electronics Corporation (CEC) took charge of MII’s investment in Huahong. 7 Huahong is sometimes spelled Hua Hong in English. 8 This technology was later upgraded to 0.35-micron (DYBG 2002, No. 11).

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bought its own fab for this amount. The firm also incurred heavy losses. In 2001, the firm lost 80 billion RMB (USD 6.4 billion in contemporary prices) alone. This huge loss clearly outweighed the nominal profits of 30 million RMB in 1999 and 3.5 to 5 billion RMB in 2000 (DYBG 2002, No. 11). The losses were quite surprising in light of the massive amounts of state procurement funneled through Huahong’s design firm (at that point called Huahong ASIC), which designed smart cards and social security cards for Shanghai Municipality and ID cards as part of the nationwide project to have chip-based ID cards. Huahong ASIC had all of these cards produced at Huahong NEC (Interviews 101, 102).9 Some have viewed the 909 Project as an important break from past technology policy practice (Naughton 1999),10 but according to analysis by MOST (DYBG 2002, No. 11), the three goals set out for HHNEC did not differ significantly from previous state ambitions. The first goal was to establish an independent IP portfolio in the IC industry to break the control that America and other leading countries had over IC technology. The second goal was to use China’s huge market to create an internationally competitive IC giant. These goals clearly show how little China broke with their past technonationalist ambitions in promoting the 909 Project. The idea of using the country’s large market to create a competitive IC industry is one that continues to be promoted by local and central government officials alike. The third goal was to train a large group of specialists in IC technology, industrial technology, and management of the IC industry. The analysis by MOST suggests a mere shift in tactics from a state-planned approach in the 908 Project to a JV approach in the 909 Project with techno-nationalist, statedriven plans forming the strategic backbone of the project. Discussions with state sources familiar with Huahong confirmed these techno-nationalist ambitions (Interviews July 14, 1998; 101). The goal to create Chinese IP was understandable given the international context of the 909 Project. Undoubtedly, the technology export controls of the Cold War-era Coordinating Committee for Multilateral Export Controls (COCOM) and the subsequent, although much weaker, Wassenaar Agreement11 heightened China’s sense of vulnerability and dependency in this 9 One of the interview subjects also mentioned that the driving force behind Shanghai’s very active support for the IC industry was the then-acting mayor and former head of the municipal informatization office, Chen Liangyu (Interview 101). Chen of course later fell from his high position of party secretary of Shanghai in a major corruption scandal. 10 Naughton sees the 909 Project as a move away from what he dubs China’s critical technologies approach to technology policy. According to Naughton, prior to the Ninth FYP China pursued a very rigid state-planned form of techno-nationalism in which the state carried out plans to develop indigenously various technologies deemed critical for economic and security reasons. These plans were carried out by state-run institutions, research units as well as SOEs, and eschewed foreign cooperation. 11 The Wassenaar Agreement was the post-Cold War technology export control regime that replaced COCOM.

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area. In the latter half of the 1990s, the ability of China to import US capital equipment for 200-mm fabs was still much in doubt due to the stringent American interpretation of the Wassenaar Agreement and was one of the reasons that China chose NEC over competing bids by IBM and Rockwell. The ability of Motorola to import 200-mm equipment in the late 1990s was the first sign that the United States was beginning to relent, given the looser interpretation of the Wassenaar Agreement by other major IC capital equipment manufacturers, such as Japan.12 While the first goal was understandable given the international context and the third goal was one shared by technoglobalists and techno-nationalists alike, the goal of creating a state-owned national champion in the IC industry shows how little the Chinese state had departed from its earlier thinking on technological development. What would be amusing if it were not so sad was the conclusion drawn by officials from MOST that one of the major problems with the Huahong Group was that the group was run by a bunch of government hacks or as they more politely phrased it, “As for Huahong Group’s managerial staff, most are originally government officials who now are involved in the work of management. Talented people with real skills in modern enterprise management are rarely seen” (DYBG 2002, No. 11: 7). The same year this report was written, two central government officials involved in promoting the IC industry expressed the same sentiment about the low quality of these officials-cummanagers as a major problem for the industry’s development (Interview 65). The MOST report also noted that the technology remained in hands of the Japanese and no Chinese IP had been created. Japanese control of the technology was confirmed by three sources very familiar with the firm who suggested the situation was even bleaker than the MOST officials’ account because the technology captured by HHNEC was narrower than the MOST officials realized. The first source was two managers who were familiar with HHNEC and the Huahong Group and jointly interviewed early in the HHNEC’s history (Interview July 14, 1998). Their concerns that China would not be able to control the technology might have been relieved through later technological transfer as it is reasonable to expect technology transfer to take some time. Unfortunately, such extensive technology transfer to Chinese hands did not happen. The second interview source, who was very familiar with HHNEC’s internal management, stated bluntly in 2002 that the technology remained firmly in Japanese hands through management of the training process. The Japanese made sure to train the Chinese engineers in specific

12

There were persistent rumors that Motorola imported more advanced equipment than US export controls of the time allowed in the late 1990s or 2000. If true, this movement was probably due to Motorola correctly anticipating the loosening of the export controls.

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tasks in order to retain knowledge of the whole process of fabrication in Japanese hands. No Chinese engineer learned much about the process outside of his narrow specialty and the Japanese made sure not to train anyone capable of managing the integration of these tasks. He lamented “The Taiwanese can build wafers; we cannot. We do not have process technology. Our engineers [in Huahong] can handle a single process but do not have integration capacity.” He went on to conclude, “So we cannot say this industry is a Chinese industry. This is [just a] wafer fab located in China” (Interview 101). He believed one could only have a true Chinese firm when the management became Chinese and the chip designs were from China, but this was unlikely to occur. This interview subject very much doubted the ability of the Chinese to run the fab without Japanese technical help even after the five years of NEC management expired. As late as 2003, a third interview source, a potential customer of HHNEC based in Shanghai, reported that HHNEC did not have the level of technology it reported to have, at least not in a stabilized ready-for-manufacturing state. More troubling still, when conversing with HHNEC’s engineers about the 0.35-micron technology that the source needed to fabricate his chips, it became apparent that the Chinese engineers could not actually run the process with the technology on hand. As the Chinese engineers explained to the potential customer, the technology necessary to run the 0.35-micron process remained in Japan and the Chinese engineering staff did not have access to this technology. To verify that HHNEC could actually fabricate the chip he wanted, the customer would need to confer with NEC’s Japanese engineers in Japan. Even though 0.35-micron technology was far from the frontier in 2003, the Japanese still resisted turning it over to Chinese engineers (Interview 260). The technological dependence on the Japanese was not rectified until David N. K. Wang (Wang Ning-Guo), a Taiwanese American executive from Applied Materials, a semiconductor equipment manufacturer, and his returnee-heavy team took over in 2005. Judging the first seven or so years of HHNEC by the standard of embedded technological upgrading, the firm was a failure. Even if the firm did have 200mm wafers running at 0.25-micron process technology, a large improvement over previous fabs in China, the firm failed to pass this technology on to local employees or local suppliers, the key criteria for the test of embeddedness at the firm level. Instead, the process technology remained firmly in Japanese hands. MOST officials saw no way out for HHNEC except for more government procurement. Their main suggestion for how the Huahong Group could turn around HHNEC was for the firm to rely on IC card sales to the government as part of its National Management Systems Project. More dangerously, they suggested that the firm needed “to lift up its financial capability and expand 125

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its cash flow,” which given its SOE status meant spending more of the state’s money on this dubious venture (DYBG 2002, No. 11: 7). The fact that the officials involved in technology policy still viewed the solutions as more loans from the state banks (the call for lifting the financial capability) and more procurement (call for the expansion of cash flow) demonstrates the reliance on the state at the heart of Chinese SOEs’ soft budget problems.13 Indeed, as early as 2002, Huahong’s main source of revenue was supplying national ID smart cards and Shanghai social security smart cards to the state (Leng 2002; Interviews 101, 102). Sadly, in Huahong’s case, policy prescription became prophecy as Huahong has continued to rely on the state despite failed experiments to branch out into the commercial marketplace.

5.2.3 Huahong after the Japanese Huahong has not failed due to a lack of new initiatives. Nor has it failed due to a lack of returnees. Indeed, during the latter half of the past decade, Huahong tried vigorously to become a competitive IC firm by mimicking the strategies of SMIC and Grace in terms of their large numbers of returnees and foundry model. Huahong hired David N. K. Wang to turn around Huahong in September 2005. Wang brought with him a team of experienced returnee experts, primarily from SMIC, including fab management guru, T. Y. Chiu (Qiu Ciyun). With the arrival of this new, highly experienced team, Huahong’s dependence on Japanese technical staff ended. Bringing in a new team was only the beginning. Wang realized that Huahong would need a new business model beyond state procurement if it were to become a successful commercial enterprise. His plan was to make Huahong a “virtual IDM” where small fabless firms would not only come to fab their products, but would also receive Huahong’s help as a marketing channel for their products. Wang recognized that Huahong needed a new technology partner for relatively advanced technologies and a dedicated customer for this plan. He also felt that to compete at contemporarily relatively cutting edge 90-nm technology the firm had to invest in a 300-mm fab because 90-nm could not be economically produced on 200-mm lines. One idea Wang pursued was to team up with Huahong shareholder, China Electronics Corporation (CEC), to lure a foreign chip producer with the promise of a captive market for digital TV chips via CEC. The targeted foreign firm was ST Micro. ST Micro wanted a large sum of money for the technology transfer for 90-nm for a 300-mm fab—something in the order of USD 100 million—and ST Micro would not budge from its demands because it already 13 See for example the calls for a state-led consolidation of Shanghai’s industry in government pronouncements in 2009 (ESJJBD 6/15/2009).

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was doing very well in China’s TV chip market. The state or Huahong (it varies by account) were not willing to pay ST Micro such a large fee for relatively old technology so the deal fell through (Interviews June 21, 2013; 438). Wang’s team decided to stake Huahong’s future on another plan. IBM would supply the technology and Spansion, a flash memory producer, would be the major customer for the new fab’s large production capacity. Wang also lined up TPG, Silver Lake, and several other foreign private equity firms to invest. In the meantime, T. Y. Chiu and the new team had turned Huahong profitable through relying on large orders of liquid crystal display (LCD) driver chips from NEC to supplement state procurement (Interview 379). Unfortunately, there was a hitch in these plans. As enthusiastic as China’s top leadership was about the new ambitious plans for Huahong,14 the state bureaucrats with the power to release the funds were reluctant to do so because of fears that selling even a minority share15 to foreign investors would make them susceptible to the charge of having mismanaged state assets. They were slow to react because there were a number of bureaucracies involved given the various state owners behind Huahong. Just among Huahong’s shareholders, there were the central government’s MII-related CEC and various Shanghai SOEs representing the Shanghai municipal government. On top of that, State-owned Assets Supervision and Administration of the State Council (SASAC), MII, and the NDRC involved themselves in key strategic decisions. While the state bureaucrats dragged their collective feet in marshaling the USD 1.5 billion needed, Spansion gave up on the plan. With Spansion bailing, the private equity partners pulled out and the plan collapsed (Interview 379).16 In the wake of these various deals falling apart, Wang and his entire team left in June 2007. With the departure of Wang’s team, HHNEC quickly fell back into the red. In part, this reversal was due to NEC’s decision to divert its LCD chip orders back home in order to fill its own fabs, but Huahong also showed its usual

14 The former member of David Wang’s executive management team who provided this information had pictures of himself with President Jiang Zemin and Premier Wen Jiabao on his wall. The interview subject stated that the top leaders were quite enthusiastic about the industry although quite ignorant about the technology itself (Interview 379). 15 David Wang had originally argued that the new fab should be majority foreign-owned in order to attract foreign investment but the state bureaucrats were adamantly opposed. 16 A slightly different account claims that the executives at Huahong NEC scuttled a potential fab deal with ST Micro and foreign private equity firms with Silver Lake Partners in the lead by claiming that Huahong International, the vehicle for Silver Lake investment, had no control rights over HHNEC (Interview 438). This account is not very believable in that Wang was CEO of the entire Huahong Group and chairman of HHNEC. A former member of the management of Wang’s at Huahong stated on June 21, 2013, that the story was incorrect and Silver Lake withdrew from the collapsed ST Micro deal.

