Judging by the recent attention given to Chinese technology companies, it appears that China might be on its way to fulfilling the destiny envisaged by John Chambers, Cisco's CEO, who last year declared that "China will become the information technology center of the world." Chinese tech companies are aiming high, angling for global capital and global markets. The media has been heaping superlatives on Baidu's big NASDAQ debut and Yahoo's US$1 billion investment in online auctioneer Alibaba, the largest investment to date in a single Chinese technology company. Earlier this year, Lenovo catapulted into the third place amongst global PC makers after buying IBM's PC business for US$1.25 billion. Now it appears that Huawei, the Shenzhen-based networking equipment maker, could make a play for Marconi, its British counterpart.
The latest forces that have come into play, include the fresh foreign capital seeking to mate with the next Microsoft, an emerging entrepreneurial-driven tech sector and the droves of overseas, and Western-trained Chinese swooping into Shanghai and Beijing offering their management expertise to local entrepreneurs. These have given China's hi-tech industrial sector an unprecedented shot in the arm.
To be sure, the new fervor, money and talent will certainly help boost China's hi-tech development just as the foreign tech transfers of the last fifteen or so years gave China its start as a manufacturer of low-tech electronics. But beyond the headlines, just how far along is China's hi-tech industry? Where are the opportunities? What are the roadblocks? How much is hype and how much is bankable? Is China's tech industry really coming of age?
A mixed bag
The IT research firm Gartner Group says China's hi-tech industries – which include the telecom, software, hardware and semi-conductor sectors – rang up US$109 billion in revenues last year. Though considered relatively modest in scale given its population of 1.3 billion people, China's hi-tech market is rapidly emerging as a key part of the Chinese economy.
In the enterprise IT space, China's market is still in its infancy. Gartner estimates China's enterprise IT market at less than 20% of Japan's and less than 8% of the US., an unsurprising statistic since many Chinese companies don't yet see the case for making significant IT investments. The conditions that drive IT investment in the West are conspicuously absent in China, most notably the modern business practices that put premiums on leveraging IT to cut costs and manage workflow. When labor is cheap and abundant, the idea of automating business processes would seem more trouble than it's worth.
"The enterprise IT sector in China is different from the Western landscape, particularly among small and medium sized businesses," said Derek Chen, a venture capitalist with Softbank, which invests in tech start-ups. "In the Mainland, [companies] usually don't have strong in-house technological capability where they are in a growth curve [to implement] the technology. The market is not yet mature in terms of consumption power."
For now, demand for more advanced products comes from the large state-owned companies like banks, airlines and telecommunications companies.
Software and services
Currently, it's the foreign vendors who dominate China's software market with a 65% share; China currently accounts for between 10-15% of global sales for many of the larger multinational IT firms, according to Jim Lewis, a global technology policy expert at the US-based Center for Strategic International Studies. Though China currently has limited enterprise IT demand, it's a given that the market will grow.
"American software companies expect this will change over time as China's businesses become more sophisticated, but for now overall levels of IT spending by companies in China remain relatively low," Lewis said.
Still, domestic enterprise software companies are popping up all over China in anticipation of an IT boom. In 2002, China had 6,000 software companies, according to the Gartner Group; this year, there are 10,000.
The proliferation of Chinese software companies says something about the maturity of the industry. While investors are warming to the software sector, the industry has not drawn much attention because of a lack of any clear leaders (though Kingdee and UFIDA are often mentioned as the top contenders) and a low adoption rate.
In its early stages, the software market clearly has plenty of room to grow and the opportunities are there for the taking. "You could argue the [software] market is somewhat wide open because it may very well be that Chinese companies may have a better idea than Siebel or Oracle on how to run enterprise applications," said Gartner vice president Jamie Popkin.
With the software industry still finding its way, China's outsourcing and software services sector is attracting investment from global firms. Drawn by China's relatively cheap technical labor, Microsoft and Indian outsourcing giants Wipro Technologies, Infosys and Tata, among others, have made sizeable investments in China's software services sector.
The country is becoming an increasingly popular outsourcing destination and has served predominantly Japanese companies, though these days, more and more outsourcing jobs are coming from Europe and the US. Jin Chuang, who heads up Powerise International, a Shenzhen listed software and services company, says last year, about 20% of Powerise's outsourcing business came from the US; by the end of this year, he expects that number to rise to 30%.
But while IT services and outsourcing is one of China's faster-growing sectors, the margins are thin.
"IT is getting more and more commoditized," Jin said. Although some companies command margins as high as 30%, it is not uncommon to see companies operate on 5% margins, particularly if they're taking on coding, programming and testing functions. Today, China is nowhere near a position to displace India as the back office of the world – partly because a lack of English fluency – however, the consensus is that China could soon gain on India as China leverages its advantages.
While China's enterprise IT market has yet to reach critical mass, its consumer-driven markets, including the Internet and wireless services, have seen impressive penetration.
With about 350 million subscribers, China is the world's largest mobile phone market, the world's second largest Internet market after the US, with 100 million users and one of the world's largest online gaming markets that last year took in US$298 million in revenues, according to IDC.
"The biggest advantage for China comes down to the numbers," said David Zhang, who oversees Beijing operations at the VC firm WI Harper Group. "You can generate a lot of value from that."
