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China's Manufacturing Powerhouse Must Learn to Innovate

Rapid absorption of foreign technology is evident in the growth of the country's now world-beating manufacturing sector

Daniel Rohr, CFA 2 October, 2017 | 8:40AM

High-speed train in China

Standard economic theory suggests that economies further away from the world technology frontier should grow faster than economies close to the frontier. That's because it's easier to grow by copying existing technology than by inventing a new one. 

Arguably, no major country has capitalised on the opportunity afforded copycats as well as China. Rapid absorption of foreign technology is evident in the growth of the country's now world-beating manufacturing sector.

Since 1990, Chinese manufacturing exports have grown at a 15% compound annual rate and are now roughly 50 times larger in nominal US dollar terms. By 2015, the last year for which worldwide data is available, China accounted for 19% of global manufacturing exports, up from 5% in 2000 and 2% in 1990. 

Success Factors

China absorbed and successfully redeployed foreign technology so quickly due to four interlinked factors:

Good timing: Over the past few decades, rapid improvements in communications technology such email and the internet, and reduced barriers to trade and investment through globalisation have allowed companies to manage further-flung operations and vendor relationships. Without these developments, it is doubtful China could have attracted the foreign investment that made possible rapid technology absorption, or redeployed that technology into the export markets as successfully as it did.  

Location: Proximity to existing supply chains in East Asia aided China's acquisition of foreign technology. Rising wages in Japan, Korea, Taiwan, and Hong Kong made mainland China an attractive and convenient alternative once Beijing opened its doors for business. 

Government support: Technology acquisition has been a major policy priority since Deng Xiaoping established the Shenzhen Special Economic Zone in 1980. In the intervening years, Beijing has used a variety of tools to aid domestic firms' acquisition of foreign technology. In its role as regulator, the government has often demanded technology-sharing agreements before granting market access. Frequently, that access is only allowed through joint ventures with domestic Chinese firms.

As a big buyer in its own right, the government has made local content or technology-sharing prerequisites to its purchases. Finally, as the owner of China's largest banks, the government has steered funding to state-owned firms that undertake mergers and acquisitions aimed at acquiring foreign technology.

Vast domestic market: Foreign willingness to share or risk losing valuable intellectual property would have been more limited were it not for China's vast and growing domestic market. The opportunity has been far too much to pass up for countless foreign firms, from automakers to software developers. Lost IP (intellectual property), whether through formal technology transfer agreements or outright theft, has often been the price of entry to the Chinese market.

China's Export Boom - graph

Closing the Gap With the Best in the World

Through this combination of factors, Chinese firms have been able to rapidly absorb foreign technology and, in many sectors, have closed the gap with the best that foreign firms have to offer. In the industrial sector, for example, the country's first domestic high-speed locomotive design, the CRH380 series, based largely on foreign designs, was rolled out in 2010. Not long after, China had captured over 40% of the global high-speed rail equipment market, much to the dismay of rivals like Japan's Kawasaki (3045), which claims the Chinese CRH380 is a copy of its Shinkansen bullet train.

A similar story has played out in the power sector, another area targeted by the government. In nuclear power, China is now aggressively marketing its first domestically developed third-generation reactors, the Hualong One and CAP1400. Those designs are based largely on Areva's PWR reactors and Westinghouse's (WAB) AP1000, respectively.

In wind power, the government's 50% local-content requirement on any sales to Chinese buyers facilitated rapid technology transfer to domestic players. By 2016, four of the 10 largest onshore wind turbine manufacturers were Chinese, including third-ranked Xinjiang Goldwind (002202). China is also home to the world's largest offshore wind turbine maker, Sewind, which builds Siemens turbines under license.

While China's rapid technological catch-up has proved a major boon to growth over the past few decades, it naturally leaves less scope for productivity-enhancing copycat behaviour going forward. Increasingly, Chinese firms will need to innovate, rather than imitate. And that's a lot harder to do. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Kawasaki & Co Ltd1,610.00 JPY0.00-
Westinghouse Air Brake Technologies Corp78.00 USD1.66-
Xinjiang Goldwind Science & Technology Co Ltd18.34 RMB10.02-
About Author

Daniel Rohr, CFA  is a senior equity analyst at Morningstar.