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inability to find any new customers or markets. Instead, it reverted back to relying on state procurement of IC cards (Interviews 376, 379). Ironically, the money was finally approved shortly after Wang had left Huahong, but with Spansion out of the picture, there was no realistic plan for filling the capacity of the 300-mm fab. Huahong invited Wang to come back to manage the firm, but viewing Huahong as a firm without a future, Wang declined to return (Interview 379). This money most likely became the state funds used to found the Huahong–Grace 300-mm JV, Huali, which began construction in 2010. The Shanghai government in its 2009 Opinion on high-tech17 and elsewhere indicated that building a 300-mm fab was a priority. There was concern in government that many firms, including the foundry Grace, had left unused large areas of the land they were provided under generous terms by the Shanghai government (ESJJBD 6.15.2009). Given the Shanghai government’s determination to make better use of industrial land and perceived need for the latest generation 300-mm fabs, as well as the reorganization of Shanghai’s Huahong Group, it is not surprising that Huahong first pursued a 300-mm JV with Grace using Grace’s empty land and then bought Grace outright in late 2011. The fundamental issue over Huahong’s investment in a new 300-mm fab in hindsight seems to have been that CEC was the major shareholder and its bureaucrats were more risk averse than Shanghai bureaucrats, given that they still ran a firm rather than a whole local jurisdiction. After all, the latter officials would benefit from this investment because even if there were initial losses, it would be located in Shanghai. Indeed, once Shanghai took over, the money for Huali came through immediately. As one former insider put it, “Even Hu Jintao [and] Wen Jiabao had signed, [but] couldn’t get the money. CEC did not want to do 12-inch [i.e. 300-mm fab] because they knew it would lose money in the first few years. They [CEC managers] do not care about industry growth. They care about their jobs—too risky. Finally, five years after [David Wang had joined the firm], the money came through. Shanghai gave Huahong Design [and] Belling to CEC and finally Shanghai had more than 50 percent of Huahong so Shanghai [was] willing to put money into firm it controlled” (Interview June 21, 2013). As for the Huahong acquisition of Grace, the prolonged nature of the courtship of Huahong and Grace from 2008/2009 until the end of 2011 reportedly was due to haggling over which firm would buy out the other. However, this was not a case of considering selling state assets to foreign firms “Guanyu Jiakuai Tuijin Shanghai Gaoxin Jishu Chanyehua de Shishi Yijian” [Opinion Concerning Speeding up the Advancement of the Implementation of Shanghai’s High and New Technology Industrialization], May 31, 2009. 17

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(e.g. Grace buying Huahong NEC from its state owners) because the only plan under consideration in which Grace would “buy” Huahong’s fab, Huahong NEC, was one in which Grace’s state shareholder, Shanghai Alliance Investment Limited (SAIL), would become the dominant shareholder in Grace and Huahong NEC (DYCJRB August 6, 2009). In effect, it was a plan in which the fabs would merge under SAIL. In essence, the haggling was over which Shanghai SOE would preside over the merger. This plan made sense financially since Grace did not really have the financial wherewithal to consider buying out another fab on its own. In 2014, the former fabs of HHNEC, Grace, and Huali were listed together under the umbrella of Huahong Semiconductor Limited (Huahong Hongli) on Hong Kong’s stock exchange (at a steep discount vis-à-vis hybrid SMIC’s share price). State agents control the firm’s board.18

5.2.4 Other State-Owned IC Firms Prior to the 908 Project, there were three other JVs. One of them, Advanced Semiconductor Manufacturing Corporation (ASMC), was briefly majority foreign-owned. Two of the firms, Shanghai Belling and ASMC, also had many returnee executives brought in, but these returnees did not turn around the fortunes of these small, technologically backward firms. ASMC started fabrication operations in 1994 as a majority Philips-owned JV with various state entities.19 Nortel invested in 1995 and eventually sold its shares to Shanghai Belling, a Shanghai SOE, and other Shanghai state entities in 2000 leaving majority control in Chinese state hands until the firm’s 2006 IPO. In terms of board representation, from 2006 onwards, state representatives and non-state directors have generally maintained a five-to-five split although there have been periods when there have been five state directors to four non-state directors. ASMC’s best technology20 in 1998 was roughly in-line with Huajing’s technology; it lagged ten to twelve years behind the global frontier. Unfortunately, ASMC remains dependent on process technology transfers from Philips/ NXP.21 This situation is hardly surprising given that the firm started out as a 18 Five of the nine board members are executives at Huahong Semiconductor itself or at other Shanghai SOEs so Shanghai’s government is effectively in control of the firm. One additional board member represents CEC. In any case, Huahong Group and SAIL own the majority of shares and SAIL now owns a majority of the voting rights of Huahong Group itself (Huahong Semiconductor Limited IPO Prospectus, October 3, 2014). 19 The JV was original called Philips Semiconductor Corporation. See Simon and Rehn (1988) for an excellent account of the history leading up to the agreement between Philips and the Shanghai government. 20 150-mm line for 0.8 to 1-micron CMOS technology (ICE 1998: Section 5, pp. 10–11). 21 ASMC has a technology transfer agreement with NXP that runs until 2017. Philips spun-off its semiconductor division as NXP.

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captive fab for Philips (Geppert 1995). ASMC has not been successful attaining either technological or even substantial commercial independence22 from Philips/NXP. Moreover, ASMC, which focuses on analog process technologies, remains quite backward according to a major firm in analog technologies (Interview 385). Revenues in recent years have fluctuated between just USD 100 and 150 million. ASMC has recruited returnees to lead the firm.23 Tony Liu from CSMC ran ASMC from 2000 until 2007. Then, Lu Hsueh-Cheng from NXP ran it until 2008. Joseph Xie (Xie Zhifeng) took over in 2011 and Jeffrey Wang (Wang Qingyu) took over from Xie in 2012. Xie and Wang were both returnees who had worked for SMIC prior to ASMC. However, the influx of returnees at the top did not change the fundamental direction of ASMC. Shanghai Belling started as a state-run24 JV between Shanghai Bell, a telecommunications equipment SOE, Shanghai’s Instrumentation Bureau, and another JV, Shanghai Bell Alcatel. Shanghai Belling originally supplied chips to Shanghai Bell (Geppert 1995). While this changed over time according to sources familiar with the firm, the shift was towards other types of state procurement (Interviews 128, 134, 254). Undoubtedly a prime reason for this diversification of customers was that Shanghai Bell ran into trouble in the mid-1990s. Belling has tried to branch into IC design, but thus far this venture has not been successful (Interviews 128, 136, 371). People who worked at the firm in the first few years of the twenty-first century reported its production process to be a disaster. The firm never really knew what its production yield would be and just took a rough guesstimate. The situation was so bad the firm’s engineers did not want to let outside consultants see their production performance data (Interview 250). Shanghai Belling has survived on state procurement for products like power meters and smart cards through the Golden Card Project (Interviews 128, 371). Sales were USD 75 million in 2014 and have not been over USD 100 million since they peaked in 2006. Shanghai Belling also actively recruited returnees. Among them were design experts such as Howard Yang in the 1990s, Guo Bin in 2000, and subsequently Howard Tang, but they all left in frustration at the lackluster design force (Interview 493). Zhang Fan ran the firm’s 100-mm fab in the first few years of

22 NXP is a major customer. ASMC’s statements do not break down the customers by name, but reports suggest that even in recent years IDMs have accounted for a third of revenues (ASMC 2011 Annual Report), and NXP is likely the bulk of those IDM orders. 23 The only non-returnee since 2002 was Zhou Weiping, who came out of Shanghai Belling and served from 2008 to 2011, when he was demoted. 24 The state owned 64 percent (GAO 2002).

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the twenty-first century, but like the others, he was very frustrated with his unmotivated workforce25 and left Belling after a few years. Shougang (Capital Steel) and NEC established their JV, Shougang NEC (SGNEC), in 1991. The firm began the assembly of ICs in 199426 and fabrication of ICs with an old 150-mm fab in 1995. Like HHNEC, the firm was dependent on orders from its Japanese partner. According to a former executive (Interview 431), Shougang gave up any real management role in SGNEC in 2004.27 SGNEC achieved its highest revenues in 2006 with USD 232.56 million in sales.28 Since that time, the revenues have slid. In January 2012, the party secretary of Shougang announced plans for withdrawal from the IC industry entirely.29

5.3 The Hybrid Firms 5.3.1 Close to the Cutting Edge: SMIC By far the most successful IC fabrication firm, in terms of contributing to China’s technological development, has been hybrid Semiconductor Manufacturing International Corporation (SMIC). This firm has trained the most engineers in relatively cutting-edge technologies and competes in competitive global markets. The downside is that SMIC has had problems with profitability due to ambitious overexpansion under its founder, Richard Chang (Zhang Rujing). More disturbing still, in 2011 the Chinese state attempted to take over the firm. However, profitability has improved under the post-Chang leaders, David N. K. Wang and T. Y. Chiu, and the state’s gambit to take over the firm has thus far come to naught. SMIC was founded in April 2000. Given the failure of major state-supported projects, including projects involving foreign technology, the notion that a foreign start-up could succeed where the state-supported firms had failed seemed dubious. While the plan was to take advantage of the modularity of the IT industry by focusing on the fabrication (chip-making) part of the

25 Zhang gave the author a memo he circulated among his staff exhorting them to work much harder and telling them inspiring tales of how hard work pays off, drawing on examples from his years in Silicon Valley. 26 One interview subject claimed the firm was already conducting packaging by 1990 (Interview 19). 27 The original ownership structure in 1991 had Shougang owning 51 percent and NEC 49 percent. With additional capital infusions and after the DRAM downturn in 1997, NEC acquired a majority of shares by 2000 with 50.3 percent. 28 This includes both fabrication and assembly revenue. 29 Shougang Party Secretary Zhu Jimin ( January 6, 2012), “Overcome Great Difficulties, Meet Challenges, Accelerate Shougang’s Innovation, Drive Transformative Development [攻坚克难迎接 挑战,加快首钢创新驱动转型发展].” Report at Shougang’s Sixth Enlarged Meeting of its 17th Party Committee [在中共首钢总公司第十七届 委员会第六次全体（扩大）会议上的报告].

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semiconductor industry (the pureplay foundry model developed in Taiwan), this model already had two Taiwanese behemoths, TSMC and UMC, dominating the market. The established rivals would undoubtedly quash the Chinese start-up if it tried to compete head-to-head with them. If the start-up were to survive, the firm would have to relegate itself to some small niche market. Thus, went the conventional thinking on the new start-up in 2000 (TCNA, December 11, 2000). Two years after its founding, SMIC started production of wafers at a technological level positioning it as a fast follower not far from the technological frontier. SMIC’s emergence forced the Taiwanese foundries to invest in China-based operations only shortly after the industry-leader, TSMC, had been vocal in dismissing China as a suitable place for foundries (TT, January 1, 2002). The success story of SMIC can be demonstrated on both technological development and market share grounds. Between 2003 and 2008, SMIC competed with Singapore’s Chartered for claim to the tile of being the world’s third largest foundry (behind the two Taiwanese foundry giants, TSMC and UMC). The creation of Global Foundries in 2009, a firm that combined the manufacturing capacity of AMD and Chartered, represented the first plausible challenge to TSMC’s supremacy in the foundry market and forced SMIC back to a distant fourth that year. Since then SMIC has bounced back and for a while threatened to overtake then third-ranked UMC. How SMIC was able to become a fast follower in a few short years was even more impressive. The firm utilized two sources of technology, partnerships with foreign firms and ethnic Chinese engineers (in this case a mix of returnees from the United States and Singapore and Taiwanese), to nip at the heels of competitors on the leading edge of technology. SMIC has managed to stay just roughly a year or two behind the International Technology Roadmap of Semiconductors (ITRS) in logic fabrication (measured by lithography technology) since 2003.30 In the spring of 2012, SMIC started its 40-nm logic process whereas the ITRS had logic at 45-nm in 2010 and 38-nm for 2011 so SMIC has continued its fast followership in an industry with a rapidly moving technology frontier.31 No other foundry in China offers fabrication technology as advanced as SMIC’s (Table 5.1) (PWC 2014).