Marrying killer apps with millions of users is the kind of story that Wall Street understands. Ecommerce, portals, search engines and now blogs – these are the hot spots where venture capitalists and private equity players are treading and where the horns are locking between industry titans, underdogs and everyone in between. Yahoo's tie-up with Chinese auctioneer Alibaba signaled the beginning of a drawn-out fight for a piece of China's US$133 million (and growing) consumer ecommerce pie, a move that has eBay on the defensive as it promptly snagged Microsoft marketing chief Martin Wu to head up its China operations. China's ecommerce turf will soon get a new player in Tencent, China's largest instant messenger service provider, which announced it would launch its auction services later this year. Meanwhile, the search wars have Google and Microsoft in a legal fracas over Google's poaching of Microsoft exec Li Kai-Fu to run its new Chinese R&D center.
"The Internet is the hottest area right now," said Victor Koo, a former Sohu executive. "The ecosystem for this market is quite healthy. The market is quite big; there's access to financing and there are good teams."
As China's IT market ramps up, the country is charging full-steam – by government decree and entrepreneurial fervor – to create a thriving high-tech industry on par with those of developed countries.
To what degree China succeeds will depend on the availability of a steady talent stream and its ability to access capital, innovate and commercialize R&D.
China's scores on these criteria are spotty today. On the one hand, China's talent pool is plenty; in 2004, it graduated 644,106 engineers, compared to 100,000 in the US – however, there are talent shortages in certain sectors, including online gaming, which needs 20,000 game developers in the next five years, but currently has only 5,000. While talent attracts capital, access to funding is not as easy as the latest headlines would suggest. To be sure, international VCs are setting up shop left and right in Shanghai and Beijing, but the demand for funding by the vast numbers of local entrepreneurs outstrips the supply available even after due diligence has narrowed down the field. "For every company that gets excellent valuation, 10 to 20 will not get funded at all," said WI Harper's Zhang. Those start-ups without a Western trained overseas Chinese to steer them will find it even harder to get foreign funding, according to those in the business, and to venture capitalists.
"Western VCs like to see western-trained managers help lead local companies," said Chen Chih Song, a US-trained overseas Chinese who in September closed the first-round venture funding for a mainland online learning startup. "People like us provide a certain comfort level to the VCs in terms of organizational skills, integrity, and knowledge of foreign markets," Chen said.
How innovative is China?
If innovation informs the progress of IT development, then China still has some ground to cover.
"In terms of tech, there's really nothing cutting-edge in China, perhaps with the exception of IC design and semiconductor fabs," said Chester Hoang, who, as director of Deloitte Touche Tohmatsu's Hong Kong corporate finance practice, conducts due diligence of Mainland start-ups on behalf of VCs and private equity firms.
Venture capitalists like Softbank's Chen agree. "There are people who are working on interesting things, but 'cutting edge' is not as widespread as in the US," he said. One reason is that as consumers of IT, China has yet to reach a point where it needs a lot of advanced technology. "If you bring a top-of-the-line server into China, who will use it? The airlines, insurance companies, they're served by mid-range servers," Hoang said.
Others say a lack of an environment conducive to creativity has also slowed innovation. "China's environment does not encourage creativity," according to Jin Chen, a technology management professor at Zhejiang University in Hangzhou. "Failure tolerance is low and there is not a tradition of risk-taking."
Moreover, China may be the victim of its own success, burdened by its legacy as a top producer of cheap and commoditized digital cameras, mobile phones and computers. "Many Chinese companies use low price to compete in international markets … while at home, the market hasn't called for advanced technology," Chen said.
Indeed, much of the advanced, high-value added parts that go into Chinese-made electronics tend to be Japanese, American and European imports. According to Nicholas Lardy of the US-based Institute for International Economics, only 15% of the value of China's exported electronic products are domestic value-added, suggesting that China is but a mere assembler of hi-tech products.
China has also yet to prove that it is fluent in commercializing R&D results. One problem is that the government, rather than commercial interests, has historically directed the bulk of the country's R&D. Powerise's Jin says China has had a "structural problem with commercializing R&D because many of the R&D facilities were government-funded, so they were only serving government requirements and tended to be disengaged with market needs."
"The companies I see are capable of innovation … but they lack the ability to take [the results] to market," according to Gartner's Wiggins. "A lot of things come out of universities but the problem is they lack the business know-how. They're technologists, not business people."
On the upside
Yet for every citation reflecting China's lack of innovation, a corresponding pocket of creativity is sprouting somewhere in the country.
"IT is a broad spectrum; you can point to pockets of the IT sector where China is innovative and ahead of the curve," said Phil Lin, a Columbia University business professor who spends half his time in China advising, funding and incubating tech startups. In fact, areas routinely cited as beacons of Chinese innovation are its more mature sectors, such as mobile, online gaming and semiconductor. For the mobile and online gaming industries, it's the scale and infrastructure that elicit the wows.
"If you look at the China [telecom] carriers, the types of scale and issues they have to face – you need a certain level of maturity to deal with that," said Wiggins, adding that China's mobile industry is years ahead of the US with its myriad of applications. The same infrastructure issues apply to the online gaming platforms capable of supporting hundreds of thousands of simultaneous players.
As for R&D, many say China is reaping the benefits of R&D facilities established by MNCs like Microsoft and Cisco. "In China, they are creating some of the most incredible products that I've ever seen being built," Wiggins said, adding that Microsoft's tablet PC came right out of China's R&D center.
Although these are foreign-led R&D, Wiggins said the Chinese will leverage the know-how and create something of their own. "The fact that they're using foreign nationals who are going to take their knowledge to the next company is significant," Wiggins said.
Ernst & Young partner Eugene Wong who works with Chinese tech companies offers another way to measure China's IT development: "Technology will grow incrementally. You will see a lot of success stories in China in the future."