30 It is important to note that the ITRS is not the technological frontier because Intel’s selfdubbed “bleeding edge” of process technology has been as much 3 to 3.5 years ahead of ITRS in recent decades. However, except for Intel and intermittently Samsung, IBM, and IBM-technologybased Global Foundries, the major IC manufacturers are not significantly ahead of ITRS. Also, the data for the earlier years in Table 5.1 are based on GAO (2002) and DB (2003), which use ITRS and predecessor data, so to be consistent, these data were used for the recent years. 31 When SMIC’s production started in 2002, it was only three years behind the ITRS as SMIC was using 0.18-microns, the 1999 logic process frontier of the ITRS.

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This partnering for technology, combined with drawing overseas Chinese talent follows the well-known Taiwanese model (Mathews and Cho 2000). As typical with successful foundries, SMIC has had technology partnerships with a number of international firms, including IBM,32 Toshiba, Fujitsu, TI, Infineon, and erstwhile competitor Chartered. The firm also has deals to gain access to the IP libraries of a number of IP vendors/IC design houses, such as Virage, Accent, and Shanghai-based Verisilicon. The firm has even cooperated with Europe’s premier semiconductor technology research center, IMEC, to co-develop advanced semiconductor technologies. Both Chartered and Toshiba took small stakes in the firm in return for technology transfer (DB 2003: 96). In contrast to HHNEC’s period of Japanese tutelage, Chinese have been in substantial technological positions in SMIC and SMIC has trained more local engineers than any MNC or domestic firm. SMIC is not hiding its knowledge in some offshore center like NEC did and is not trying to limit the knowledge of its local workforce. Given that SMIC’s operations, aside from some sales offices, are entirely China-based, limiting the knowledge and technical prowess of the local workforce would not make any sense. As one mark of SMIC’s successful development of IC engineering talent, Chartered headhunted hundreds of engineers trained in SMIC and brought them to Singapore between 2003 and 2005 (Interview 431 and discussion with a SMIC executive on August 2, 2005). Indeed, one semiconductor capital equipment executive remarked that SMIC was the training school for China’s fab industry noting that Intel’s Dalian fab had also relied heavily on SMIC personnel (Interview 433). SMIC has been able to gather a corps of leading IC fabrication engineers drawn from the top foundries and American IDMs to come to China, but what has been missed in much of the commentary on the rise of the new Chinabased foundries has been the training that these engineers provide to local recruits. While some commentators assumed that the new foundries would remain dependent on overseas talent because of the dearth of experienced local engineers in this area (DB 2003; Woetzel 2003), SMIC’s strategy in setting up fabs in China has been to take advantage of the skilled, educated, if inexperienced, workforce in China. While employers coming from Taiwan’s IT industry generally report that these graduates have not had the same exposure to technology that their Taiwanese counterparts have had, the employers also feel that the young Chinese technologists are educated and training can make up for the lag. Localizing the staff has been a strategic goal at all the foreign-invested 32 In 2012, SMIC signed an agreement to collaborate with IBM on 28-nm fabrication technology (EET April 2, 2012).

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pureplays in China as localization is their key competitive advantage: wage rates for comparable engineers are significantly higher abroad and foundry work is fundamentally human capital-intensive33 (Interviews 1, 7, 110, 168, 169). In building up its workforce, SMIC had a slogan “yi lao dai er xin” (one old one brings along two new ones) to describe the practice where experienced engineers train local staff (DYBG 2002, No. 12). This process appears to have worked as the firm had almost double the local engineering staff compared to overseas engineers as early as August 2002 (Table 5.2). Of course, the downside was that other firms tried to steal SMIC-trained engineers. As a top executive from SMIC put it in a meeting with the author and his colleagues at an American university, “To be frank, we have lost lots and lots of engineers to Singapore and others.” However, he went on to say that although they feel like GE training the future managers for a whole slew of companies, in SMIC’s case, the best engineers remained at SMIC because they get promoted faster than the others so “we’re able to operate without feeling that much pain.”34 In general, the hybrid foundries in China have emphasized the need to train local talent as the basic competitive strategy because these local engineers have been cheaper than expatriates even when training costs are included (Interviews 1, 7, 110, 168, 169). In the first few years after the founding of SMIC and Grace, engineers were running back and forth between the two firms as these firms were the two potential stars of China’s fledgling foundry industry. “Engineers look at brand. Thus far, SMIC has a better brand so engineers go there,” as another employer in Zhangjiang High-Tech Park (Interview 124), home to both SMIC and Grace, put it. This interlocutor, while seeing SMIC having the upper hand in the war for talent, was uncertain at the time about which firm would win out. However, success fed success. SMIC’s faster ramp-up in its operations and subsequent 2004 listing abroad were signals to engineers that the firm was the foundry to work for. Grace also lost engineers to Chartered and was continuing to do so even in 2007, while SMIC basically stemmed any serious losses of human capital to Chartered and other Asian fabs from 2006 onwards (Interviews 367, 375). What attracted many experienced engineers to join SMIC and Grace in the first place was the prospect of becoming wealthy as the first generation of engineers at Taiwan’s UMC and, especially, TSMC, did through their stock options. In this way, SMIC and Grace being able to list was critical. These 33 As the head of one of Intel’s fabs put it “A university graduate needs four to five years to go from graduation to becoming an engineer capable in both yields and process technology, semiconductor process technology is very complex” (Zhongguo Dianzi Bao October 2, 2010). 34 The source is a conversation of the author and other academics with the SMIC executive on August 2, 2005, at an American university. This source and Interview 367 both pointed to the higher pay Chartered offered.

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Table 5.2 SMIC’s localization of engineering talent 2001 (DYBG No. 12)

2002 (Interview source)

2007 (Interview source)

2011 (Interview source)

Local engineers

650

700–800

Overseas engineers (managers/senior engineers)

393: 240 Taiwan; 120 US; 30 Italy; 3 Japanese

470 from Taiwan; 150 returnees; a few non-ethnic Chinese foreigners

2,800 engineers (includes technical managers/senior engineers) with approximately 1,000 overseas (mainly returnees and Taiwanese) engineers

3,000 engineers (includes technical managers/senior engineers) with approximately 500 overseas (mainly returnees and Taiwanese) engineers

Total staff

1,043 (engineering staff only)

2,600 (includes non-university educated operators)

4,000 (excludes the nonuniversity educated operators)

11,000 (includes non-university educated operators)

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bonuses are regarded as so critical to success in Taiwanese foundries that two Taiwanese scholars of high-technology industry insisted that TSMC’s real strategy in placing a fab in Shanghai was to delay the listing of SMIC and Grace on the grounds that no one would be interested in SMIC’s IPO if they could instead buy the stock of the leading foundry that also had a new and compelling China strategy. These scholars thought in the spring of 2003 that SMIC would collapse due to the loss of its team if the firm could not list within a year. Fortunately for SMIC, the firm was able to raise USD 937 million in its listings on the New York Stock Exchange and in Hong Kong in March of 2004.35 Disappointingly from the perspective of its founder and employees, SMIC’s stock has not been a high performer—probably in large part due to the ferocious competition within the foundry space—but this low share price likely hurt Grace much more than SMIC. Either way, the market’s growing distaste for new foundry IPOs played a large part in Grace’s inability to list (SS September 8, 2004). The inability to list undermined Grace’s ability to compete with SMIC in the battle for semiconductor talent as widely acknowledged by industry participants.36 One major concern for the foundries in China initially was IP protection. They were concerned less about losing IP to customers than they worried about customers losing faith in the foundries’ ability to protect their IP. The main reason for this concern is the fact that IP is most easily expropriated during the transfer of designs from the design houses to the foundries because all the necessary data are encapsulated in a GDSII digital file. The hybrid foundries recognized that meeting the concerns of foreign customers, precisely the sophisticated customers they were targeting, required them to try to reassure the customers that the IP would be protected. Meeting concerns for IP protection was also a major initial stumbling block in the development of Taiwan’s foundries’ development, and if the Taiwanese foundries had not risen to the challenge, then the foundry model would have most likely failed. Executives at China’s hybrid foundries frankly admitted that if they could not assure protection of customers’ IP, they would fail (Interviews 168, 169). SMIC has clearly met this challenge as the firm has been able to lure an impressive list of international clients to become major SMIC clients. The firm’s main customers over the years have been technologically sophisticated foreign firms, such as Broadcom, Infineon, ISSI, Fujitsu, LSI, Qualcomm, Samsung, and TI. SMIC also received IP from major vendors such as Virage Logic.

35 36

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SMIC SEC Form 42484. August 2004 follow-up with Interview 241; Interviews 284, 288.

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SMIC has had IP problems on another front. The customers apparently trust the firm, but TSMC, a competitor, sued SMIC for IP violations in two separate suits in 2003 and 2004. Given the number of ex-TSMC employees at SMIC, undoubtedly there was at least some leakage of knowledge embodied in exTSMC engineers. The fact that TSMC discovered a supposed SMIC mole among their current employees undoubtedly made life more difficult for SMIC, but it also suggests that TSMC took SMIC seriously enough as a competitor to throw legal obstacles in its path. The matter appeared to be over in 2005 when SMIC agreed to pay TSMC USD 175 million over six years to end all of its legal actions (WSJ 1.31.2005). Additionally, TSMC and SMIC agreed to cross-license their patents through 2010. This agreement turned out to be just a short-lived truce in the legal war TSMC waged against SMIC. In 2006, TSMC announced that it was filing suit against SMIC again because it believed SMIC had breached the settlement agreement. As part of this agreement, TSMC wanted to prevent SMIC from utilizing TSMC’s trademarks and patents (EET 8.27.2006). The fact that over 100 TSMC employees went to SMIC spurred the original lawsuit. Not coincidentally, the second round of lawsuits were not resolved until Richard Chang, SMIC’s founder, was ousted from his position as CEO in November 2009. Chang had worked for TSMC and led SMIC’s team of “defectors” to China.37 Chang’s departure and the transfer of 9 percent of SMIC to TSMC resolved this issue to TSMC’s satisfaction.38 A FETISH FOR FABS: THE TRIUMPH AND TRAGEDY OF RICHARD CHANG

Richard Chang has been a visionary responsible for founding two major foundries, World Semiconductor (WSMC) in Taiwan and SMIC in China. While he sold WSMC to TSMC, earning a tidy sum for himself and his fellow WSMC executives, Chang’s greatest success was founding SMIC. In competition with state-supported firms and subsidiaries of Taiwan’s giant foundries, Chang was able to create a firm that became the largest foundry firm in China (in revenue terms) and brought China’s technologically backward semiconductor manufacturing close to the technological frontier. What has sullied this triumph of technological entrepreneurship has been SMIC’s less-than-stellar financial performance under Chang due to his rash

37 Chang had not only set up a rival that TSMC perceived as stealing TSMC’s technology. In addition, Chang’s WSMC had also been bought by TSMC for what many within TSMC considered as too high a price. Consequently, Chang had been unpopular with a lot of TSMC’s top executives from the start of his time at TSMC (Author’s interviews with TSMC executives in 2000). 38 Originally, reports had the settlement between SMIC and TSMC being an 8 percent stake (EET November 10, 2009). TSMC actually took a stake of over 9 percent once Taiwan’s Ministry of Economic Affairs officially approved.

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overexpansion of production capacity. Chang’s tragic flaw was a fetish for fabbuilding. In many ways, this irrational quest to build as many fabs as possible was understandable given Chang’s background. When he worked for TI in the United States, his job was fab-building. His 1990s’ WSMC success was essentially due to the rapid building of its fab followed by quick acquisition by TSMC. With SMIC, Chang took his fab-building fetish to a whole new level. Once the first two 200-mm fabs39 in Shanghai were up and running by 2002, SMIC added, in chronological order, a 200-mm fab in Tianjin (acquired from Motorola) in late 2003,40 a 300-mm fab in Beijing (operations started at the end of 2004), a 200-mm fab in Chengdu (construction began in 2005 and production commenced in May 2007), and a 300-mm fab in Wuhan (construction began in 2006 and fabrication operations commenced in the fall of 2008). In January 2008, SMIC struck a deal to manage one 200-mm and one 300-mm fab for the Shenzhen government (EET 1.29.2008). Prior to adding all of this new capacity outside of Shanghai, SMIC had been running at near full capacity (SMIC SEC Form F-1, February 11, 2004). Additionally, SMIC and Toppan of Japan set up an on-chip color filter and micro-lens manufacturing JV with operations commencing in 2005. The fabs in Wuhan (called Wuhan Xinxin), Chengdu (called Cension), and the planned fabs in Shenzhen, were part of a cheaper, “virtual” fab strategy by SMIC where the local governments would put up the funds to build the fabs and SMIC would rent them. Cension in Chengdu had minor outside investors in addition to the local government (EET February 11, 2008). SMIC was in charge of building the fabs and its role in doing so was controversial. According to industry insiders and former SMIC executives (Interviews 379, 431), SMIC moved old equipment from one or more of its established sites (Beijing/ Tianjin/Shanghai) to Chengdu.41 Two interview subjects were adamant that these old equipment deals were too favorable to SMIC and essentially cheated the local government (Interviews 431, 433).42 David N. K. Wang rationalized SMIC’s production capacity when he took over. Cension was sold to TI in 2010 and 700 SMIC employees were transferred to TI to run its newly acquired fab (EET 10.14.2010). In May 2011, SMIC bought a controlling interest of 66.7 percent in Wuhan Xinxin (China Times 39 SMIC now counts the two 200-mm fabs in Shanghai as one fab and also has a 300-mm fab in Shanghai. 40 SMIC had been rumored to buy this fab as early as July 2003 (EET July 7, 2003). 41 The interview accounts differ as to which old sites gave equipment to Chengdu. According to one report, old equipment was moved from both Shanghai and Tianjin to Chengdu (“Elpida Sells 200mm Equipment to SMIC,” Simmtester.com. ). 42 Both interview subjects told the same unconfirmed story that the head of SMIC Chengdu committed suicide over these nefarious doings.

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5.14.2011), but subsequently withdrew from the now independent Xinxin foundry (EET 3.19.2013). Such a rationalization was long overdue. In early 2010, with its many fabs running well under capacity, SMIC employed as many people as UMC with only a third of UMC’s revenues (FT 2.20.2010). To be fair, Richard Chang’s fab-building binge, at least initially, was not without its merits and strategic logic. Being able to invest in new fabs is one of the critical competitive metrics in the pureplay foundry business. It would have been hard for new pureplays to compete with TSMC and UMC if they only had limited capacity to offer potential customers. Fab-building also served to distinguish and distance SMIC from its main hybrid competitor, Grace, which had failed to ramp up its fabs. To quote one analyst who argued in defense of SMIC’s aggressive fab-building and situating some new fabs in Beijing, “SMIC has no other choice but to expand its fab capacity—if it truly wants to be a big player. In today’s foundry market, the larger players must offer a range of services, processes and options—such as 200- and 300-mm capacity—in various locations to satisfy the customer base” (Lapedus 2003b). SMIC’s expansion contrasts with Huajing and HHNEC’s profligate use of capital that resulted in few gains in fab capacity. From the end of 2003 to the end of 2004, SMIC increased its capacity to 350 percent of its 2003 year-end size through acquisitions and expansions (Wallace 2004). Unlike its Chinese SOE counterparts and Grace, SMIC was scrupulously on target in scheduling its ramp-up of operations, at least for the Shanghai operations.43

SMIC FENDS OFF THE STATE’S GRABBING HANDS

Despite SMIC’s technical prowess and dominant market share vis-à-vis the other foundries in China, one has to ask to what extent the Chinese government owned or acquired a controlling stake in SMIC, given the state’s proclivities to encroach on private businesses in the strategic semiconductor industry. SMIC has succeeded in remaining managerially independent from the Chinese state, but this has been a struggle. SMIC started out as a hybrid FIE with some investment by Shanghai state entities, but over time the Chinese state has gained shares in the firm. A number of Chinese state entities gained shares as SMIC made deals to build various fabs in various parts of China. For instance, Beijing Jade Bird (Beijing Qingniao)44 became a shareholder as SMIC set up fab operations in

43 Controlling for the release date of information, SMIC’s estimates about ramp-ups have erred by only a quarter or so. 44 Jade Bird likely took over the role of investment vehicle for Beijing Municipality from Shougang’s affiliate.

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Beijing, while Shanghai Industrial Holdings has always been a shareholder since SMIC is a Shanghai-based firm. Prior to SMIC’s 2004 IPO, the large majority of SMIC’s shares were held by foreign private entities although there were small shareholdings owned by companies connected with the Chinese and Singaporean governments. After the IPO, the major state owner was the Shanghai municipal government through its Shanghai Industrial Holdings (SIH) until December 2008 when Datang, the telecommunications SOE, bought 16.57 percent of SMIC to surpass SIH as the largest shareholder. Datang increased its stake when TSMC became a major shareholder in 2010 and did so again when China Investment Corporation (CIC) bought a larger stake in 2011–2012. At the same time that Datang and CIC bought large stakes, SIH’s shareholdings became diluted down to under half their 2006 height. When one looks at the actual control of the firm through the board of directors, it is apparent that state control has yet to be attained, despite Datang’s ambitions. It was SMIC’s frantic fab-building and concomitant costs that made SMIC vulnerable to state takeover: SIH was always a significant shareholder and has always had a representative on SMIC’s boards (see Tables 5.3 and 5.4) and Beida Qingniao had a stake without board representation until it liquidated its stake in 2010. Neither of these state shareholders represented a serious threat to take over the firm. With the need for cash to continue its fab-building or joint fab-building with local entities, SMIC turned to another state firm, Datang Holdings (EET November 10, 2008). With Datang’s purchase of shares in December of 2008 for USD 1.72 billion, the balance of the board shifted from a single member who represented stateowned entities to three in 2009. There was continued speculation that Datang had ambitions to turn SMIC into its captive foundry (ESJJBD July 4, 2011). Although TSMC took a major stake in 2009, it never arranged to have a representative on the board due to its inherent conflict of interest as a direct competitor to SMIC. When Richard Chang stepped down from the board, his fellow executive, Edward Yang, did the same so the board was nearly split with four non-state members, compared to three representing state firms. Datang bought more shares in 2010 for USD 1 billion and sought to protect its position by purchasing convertible shares when the state-owned CIC purchased convertible shares for USD 2.5 billion in April 2011. Datang also blocked Citigroup and JP Morgan from investing USD 500 million during David Wang’s tenure because Datang did not want to diminish its holdings and it could conveniently cloak its self-interest in patriotism by refusing to sell more of SMIC to foreigners (Interview June 21, 2013). Increasing state shareholding did not help with easy access to state banks, however. According to one former executive, during David Wang’s tenure one of the large state shareholders demanded a 3 percent fee if they were going to 140

Table 5.3 SMIC shareholders, 2004–2012 2005

2006

2007

2008

2009

2010

2011a

June 30, 2012

Shanghai Industrial Holdings 9.95% Motorola 7.8%

Credit Suisse Group 21.76%b

Shanghai Industrial Holdings 15%

Shanghai Industrial Holdings 10.94%

Datang Holdings 16.57%

Datang Holdings 16.53%

Datang Holdings 19.12%

Datang Holdings 19.33%

Datang Holdings 19.43%

Shanghai Industrial Holdings 10.18%c

Credit Suisse Group 4.29%

Shanghai Industrial Holdings 10.09% Donald Smith and Company 5.94%

Shanghai Industrial Holdings 10.07% Donald Smith and Company 5.55%

TSMC 9.14%

TSMC 9.54%

Shanghai Industrial Holdings 7.84%

Shanghai Industrial Holdings 7.79%

China Investment Corporation 11.28% TSMC 8.23%

Blessington Services Limited 5.8% Beijing Beida Jade Bird 4.8% Total state shareholding 14.75%e

Beijing Beida Jade Birdd 1.08% Total state shareholding 11.26%

Beijing Beida Jade Bird 1.08% Total state shareholding 16.08%

Beijing Beida Beijing Beida Beijing Beida Jade Bird 1.08% Jade Bird 1.08% Jade Bird 1.08% Total state shareholding 12.02%

Total state shareholding 17.54%

Total state shareholding 17.50%

Total state shareholding 26.96%

Total state shareholding 27.12%

Shanghai Industrial Holdings 6.19% Total state Shareholding 36.90%

Bold names indicate state-owned firms. Source: Based on company filings with US SEC and Hong Kong Stock Exchange a Does not include the convertible preferred shares of Datang and CIC that were not converted into ordinary shares until the spring of 2012. b The long position was 9.8 percent and the short position was 11.96 percent. c The long position was 10.12 percent and the short position was 0.06 percent. d When Jade Bird sold its remaining shares in April of 2010, it was reported to have only 1.08 percent remaining. After 2004, it was never reported as having significant shareholdings in SMIC in company filings. e Immediately after SMIC’s IPO, it is possible that the state shareholdings were slightly higher, at just below 16.8 percent, due to small stakes by other state entities.

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2004

2004 Board

June 2, 2008a

June 23, 2009

November 23, 2009

July 15, 2011

August 5, 2011

August 23, 2011

Executive and independent directors (7): 1. Richard Chang, CEO and Chairman 2. Ta-lin Hsu, Independent 3. Yen-pong Jou, Independent 4. Tsuyoshi Kawanishi, Independent 5. Henry Shaw, Independent 6. Lip-bu Tan, Independent 7. Yang-Yuan Wang, Independent 8. Sean Hunkler, Motorolaf State-linked directors (1): Laxing Cai (Shanghai Industrial Holdings)

Executive and independent directors (7): 1. Yang-Yuan Wang, Chairman and Independent Directorc 2. Richard Chang, CEO

Executive and independent directors (5):b 1. Shang-zhou Jiang, Chairman and Independent Director 2. Richard Chang, CEO

Executive and independent directors (5): 1. Wenyi Zhang, Chairman and Executive 2. T.Y. Chiu, CEO

3. Edward S. Yange, Executive 4. Lip-bu Tan, Independent

Executive and independent directors (3): 1. Wenyi Zhang, Chairman and Acting CEOd 2. Lip-bu Tan, Independent 3. T. Kawanishi, Independent

Executive and independent directors (4): 1. Wenyi Zhang, Chairman and Executive 2. T. Y. Chiu, CEO

3. Ta-lin Hsu, Independent 4. Henry Shaw, Independent

Executive and independent directors (4): 1. Shang-zhou Jiang, Chairman and Independent Director 2. David N.K. Wang, CEO 3. Lip-bu Tan, Independent 4. T. Kawanishi, Independent

3. Lip-bu Tan, Independent 4. T. Kawanishi, Independent

3. Lip-bu Tan, Independent 4. T. Kawanishi, Independent

5. T. Kawanishi, Independent 6. Lip-bu Tan, Independent 7. Shang-zhou Jiang, Independent

5. T. Kawanishi, Independent

State-linked directors (1): Zheng-gang Wangg (Shanghai Industrial Holdings)

State-linked directors (3): 1. Jie Zhou,h (Shanghai Industrial)

5. Frank Meng, Independent

State-linked directors (3): 1. Jie Zhou (Shanghai Industrial)

State-linked directors (4): 1. Jie Zhou (Shanghai Industrial)

State-linked directors (4): 1. Jie Zhou (Shanghai Industrial)

State-linked directors (4): 1. Jie Zhou (Shanghai Industrial)

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Table 5.4 SMIC board of directors, 2004–2011

a

Ratio: 7:1

2. Yonggang Gao (Datang) 3. Shanzhi Chen (Datang)

Ratio: 5:3

Ratio: 4:3

2. Yonggang Gao (Datang) 3. Shanzhi Chen (Datang) 4. Lawrence Laui (CIC) Ratio: 3:4

2. Yonggang Gao (Datang) 3. Shanzhi Chen (Datang) 4. Lawrence Lau (CIC) Ratio: 4:4

2. Yonggang Gao (Datang) 3. Shanzhi Chen (Datang) 4. Lawrence Lau (CIC) Ratio: 5:4

Jou was replaced in May 2006 by Albert Yu, who resigned on June 2, 2008 and was not replaced. Jiang joined the board in May 2006. Hsu resigned in October 2008. Shaw resigned in January 2009. Yang Yuan Wang resigned on June 23, 2009 and was simultaneously replaced as chairman by Jiang. Wang was appointed chairman of the board in July of 2005. d Zhang was appointed as an independent director on June 23, 2011 and then made chairman and acting CEO on July 15 in the wake of Jiang’s death on June 27 and the resignation of David N. K. Wang on July 13. e Yang arrived on February 5, 2009. f Motorola’s representative resigned the same year appointed and Motorola never replaced him. g In August 2007, Wang replaced the previous Shanghai Industrial representative on the board, Yao Fang, who had replaced Cai in February 2006. h Zhou replaced Zheng-gang Wang as director in January 2009. i Lau was appointed the director representing CIC on June 23, 2011. b c

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Ratio: 8:1

2. Yonggang Gao (Datang) 3. Shanzhi Chen (Datang)

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help SMIC get a loan from state banks (Interview June 21, 2013). Thus, SMIC did not have the advantage of state firms even as it confronted increasing state interference. With the entrance of Lawrence Lau representing CIC and Zhang Wenyi as an independent director on June 23, 2011, the board balance remained in the favor of the non-state members by five to four.45 Even at this juncture, Datang was becoming a bit obstreperous and Datang’s two representatives voted against Zhang becoming a member of the board probably because he was viewed as a protégé of the chairman, Jiang Shangzhou,46 and thus likely to oppose any plans by Datang to convert SMIC into its subsidiary rather than continuing to be an “independent, international semiconductor manufacturing company” as envisioned by both Jiang and David N. K. Wang (ESJJBD July 4, 2011). However, with Jiang Shangzhou’s death on June 27, Datang saw its chance and voted against re-electing David N. K. Wang to the board on June 29. The other state representatives abstained from voting (ESJJBD July 4, 2011), but the result was Wang lost the shareholder vote. Datang’s plan seems to have been to promote Simon Yang to CEO (ESJJBD July 4, 2011, July 14, 2011) possibly because as a mainlander returnee they deemed him more reliable than a Taiwanese American returnee such as Wang.47 With Wang off the board, the state members had a majority on the board. David N. K. Wang’s resignation as CEO was made official on July 13, but the July 15 board meeting made Zhang Wenyi the acting CEO,48 signifying that Datang had abandoned its attempt to take over the firm. Moreover, Simon Yang, Datang’s purported favorite, was left out in the cold (ESJJBD 7.16.2011, 7.14. 2011). Datang’s retreat from its gambit to take over the firm was further underlined by the return of T. Y. Chiu to the firm as CEO on August 5. Chiu was one of the original members of the top management team of SMIC and someone who originally had been hired away from SMIC by David N. K. Wang at Huahong. More importantly, T. Y. Chiu was simultaneously appointed to

45 It must be said that Lawrence Lau is not your typical state cadre. He is a renowned professor of economics who taught at Stanford and served as chancellor of Chinese University of Hong Kong before becoming vice chairman of CIC. I had an opportunity in 2007 to discuss with Lawrence Lau the Chinese semiconductor industry among other topics and Lau expressed great skepticism of China’s SOEs’ approach. 46 Among other things indicating the personal closeness of Jiang and Zhang, Zhang was Jiang’s university classmate. 47 Technically, David N. K. Wang is a so-called waishengren in Taiwanese terminology, i.e. someone whose parents or themselves came to Taiwan from the mainland after 1945. T. Y. Chiu is also waishengren, but in both cases, born-and-raised mainlanders consider these waishengren to be different from themselves and conflate them at least partially with the native Taiwanese. An interview subject who was a former SMIC insider confirmed on June 21, 2013, this division between Simon Yang’s mainlanders and T. Y. Chiu’s Taiwanese. As he put it, Simon came in with his “back up to push out Taiwanese . . . More than 50 percent of these Taiwanese were pushed out by Simon. Now TY has brought them back.” 48 Zhang also became chairman of SMIC’s board.

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the board of directors, restoring the balance of four non-state directors versus four state directors. In the wake of Chiu’s arrival, Simon Yang announced his resignation on August 15. What further strengthened the hand of private investors and led at least temporarily to the defeat of Datang’s attempt to seize power was the appointment of Frank Meng, a Taiwanese American, as another independent director on August 23, 2011. The non-state board members were now once again in the majority. However, the future is still uncertain for SMIC. The Chinese state unveiled the outline of a megaproject for the IC industry in June 2014.49 As part of this initiative, the central government via the China Development Bank has established a 120 billion RMB investment fund, the China IC Industry Investment Fund, managed by Sino IC Capital. This fund bought up 11.03 percent of SMIC’s shares in February 2015 and shortly afterward placed Ren Kai of Sino IC Capital on SMIC’s board of directors. Thus, the total state shares of SMIC are likely to be over 42 percent and could be as high as 46 percent.50 The balance of power on the board looks slightly more favorable to limiting the state’s influence. As of August 2015, there are still four independent directors51 to three directors representing Datang, SIH, and Sino IC Capital, respectively. In addition to T. Y. Chiu, there are two other executive directors on the board, Gao Yonggang and Zhou Zixue, the latter of whom replaced Zhang as chairman in March 2015. However, Gao and Zhou come from Datang and MIIT, respectively, so the current board split might be considered more of an even split of five versus five between those aligned with the state and those from outside the state. One factor likely to have made SIH less active in machinations to take over SMIC and its overall willingness to see its ownership share of SMIC diminish over time is that SIH and the Shanghai municipal government were already more focused on Huahong’s imminent takeover of Grace. We will now turn to that story of the state’s encroachment.

5.3.2 Grace: The Other Hybrid Foundry Grace was another hybrid that followed the same model as SMIC though Grace continually lagged behind SMIC in technology and revenues even 49 Some attribute the impetus for this IC megaproject to a 2009 letter Yu Zhengsheng, at that time Politburo member and party secretary of Shanghai, wrote to the leadership calling for such a project (Interview August 27, 2014). 50 Datang and CIC have 19.48 percent and 10.75 percent of SMIC’s shares and SIH still has some shares although certainly less than 5 percent since SEC filings require reporting the holdings of major shareholders with at least 5 percent of outstanding shares (SMIC US SEC Form 6-K, February 17, 2015). 51 They are William Tudor Brown, Sean Maloney, Lip-bu Tan, and Carmen I-Hua Chang.

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though it was founded the same year. Grace’s better state connections have not given the firm any competitive advantage over SMIC, illustrating that government connections do little to determine success for hybrid FIEs. Furthermore, Grace’s closer government connections probably enhanced the firm’s susceptibility to state encroachment. Grace had the potential to be a major player in the pureplay foundry market. The firm was essentially pursuing the same model as SMIC, bringing over experienced engineers from Taiwan and the United States to manage and train the local engineering workforce. The firm had a slower production rampup than SMIC due to what appears to have been a more precarious funding situation. Despite the relatively slow build-up in production compared to SMIC, the firm also trained significant numbers of local engineers. The firm had 160 overseas managers and 400 local engineers by the end of 2003. By 2007, the firm had 1,370 employees with 500–600 engineers, all of whom were local, except for 70 returnees and expatriates. Thus, the firm embedded its technology in the local economy by training local engineering staff in a manner similar to SMIC. Grace too lost some 50 locally trained engineers to headhunting from Chartered (Interview 367). Like SMIC and the foundry forerunners, TSMC and UMC, Grace gained a lot of technology from its clients and from firms looking to wind down their semiconductor businesses. In 2003, the firm received 0.18-micron technology from SST, an American fabless firm. This technology placed Grace behind only SMIC among China’s fabrication facilities in terms of its technology (SS 11.21.2003). Grace received its original 0.25-micron process technology from Oki and sent many young engineers to be trained in Oki’s facilities in Japan. Similar to SMIC, the firm made deals to boost the IP offerings it could provide customers. The firm procured Shanghai-based Verisilicon’s 0.18-micron IP library and Toshiba’s embedded microprocessor IP. The firm’s major clients initially were Sanyo and SST with Oki also becoming an important client by the mid-2000s (Interviews 1, 367). Grace kept mum about its ownership structure and did not fully disclose the investors in its several rounds of funding although Hong Kong billionaire Li Ka-shing’s Hutchinson Whampoa and Cheung Kong companies did invest USD 90 million (EET 3.28.2006). In total, SST invested USD 83 million in Grace through the first two rounds of investment (SS 3.8.2004), but it is unclear whether or not Oki had a stake in Grace. Winston Wang52 (Wang Wenyang), son of the Formosa Plastic’s Wang Yongqing, established the Cayman Islands holding company that owned Grace, Grace Semiconductor Manufacturing Corporation. Presumably, he did not want to disclose the

52

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ownership of this holding company because of Taiwan’s restrictions on investing in semiconductors in China.53 At least one person close to Grace alluded to the fact that Grace had received investment from Winston Wang’s siblings’ firms, VIA and FIC (Interview 1). Grace also had significant, if murky and not controlling, levels of state ownership from the beginning. Grace’s experience shows that good government connections are not the determining factor of success if your firm’s strategy is not based on government procurement. If one had to predict based solely on government pedigree which foundry start-up would excel, one would have picked Grace because this firm combined the Wang family, a wealthy Taiwanese family with significant investments in China, with Jiang Mianheng, former head of the Institute of Metallurgy in Shanghai (the main research institute for Shanghai’s semiconductor industry) and son of former (then current) China’s president, Jiang Zemin.54 Some have said that Jiang Mianheng had a major holding in the company, but it appears that the Shanghai government-owned firms, rather than Jiang himself, had a minority stake in the firm (possibly about 10 percent).55 In more recent years, Grace publicly admitted that SAIL, a Jiang Mianhengrun Shanghai government investment vehicle, was a major shareholder although exact figures were still not forthcoming (Interview 367; EET 2.15.2010). In any case, Jiang’s involvement in the firm has not helped Grace beat SMIC to the market even though the two firms were founded at approximately the same time and Grace attracted significant attention due to the family connection to Jiang Zemin. Grace did not attract the level of foreign investment that SMIC did despite the more favorable treatment it had in terms of lending by the Chinese state.56 SMIC’s estimated FDI prior to the IPO of USD 900 was approximately USD 1.3 billion whereas Grace’s total equity was approximately USD 800 million.57 One could argue that Grace missed out on the best of both worlds because it received less state largesse than the SOEs, but less foreign capital than SMIC.

53 As of 2002, Taiwan legalized investment in 200-mm wafer fabs in China, but the Grace investments were made two years prior to the legalization. 54 Jiang Zemin was not the only president whose son was involved with Grace. Neil Bush, son of the 41st and brother of the 43rd US presidents, reportedly signed a contract in 2002 to be an adviser and director of Grace for five years (EET 3.28.2006). This connection did not seem to help the firm much either, as SMIC, rather than Grace, was the first China-based firm to be fast-tracked for US export licenses for semiconductor capital equipment. 55 DB (2003: 97) arrives at the 10 percent figure from looking at the Chinese holdings in two other enterprises, Honghe and Honglian. 56 As of 2003, Grace, despite being much smaller, had received double the amount of loans that SMIC had managed to secure from the Chinese state banking system (Clendenin 2004; DT 7.15.2002). 57 This comparison is based on figures from Clendenin (2004), DT (7.15.2002), and SMIC SEC (2004).

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Both firms adopted business strategies that sought to avoid dependence on government procurement. They wanted to be globally competitive foundries. Thus, they could not rely on government procurement of IC cards used by the Chinese government for IDs as the mainstay of their business like many SOEs did. The reason was not just because of their strategy of serving a global customer base, but also because the government’s IC cards were generally designed using older generations of technology, such as 0.35-micron technology, that were not the technologies SMIC and Grace needed to perfect in order to be competitive global foundries. These two firms’ fabs from the very beginning were manufacturing at more advanced technologies than 0.35-micron. Indeed, only 25 percent of the orders from leading fabless firms were using 0.35-micron and above process technology.58 Unfortunately for Grace, the firm never managed to grow large. It seemed to be caught in a vicious cycle. Trouble attracting and retaining key staff meant that the company did not attract large orders which in turn meant that it kept having staff retention problems. Thus, Grace lost out in the war for talent with SMIC. Grace went through three waves of management teams: (1) Winston Wang as CEO and Nasa Tsai as president and Chief Operating Officer (COO) until 2004; (2) a group of ethnic Chinese executives from Chartered in Singapore starting in 2005; and then (3) a team starting in 2007 that included former Siemens Semiconductor/Infineon CEO, Ulrich Schumacher, as CEO.59 The firm kept missing its target dates for an IPO and after delaying the IPO for a third time in 2006, it never again issued a public target date for an IPO. Grace’s revenues fluctuated around USD 200 million between 2007 through 2010. However, the quality of its foundry was still considered better than those of SOEs. When renewed rumors of a takeover by Huahong started going around in 2008, one hybrid fabless design firm’s CEO expressed his great distress about this turn of events given his firm was a Grace customer exclaiming, “They [Huahong] don’t even know how to manufacture properly. Nobody really cares about it [the firm] because it belongs to the state” (Interview 442). The encroachment of the state was gradual. Dong Yeshun, a vice president at SAIL and not a semiconductor expert, was appointed chairman, president, and acting CEO in 2004.60 A much more ominous sign of encroachment was the appointment of Fu Wenbiao, who had been chairman of Grace since 58 The figures for fabless design were the Fabless Semiconductor Association’s (FSA’s) for 2003, and are a good proxy for leading fabless firms because low-end low-tech design firms from the developing world are not members of FSA. Nor are low-tech design firms the target clients of SMIC and Grace (author’s interviews with company sources). 59 Another former Infineon executive served briefly as COO. 60 Those familiar with Grace claimed that from the arrival of a team of Chartered executives in 2005 the real executive decisions were made primarily by the COO K. Y. Liao, a veteran of UMC and Chartered (Interview 367).

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February 2009 and prior to that, director of Shanghai Municipality’s Informatization Commission, to the chairmanship of Huahong in August 2009, giving the two firms the same chairman. The two firms then started to build a JV 300-mm fab in January 2010. The CEO Ulrich Schumacher admitted in 2010 that the Chinese state was also trying to drive consolidation in an interview just seven months before he resigned: economic policy makers here have realized that it is not promising to have ten small sub-critical foundries. For this reason, I believe that there is also the political intention to drive this consolidation, and once China adopts a policy, it implements it very forcefully. Thus, the likelihood for a semiconductor industry consolidation in China is extremely high. (EET 2/15/2010)

Given the very trends Schumacher outlined in his interview, it was unsurprising to anyone but perhaps Schumacher himself61 that he was replaced by William Yu Wang (Wang Yu), a Grace executive and former Huahong executive, as president of Grace in September 2010. The long-expected merger was announced in December 2011, but the agreement had actually been signed in September. State entities still held a dominant position in the new, enlarged Huahong Semiconductor (see previous section on Huahong). NEC still held a minority stake as did Winston Wang.

5.4 The MNCs 5.4.1 The Taiwanese Pureplay Foundries Reacting to the creation of SMIC and Grace, the Taiwanese pureplay foundries re-evaluated what, if any, role China could have in their strategic plans. Prior to SMIC and Grace, neither UMC nor TSMC considered China a suitable place to invest in IC fabrication.62 The emerging competition forced UMC to reconsider production in China, which the company, in the guise of Hejian (its Chinese affiliate’s name), initiated with 200-mm fab production in Suzhou. In contrast to UMC’s rapid reaction, TSMC dragged its feet before investing in China. Neither firm ended up embracing a China-based operational strategy. Instead, they both behaved like typical MNCs, and unlike those Taiwanese firms, such as Inventec and Hon Hai, that have embraced more China-based operational strategies. Legal sanction by the Taiwanese state may have played

61 According to some accounts, Schumacher desired to be head of the Huahong-Grace JV, Huali, if no longer CEO of Grace itself, but when he did not become CEO of the JV, he quit Grace (DYCJRB 9.14.2010). 62 Interviews with Taiwanese semiconductor firms in 1999 and 2000.

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a role in dulling UMC’s enthusiasm for China, but the legal crackdown came after Hejian’s expansion had already stalled between 2003 and 2006. The initial difference in enthusiasm for China displayed by Taiwan’s two major foundries demonstrates the split in strategic thinking between firms in Taiwan. UMC has played a resentful second fiddle to TSMC since 1994. Due to its lead position and performance, TSMC has charged about a 30 percent premium over UMC on wafers.63 Naturally, TSMC should be more comfortable with its current strategy of relying on Taiwan as its main operational base than UMC because the returns on that strategy have been so much greater. When one examines the two firms’ activities in China, UMC’s initially proactive China strategy stands in sharp contrast to TSMC’s criticism of China’s prospects. While UMC was quietly planning its 200-mm fab investment in China by 2001, TSMC continued to disparage China’s policies and China’s IC industry prospects. TSMC continued to be critical even after TSMC received permission to build a fab in China. UMC was so eager to set up operations in China that it did not wait for Taiwan’s government to make the decision to legalize the investment of 200-mm fabs whereas TSMC has pursued a course of antagonizing China’s government, threatening to sue China and publicly blaming China for a potential glut of capacity even after agreeing to invest there (Lin 2003b). While UMC flirted with adopting a China-based operational strategy, TSMC at best has been forced to incorporate China as a small component in its operations by the force of investor opinion in Taiwan in the early 2000s. In the end, neither UMC nor TSMC has been very active in China. UMC’s fab in Suzhou has been up and running since mid-2003, but it has not really seen much expansion since the initial ramp-up.64 UMC started this plan in 2001 and did not seek permission of the Taiwanese state even after Taiwan indicated a likely lifting of the ban on 200-mm fab investment in August 2001.65 UMC tried to deny that Hejian was an affiliate of UMC, but two Wall Street Journal reporters by sifting through company documents discovered that the two nominal owners of Hejian were mid-level UMC managers still working in UMC’s Hsinchu headquarters (WSJ April 1, 2002). Nevertheless, the Taiwanese government only charged UMC’s chairman, Robert Tsao (Cao Xingcheng), and other UMC executives of illegally investing

63 Interview 166. His claim is also backed up by this report (UBS Warburg, “Update form SMIC Investor Lunch,” February 24, 2004) and another report (TSMC Financial Status Plus OIP Update! 2011) though in the latter report TSMC’s gross margins are twenty-two percentage points above UMC’s. 64 UMC announced a plan to build a 300-mm wafer fab in Xiamen in 2014. 65 Yang and Hung (2003) note that in August 2001, the Taiwanese government indicated further liberalization of outbound investment, but the issue of whether or not 200-mm wafer fabs would be included in the list of permitted investments was not resolved until April 2002.

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in China in 2006. After two trials on various charges, which extended into 2010, the government abandoned its case against Tsao. TSMC’s Chinese fab only began operating in the final quarter of 2004 after receiving approval to invest from Taiwan’s government in the autumn of 2002. TSMC’s plant is in Shanghai’s Songjiang County. The only other location TSMC considered, Kunshan in Jiangsu Province, is also a bit removed from Shanghai and like Songjiang does not have a cluster of semiconductor fabrication. Both Songjiang and Kunshan offered TSMC very lucrative packages of incentives.66 Whatever the reason for its locational decision, TSMC has not been ambitious in its plans to develop its Shanghai site. Having been given enough land for several fabs, TSMC only built one such fab and the rest of the land remains unused (ESJJBD 6.15.2009).

5.4.2 Motorola The first big wholly foreign-owned enterprise (WFOE) fab project was Motorola’s fab in Tianjin. This fab was announced in 1995 (Geppert 1995) although planning for it started even earlier. Given how dependent Motorola was on China’s telecommunications market, this investment represents something of a critical case. China should have had significant leverage in terms of market access to gain technology from Motorola, and yet, Motorola’s fab never contributed much to China’s technological upgrading. Motorola needed to ensure its access to the Chinese market because Motorola had a large lead in pagers and subsequently mobile phone sales in the rapidly growing and large Chinese market, even as its share was declining rapidly everywhere else. Equally enticing, China was investing heavily in telecommunications infrastructure, an area in which Motorola had a variety of products. This classic dependence of the MNC on the host government’s power over market access should have given China significant leverage to wrest some technological contributions from Motorola. A former Motorola executive, who was extensively involved in many of the negotiations with the Chinese government over the course of the 1990s, admitted that Motorola’s aim in putting the fab in China was to please the Chinese government so as to keep the market open to Motorola’s telecommunications products (Interview 223). MEI was especially keen to receive semiconductor technology. To play the good MNC, Motorola decided to place a fab in China. Unfortunately for Motorola, the ministry most critical for success in telecommunications was Ministry of Post and Telecommunications (MPT), a ministry that could not care less about semiconductors as it was outside of 66 Some Taiwanese businessmen reported that they heard that TSMC received up to seven years of tax-exempt status, which far exceeds the three years authorized by the central government.

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MPT’s purview. Still, placing a fab in China looked good to Chinese officialdom from the point of view of contributing technology to China, especially at a time when numerous Chinese scholars of industry were denouncing Motorola’s “hegemonic” control of the mobile phone market (CASS 1997, 1999). Motorola ran into a bit of good luck because the reorganization of the ministries in 1998 merged MPT and MEI into MII, so the officials Motorola had most pleased could return the favor. However, this reorganization also gave MII more leverage because if Motorola did not deliver, the unhappiest officials would also be those officials in charge of regulating the markets Motorola would most like to participate in: telecommunications. More alarmingly, Motorola’s own executives deemed that, given the state of the Chinese legal system at the time, the company would have no legal recourse if it wished to challenge the legality of MII’s regulations (Interview 223). Despite its leverage, China never really received the level or amount of technology it hoped, just like with many of China’s interactions with MNCs as discussed in Chapter 4. Motorola spent a long time training Chinese engineers in the United States only to have them jump ship to other firms abroad before they were sent back to Tianjin.67 Thus, the ramping up of production was painfully slow. Motorola’s semiconductor division had encountered problems for years, and in the last few years before selling the fab to SMIC, it had announced a fab-light strategy that would outsource more to foundries. Before going fablight, the firm had been proclaiming that it would concentrate its Asian IC production in Tianjin and move production out of Japan, but the firm ran into political difficulties in Japan and other countries as well. A contemporary analysis viewed Motorola’s problem as having old fabs in places where it also did not want to upset the government by closing fabs, such as France and Japan. The only solution was selling the new fab in China because selling it would not mean closing it, i.e. the fab had enough value to be kept up and running ( Jelinek 2003). Plus, selling the new fab would not affect relations with that host government, i.e. China. While Motorola did have special circumstances and did in some sense try to transfer technology to Chinese hands, Motorola’s difficulties were not the only intervening variable that affected the access for performance trade-off. The Chinese state could have been stricter with Motorola about ramping up the plant. From bringing in equipment in 1998–1999 to the plant’s sale in 2003, the plant only managed to ramp up to a trickle on the basis of not very large capacity (12,000 wafers/month). This may have been due to Motorola’s internal difficulties, but the fact that the capacity of the plant’s capacity was so 67 Information drawn from an interview conducted by a former colleague and long-term research collaborator on December 3, 2001, with IC industry executives.

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small shows how little the Chinese government held Motorola to any performance targets. One needs only to eyeball the number of pieces of capital equipment in the fab to know the approximate level of production, so this information was not something hard to uncover if MII had wished to learn about it. Instead, Motorola moved very slowly and still retained all of its privileges in China.68 Boosting capacity had nothing to do with the physical limitations of the plant. SMIC began bringing in more equipment to the same plant and tripled the plant’s capacity.

5.4.3 SK Hynix and Intel With the establishment of the hybrids and the first tentative investments by Taiwanese foundries, major MNCs beyond Motorola began to consider building fabs in China. First, Korea’s Hynix69 built a 200-mm fab in Wuxi in 2005 taking advantage of the trained workforce CSMC had built up there. Hynix then expanded its Wuxi facility to include a 300-mm fab in 2006. Intel began looking for a location for a fab in China in 2005 and decided to invest in Dalian in northeast China in 2007. Intel’s 300-mm fab opened in 2010, but the logic of luring Intel to Dalian in terms of development policy seems very questionable. Intel has not brought production of its core product, microprocessors, to Dalian and instead has been producing chipsets there. Indeed, analysts think that without subsidies for production in China, Intel would either have abandoned chipsets as a product or outsourced it to Taiwanese foundries (EET 11.3.2010). Furthermore, as further evidence of Intel’s lack of commitment to locate leading technologies in China, Intel employed 65-nm process technology in its Dalian fab while it simultaneously advanced four of its existing and new fabs in the United States to 22-nm technology. Of course, as an American company, Intel was also subject to US export control laws that arguably impinge on its ability to export leading edge processes to China. However, Intel’s record suffers in comparison with SMIC. SMIC has subjected itself to the export control process of the US government in order to receive capital equipment from American firms, and SMIC has advanced its China-based processes farther than Intel, even though Intel is renowned for being on the “bleeding edge” of semiconductor process technology. 68 For those who wonder what, if any, weapons MII had at its deposal, the ministry had two very powerful weapons: (1) it had licensing power over what foreign firms may sell cellular phones in China and (2) it still controlled China’s telecommunications service providers in China so it could easily influence their purchasing decisions. Of these two, obviously, the licensing power was a much more formidable cudgel to bang Motorola over the head with, but this threat was never voiced by MII, according to my interviews. 69 This section will just refer to SK Hynix as Hynix. ST Microelectronics and, subsequently, ST’s JV NOR flash venture with Intel, Numonyx, were minority owners of the Hynix facilities in Wuxi.

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Beyond the issue of credible commitment to place technology in China, these fabs were the product of large-scale subsidies.70 As in many other deals with local governments, Hynix was given a generous deal on land (Chosun Ilbo [English 1.30.2007]). Intel may have received USD 1 billion in aid from the Dalian government for the fab, essentially making the investment free for Intel (assuming the reports of the use of old equipment are true) (EET 4.3.2007). Some descriptions suggest that the total investment by Intel will actually be only USD 1 billion not the headline figure of USD 2.5 billion (China Knowledge 7.23.2010). If true, then Intel possibly did not actually spend any of its own money on this fab. Even so, the incentives for local government officials (see Chapter 2) still make sense as long as the appearance of a large amount of FDI holds true. Central government officials are well aware of this problem of irrational fabbuilding by local governments driven by the rational careerist motivations of local officials. As one central government official involved in semiconductor policy stated about local governments competing with each other to give all sorts of subsidies and tax breaks to MNCs: We need to encourage the proactiveness of local governments but they need to be more careful in what they do. Local governments like to invest in fabs because few industries offer such large single investments. They are political merit points (zhengji) for these officials. If the local governments absolutely are determined to do it, we cannot stop them. (Interview 421)

Local governments defend such policies to lure such investments by invoking the wonders the investments will work in terms of the chanyelian (industry chain or, more colloquially, the value chain) or the chanye shengtai lian (the industrial ecosystem chain). The argument made time and again to this author by various local government officials is that enticing fabs to locate locally will then attract the rest of the value chain (or at least the high value-added parts) to the same location. Mayor of Dalian, Xia Deren, stated explicitly his hope that the Intel investment would bring further parts of the industrial ecosystem chain to Dalian (Zhongguo Dianzi Bao 10.26.2010). Leaving aside whether these arguments are simply cover for officials to capture large investments they want for careerist motivations, the value chain argument is quite troubling as a matter of public policy because co-location across the value chain is not critical or even common in the IT industry broadly, especially in semiconductors (this issue will be discussed further in Chapter 7).

70

There was lots of talk in the Chinese language press about the Dalian municipal government’s extensive support for the Intel investment (see for example Zhongguo Dianzi Bao 10.26.2010 and Tianxia [Commonwealth Magazine] 1.30.2008).

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Samsung has built a new fab in Xi’an that is currently ramping up. China now has fabs owned by the biggest fabrication firms in the world: Intel, Samsung, TSMC, TI (SMIC’s old Chengdu fab), and Hynix. However, none of these firms other than Hynix have more than one fab, and the MNCs are running older processes in their Chinese fabs than SMIC. Furthermore, the MNC fabs are either directly (TI in Chengdu) or indirectly (Hynix via CSMC and Intel via SMIC) taking advantage of the workforce the hybrids trained prior to their arrival. The Chinese state, aware of its past failures, issued its 2014 semiconductor policy with promises for the central government’s IC fund to spend 120 billion RMB on the industry with as much as 60–70 percent spent on fabs. Local governments will also spend money to promote the industry (EET 1.14.2015; ESJJBD 9.17.2014). Some have placed the total government support as high as 1 trillion RMB through 2020 or 2025 (McKinsey 2014). The problem of course is a fully loaded, cutting edge fab will cost up to USD 20 billion to build by 2020 (EET 10.3.2012). Lu Jun of the National Semiconductor Investment Fund suggested that the Chinese government would aim at more mature fabs.71 This may be wise in light of the costs involved, but it will also mean China remains far behind the frontier. Of course, firms’ government spending targets will likely decide how effective the policy is. If SOEs are the main vehicles of this policy, it will most likely fail.

71

Presentation at IC China on October 28, 2014.

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6 IC Design From Reverse Engineering to Innovation

6.1 Introduction As recently as the late 1990s, IC design activities as done in the advanced industrial world were virtually nonexistent in China. Outside of university labs, China’s major design-related activity was buying imported chips, and then reverse engineering them (replicating the design via copying the circuitry). And yet, just a few years later, a number of commentators began to recognize China’s growing design talent (Lin-Liu 2002; DB 2003; Woetzel 2003; Ernst 2004a). This chapter will first consider the state policies aimed at promoting this sector and then turn to the actual performance of domestic, hybrid, and MNC firms in this sector.

6.2 State Promotion of IC Design Several major policies have attempted to promote the IC design sector in China. These policies have either completely failed to produce commercially viable firms or, at best, have somewhat eased barriers to entry into this sector. As with IC fabrication, the firms targeted for promotion have performed much worse in terms of contributing to China’s technological upgrading than the foreign-financed firms neglected by government policies.

6.2.1 The 908 and 909 Projects During the Eighth and Ninth FYPs respectively, the state carried out the 908 and 909 Projects that aimed to build up design capabilities of Chinese firms

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through the creation of design centers (usually within SOEs) and firms in a number of cities across China. During the 908 Project, a number of firms and research units in Beijing, Shanghai, Shenzhen, and Wuxi were given funds to research IC design, particularly electronic design automation (EDA). As part of the 909 Project, the state gave support to seven design houses including SSMEC (Shenzhen Guowei) in Shenzhen, Huada in Beijing (DYBG 2002, No. 11), and Panda in Nanjing. Huada has been at the center of state IC design plans since Huada’s founding in 1986. Under the 908 Project, technology transfer of foreign computer aided design (CAD) technology1 via Huada (aided in part by the presence of an ex-Berkeley electrical engineering professor, Ed Lien2), was a central part of the project, but under the 909 Project funds were simply distributed to firms for their own research (Interview 489). Approximately 100 million RMB were spent on Project 909’s design side according to one participant (Interview 499). Many of these firms, such as ZTE IC Design (now known as Nationz or Guomin Jishu) and Nanjing Weimeng (the former IC design division of Panda), were eventually combined as subsidiaries under Huada. Following the 908 and 909 Projects, even the leading industrial policy organ of the Chinese state, the State Planning Commission (SPC), viewed these IC industry policies as failures, according to a member of the expert small group on IC policies created within the government in the wake of the 909 Project (Interview 61). Researchers in MOST agreed (DYBG No. 11, 2002). After two decades of living off government research funds and procurement, none of these entities have evolved into viable commercial enterprises except for one 2003 spin-off of the SSMEC, which was bought out by its own management and foreign investors and renamed Guowei Jishu or SMIT. Tongfang Microelectronics, a firm connected to Tsinghua University, bought out the main state defense procurement business of SSMEC. The remaining firms have survived by serving protected state procurement markets, such as smart cards, the defense industry, and specialty ICs for China’s state banks (Interviews 319, 489, 499). Like many other state-linked projects, returnees were heavily involved. Ed Lien came to Beijing and took part in 908 in the early 1990s as an executive of Huada, but failed to create a viable enterprise internally. He eventually left to start his own design house in Beijing, which was eventually sold to Analog Devices to jumpstart Analog’s own design base in China. A number of other returnees joined Huada in the subsequent two decades, but all of them eventually left Huada, with many going abroad again (Interview 499).

1

This CAD technology was essentially the forerunner of electronic design automation (EDA) tools that help designers to create chip designs on computers. 2 Lian Yongnian.

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6.2.2 Circulars No. 18 (2000) and 4 (2011) and State Procurement Despite the SPC’s assessment that the policies of the 1990s had failed to create a viable IC industry, the State Council announced a new tax policy designed to promote China’s software and IC industries in January 2000.3 The State Council’s Circular No. 18 in 2000 proposed to cut the value added tax (VAT) from 17 percent to 3 percent for ICs fabricated or designed in China. These incentives were available to both foreign and domestic firms as long as the relevant fabrication or design was done in China. The policy also offered the liang mian san jian ban or 2+3 corporate income tax break (two years tax-free and three years of tax reduced by half)4 and zero import duties for these sectors. Despite the goal of creating a local industry, at least half of the VAT subsidies went to FIEs, and even these subsidies were paltry as they amounted to only 200 million RMB (JJGC July 19, 2004). Two hundred million RMB was onethird of 1 percent of China’s domestic IC production in 2004 and this two hundred million RMB was doled out gradually over more than three years, rather than in just one. Nevertheless, the US government, at the prompting of the Semiconductor Industry Association (SIA), objected vociferously to these tax breaks that were in clear violation of the WTO’s Agreement on TradeRelated Investment Measures (TRIMs) since they explicitly required local design for the tax breaks. The Chinese government in 2004 realized the law as written was indefensible under WTO law so they did not contest the US lawsuit and dropped the offending VAT policies. The US government and SIA probably should not have been so overwrought about this particular policy given that No. 18 proved to be extremely hard to implement in practice. In order to receive tax breaks, there was a complicated two-step process to be completed. First, the company’s overall design operations had to be approved as fulfilling the China-based design requirements of No. 18. Then individual products had to be recognized as fulfilling No. 18’s requirements. According to one returnee who led a large hybrid design center in Beijing and was involved in advising the Chinese government on how to go 3 The role of the State Planning Commission is interesting because it served as both skeptic and advocate of IC industrial policy. According to a member of the expert small group that worked with the SPC, the State Council, MOST, SETC, and the Ministry of Education to create a report that the SPC submitted to the State Council, it was this very SPC-approved report that served as the basis for No. 18. However, it appears that the SPC was initially only interested in having No. 18 promote the software industry. Only with persuasion by Gou Zhongwen, then director of the China Center for Information Industry Development (CCID), the consulting arm of MII, and his subordinate did the final report to the State Council include policies for the IC industry that were as generous as those granted the software industry, requiring lower investment hurdles than the SPC was originally going to endorse (Interview 61). 4 This 2+3 tax break was also available from many other policies, such as location in various national technology and industrial parks, in which many of these firms were already located or likely to locate, making it somewhat redundant.

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about the process of recognizing local design operations, no firms had received product-level recognition by August 2002, almost three years after the start of the project. Coordinating between the local tax bureau and customs was particularly problematic (Interview 177).5 An ex-manager of one of the most cutting-edge Shanghai hybrids, Newave, pointed out in 2004 that despite his firm being a star that met all the conditions, “No. 18 never materialized” (Interview 288). Another manager in a hybrid design operation in Shanghai also criticized the time-consuming nature and limited benefits of the policy. He noted that the policy had “reverse graduation” of the VAT (i.e. staggered tax breaks depending on what firms actually did in China) so the VAT was not going to decline to 3 percent easily. Furthermore, firms would need two years to complete the product recognition process needed to get the tax breaks even after first receiving the required state recognition of a given firm’s China-based design operations. Moreover, each product needed to be recognized as meeting the policy’s requirements (Interview 160). These implementation and verification difficulties help to explain why just 200 million RMB was doled out during the life of the policy. In the wake of dropping the VAT incentives, China redoubled its industrial policymaking efforts rather than abandoning them. Early reports speculating about the new policies envisioned the state spending as much as 10 billion RMB (approximately USD 1.25 billion at contemporary exchange rates) to support domestic industry through 2010 (JJGC 7.17.2002; ASWJ 11.26.2004). Despite the hype, China’s government did not formally announce another policy designed specifically to replace No. 18 until 2011. In some respects, waiting until 2011 was not surprising given that the original policies were to extend through 2010 and the parts of No. 18 that the United States had not challenged in WTO court continued as planned. Nevertheless, the state continued to be very active in supporting this industry even without another grand policy announcement. Various interlocutors said that the central government had indeed spent 10 billion RMB or more6 to support the IC industry during this period. MII/MIIT and, secondarily, MOST provided research funds to many local IC design firms. In addition to these efforts, the procurement policies just mentioned continued apace and provided the main markets for most of the state-linked design firms. Much of this state procurement has been through the series of

5 This firm initially underestimated how difficult it would be to enjoy the benefits of No. 18. In an earlier interview with the firm in December 2001 (Interview 48), the firm anticipated being able to enjoy the full benefits even without having all of their design located in China. 6 One industry observer, who had high-level executive positions in both FIEs and state-owned firms during the relevant time period, put the figure of support at over 100 billion RMB per FYP for the last several FYPs, but this figure most likely includes all sorts of local government subsidies (Interview on June 21, 2013).

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Paper Tigers, Hidden Dragons Table 6.1 Top ten fabless firms and state procurement, 2011 Company name

Ownership

2011 revenue (USD millions)

Role of state procurement

1. Spreadtrum* 2. RDA* 3. Galaxycore 4. SSMEC** 5. Leadcore

Hybrid Hybrid Hybrid Domestic state Domestic state

663 281 181 173 146

6. CEC Huada

Domestic state

127

7. CR Semico

Domestic state

124

Domestic private Domestic state

98 97

Domestic state

94

Minimal Minimal Minimal Military procurement Most sales due to state support in the telecommunications sector (formerly part of Datang) Most sales to the various outlets of the Golden Card project Most sales due to state procurement of power meters Minimal Most sales to Golden Card state procurement Most sales to Golden Card state procurement

8. Rockchip 9. Datang Microelectronics 10. Shanghai Huahong IC

Sources: PWC (2012) and Interviews. Only independent fabless firms were included. * Spreadtrum was bought out and RDA agreed to be bought out by Tsinghua Unigroup in 2013. ** SSMEC was bought out by Tongfang Guoxin, another state firm, in 2012.

Golden Projects to promote various technology-intensive goods. The most important has been the Golden Card project to promote the adoption of IC cards through state procurement. IC cards are cards with chips that carry adjustable information used for such things as telephone cards and transportation cards in China. A director of the most active national IC design center in China admitted that state procurement played a very large role when he noted that there were two types of products the center supported: “global products” and “completely government-guided market products,” a euphemism for direct and indirect government procurement (Interview 446). On the surface, developing “government-guided market” products seems to be offset by supporting “global products,” but the reality is that the state-linked firms almost completely relied on the former as shown in Table 6.1. This phenomenon of state procurement channeled to the statelinked firms is widely understood within the industry in China. As one IC designer who had originally worked in the state sector wryly put it when giving his assessment of Huahong Beijing’s ID card chips, “Not anything special—just a special relationship with the government” (Interview 435). These markets are also extremely large, with the bank IC card market alone estimated to have been worth 30 billion RMB (almost USD 5 billion) in 2012 (Sina Tech August 10, 2012). 160

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While it is true that the beginning of Silicon Valley’s IC industry was closely related to US military procurement (Leslie 2000), procurement in China has not led to viable commercial firms that could create new markets beyond state procurement. After over twenty years of heavy government support, 908 and 909-supported firms, and certain state telecommunications firms, such as Datang and its spin-off Leadcore, still rely on state procurement to survive. There firms are hardly Intel or any of the other “Fairchildren” that sprang up in Silicon Valley with an initial boost from military spending and human capital exodus from the original Silicon Valley IC firms, Fairchild and Shockley. Access to state procurement is also quite closed to most private firms. One local private firm reported that it had tried to compete with the statelinked firms in the large IC card market, but had to resort to supplying a state-linked firm with chips because it could not get into the state’s procurement channels. The margins were very low since it could not sell directly to the state and it decided to try to develop alternative businesses (Interview 272). The hard reality—that foreign-invested firms were also cut off from national and local level research funding—was confirmed by a 2008 visit to a firm I undertook with two officials from the local semiconductor associations in a city with one of the largest clusters of semiconductor design in China. I had wanted to visit the firm, but had trouble making contact with it. The local semiconductor association told me they would be happy to provide an introduction. This introduction morphed into a visit by the two officials and myself to see the firm.7 To my surprise, this firm, which had spun-off from a state research institute, actually had embraced the foreigninvestment route. To my even greater astonishment, the local officials were completely uninhibited about expressing in front of a foreign observer how they were not going to give any research funds or any other support to this or any other such foreign-invested firm. They warned the firm that it should mend its way by shedding its foreign ownership and becoming a domestic firm. The new program announced in State Council Circular No. 4 in 2011 showed tremendous continuity with No. 18, although the tax breaks for certain categories were even more substantial (see Table 6.2). More tellingly, there were promises for generous, if not clearly specified, support for the

7 I must stress that this is the only occasion when I went with local officials to visit a firm, and it was not my intention to do so on this occasion either. The manner of the introduction in the form of a visit to the firm only became clear at the very last minute. Backing out at that juncture would have been very bad etiquette, so I went with the flow.

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Paper Tigers, Hidden Dragons Table 6.2 IC industry promotion policies Policy type

No. 18 policies (2000)

No. 4 policies (2011)

Tax incentives

² 17% VAT reduced to 3–6% (dropped after WTO lawsuit) ² Corporate Income Tax (CIT): 2+3 tax holiday for investments over 8 billion RMB or under 0.25-micron process technology fab lines

² VAT breaks on procurement for largescale projects ² CIT: 2+3 tax holiday for fab lines of less than 0.8-micron; 5+5 tax holiday for less than 0.25-micron fab lines or investments of over 8 billion RMB; CIT at 15%* ² New design firms enjoy 2+3 exempt from import VAT and duties and business tax ² Unspecified CIT tax incentives for design firms under the state plan, packaging firms, and semiconductor materials firms ² Import duties free for design firms’ goods imported on a bonded basis

² Zero import duties (including import VAT) on technology and IC capital equipment

Investment

Promises of generous support for IC projects and technology advancements.

* The 5+5 reverts to simply a 15 percent tax rate if the lines operate for less than 15 years. Sources: ESJJBD (2.21.2011); Guofa ([2011] No. 4), and KPMG (March 2011).

industry. The lack of detail was particularly apparent in the dropping of statements of outright positive discrimination for domestic firms in procurement that were in the original No. 18 alongside the WTO-incompatible VAT breaks. One newspaper report noted this lack of specificity and partially attributed it to a deliberate strategic choice to avoid friction with trade partners (ESJJBD 2.21.2011). In any case, the promises for greater support for the IC industry were clear, especially when compared to the lack of IC industryspecific investment policies in the original No. 18, where such policies focused on the software industry. In November 2013, Xu Xiaotian of the China Semiconductor Industry Association and a former MII/MIIT official announced at the IC China Summit that the government was going to commit a large sum of money that went far beyond the support of No. 18. His statement indicated that the government would go beyond promised tax breaks for private capital participation and vague promises of state support contained in Circular No. 4 and provide large amounts of state capital to support the sector (Dongfang Zaobao November 12, 2013). What Xu was alluding to was the megaproject (see Chapter 2) for the IC industry, which was formally announced on June 26, 2014. The conclusion of this chapter discusses the state-backed acquisition of foreign design firms that are linked to this policy. 162

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6.2.3 National IC Design Bases In parallel with the tax promotion policies of No. 18, MOST proposed to create nationally designated IC design bases to provide support for design activities in various parts of China. During 2000 and 2001, seven cities were selected to host these bases: Beijing, Shanghai, Xi’an, Wuxi, Hangzhou, Chengdu, and Shenzhen.8 All of these cities had strong technical universities or a historical cluster of IC research (in the case of Wuxi) except for Shenzhen, which was selected after all the other bases. As the premier electronics-manufacturing hub in the Pearl River Delta, Shenzhen was an understandable choice, although it received heated competition from Guangzhou, Zhuhai, and even Hunan Province, to serve as the main base for southern China. MOST provided seed funding that aimed to provide a training and support platform for local design firms. The primary focus was funding for EDA tools to be shared legally by firms doing design on-site at each national IC design center. MOST funding was widely acknowledged by the management of the various design centers to be quite limited, seed funding. What distinguished the more ambitious national design centers from the lesser ones was the amount of local/ regional government funding they received. The level of such funding can be clearly seen from the personnel allocation (bianzhi) provided by each local government to its design center. Those design centers not provided with any personnel allocation generally morphed into commercial enterprises that aimed to make enough money through charging for their services to cover their costs. At least one IC design center conceded that commercial services were not very successful in generating sufficient revenue so their main income came from renting out office space in the IC design center building (Interview 450). Rental income is likely to be a major source for a number of the other design centers as they have often been given control over the buildings in which they are located. A number of the design bases were placed under the jurisdiction of development zones, which as we saw in Chapter 2 are generally more interested in attracting investment than providing services to propel the upgrading of local firms. Indeed, at least two design centers in this situation reported that one of their activities was IC-specific investment recruitment. At the same time these design centers are supposed to verify which IC firms are really doing IC design, a problematic conflict of interest given that the firms that do not receive this approval cannot invest in the zone (Interviews 425, 450).9 8 On May 16, 2008, MOST recognized a new design base in Jinan, the capital of Shandong, as the eighth national IC design base. However, the scale of this design base is very small. As of July 29, 2013, only five firms had been recognized as fulfilling the requirements for recognized IC design firms (, downloaded on August 24, 2013). 9 One of the firms resolved this by outsourcing one type of verification required by MIIT to receive its funding to the Chinese Semiconductor Industry Association (CSIA). However, that was problematic because the verification process was originally intended to include two levels, one

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The two zones generally recognized as offering broader and deeper levels of support services are Shanghai and secondarily Shenzhen.10 These two are not under the jurisdiction of development zones, but instead under regional/ municipal government’s science and technology bureaus. Shanghai and Shenzhen also have the highest personnel allocation of the seven, demonstrating the higher level of investment made by their respective governments. By one estimate, Shanghai invested 50 million RMB annually in the design base during its first three years of operations (Interview 398). As shown in Table 6.3, most of the design centers nominally offered most of the services the others offered. In reality, the low quality of the services and/or the prohibitively high prices charged by the less well-funded bases make the services ineffective vehicles for upgrading (Interviews 392, 425). For example, Xi’an’s base, despite offering the complete range of services, is generally regarded as of inferior quality and expensive by local IC entrepreneurs (Interviews 284, 424). In Wuxi, there are similar complaints about the cost of services and particularly rent within the design base (Interview 449). In contrast, Shenzhen outsources some of its services, but generally has done so in a manner that makes them cost effective for local firms, given the greater support of the Shenzhen design base.11 Additionally, some of the services in various design bases reported in Table 6.3 are most likely outsourced, even if they were not reported as such.12 Critically, even Shenzhen and Shanghai have limits to the quality of services offered as many firms have turned to the design services offered in Hong Kong13 when Shanghai’s and Shenzhen’s support has proved insufficient (Interviews 381, 392, 474). More damning still, the support offered by even the most complete and advanced of the IC design centers, Shanghai, has not really been provided to the firms driving upgrading. Most of the interviewed firms that went on to be commercially successful reported that they did not use the center’s services. Some of them feared that the center would not protect their IP from others using the center. Others received sufficient private investment that they had already acquired EDA tools and other services that were superior to what the

conducted by the local level and the other by CSIA (Interview 450), so there could be a crosscheck on the verification process. 10 Some interlocutors from outside Beijing also mention Beijing’s base as actually offering a reasonable range of services (Interviews 392, 398). 11 However, it must also be pointed out that Shenzhen’s design services, like other design bases have low cut-off points, where the design base stops serving firms at subsidized rates when they reach certain revenue thresholds, such as USD 20 million in sales. 12 Shanghai provided MPW services to Beijing and Wuxi as well as Shenzhen in 2002 (Interview 105). 13 Hong Kong’s design services are often referred to as the additional national design base in the so-called “7+1” formula, with Hong Kong being the one added to the original seven. However, this is a merely honorific title since Hong Kong’s design services have not received MOST funding (Interviews 380, 411, 412).

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Table 6.3 National IC design bases MPW

Test & verification

SIP

EDA

DFT

Information support

Training

Personnel allocation (bianzhi)

Undertaking unit (shiye danwei) dominant within the base organization

Firm (qiye) dominant within the base organization

Supervisory unit

Shanghai Xi’an

✓ ✓

✓ ✓

✓ ✓

✓ ✓

✓ ✓

✓ ✓

✓ ✓

25 0

Yes No

No Yes

Chengdu

X*

✓

✓

✓

✓

✓

✓

5