Beyond The Global Factory' Model: Innovative Capabilities For Upgrading China's IT Industry

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Int. J. Technology and Globalisation, Vol. x, No.

x, xxxx 1

Beyond the ‘Global Factory’ model: innovative


capabilities for upgrading China’s IT Industry

Dieter Ernst
East-West Center,
1601 East-West Road, Honolulu, HI 96848
Fax: 808-944-7399 E-mail: [email protected]

Abstract: China is now the largest exporter of IT goods, surpassing the USA,
up from a world ranking of tenth in the year 2000. But this ‘global factory’
model now faces new competitive challenges as globalisation transforms
markets for technology and knowledge workers. This has forced China’s policy
makers and corporate strategists to seek ways to move beyond the ‘global Author: Please
factory’ model. A brief review of China’s ‘global factory’ model highlights its reduce abstract
integration into diverse global network arrangements. This paper introduces the of no more than
concept of ‘Industrial Upgrading’ (IU) that links specialisation with firm-level 100 words.
and industry-level upgrading. This concept is used to discuss what specific
innovative capabilities are required to upgrade China’s IT industry. This paper
also emphasises that ‘soft’ entrepreneurial, management and system integration
capabilities need to complement ‘hard’ R&D. The argument is that ‘technology
leadership strategies’ that focus on ‘radical’ innovations are not the only option.
‘Technology diversification’ can serve as a complementary and arguably less
costly option.

Keywords: China; ICT; capabilities; ‘global factory’; industrialisation;


networks; upgrading; venture capital.

Reference to this paper should be made as follows: Ernst, D. (xxxx) ‘Beyond


the ‘Global Factory’ model: innovative capabilities for upgrading China’s IT
Industry’, Int. J. Technology and Globalisation, Vol. x, No. x, pp.xxx–xxx.

Biographical notes: Dieter Ernst is a Senior Fellow at the East-West Center.


He was Senior Advisor to the OECD, Paris; Research Director at the Berkeley
Roundtable, University of California, Berkeley; and Professor of International
Business at the Copenhagen Business School. He has co-chaired an advisory Author: Please
committee of the US Social Science Research Council to develop a new
reduce career
programme on Innovation, Business Institutions, and Governance in Asia.
He has served as scientific advisor to several institutions, among them the history of no more
Organisation of Economic Cooperation and Development, the World Bank, than 100 words.
the Asian Development Bank, the UN Conference on Trade and Development,
and the UN Industrial Development Organisation. His research covers global
production and innovation networks and implications for industrial and
technology policies. Books include Technological Capabilities and Export
Success in Asia, What are the Limits to the Korean Model?, International
Production Networks in Asia, and Innovation Offshoring – Asia’s Emerging
Role in Global Innovation Networks.

Copyright © 200x Inderscience Enterprises Ltd.


2 D. Ernst

1 Introduction

China’s Information Technology (IT) industry may be a relative newcomer on the world
scene but it is doing something right, and in a big way. China is now the largest exporter Author: Please
check if the
of IT goods, surpassing the USA, up from a world ranking of tenth in the year 2000.
highlighted
And China’s booming market for electronics products and services reshapes the global reference
IT market and defines innovation roadmaps (von Hippel, 1988, 2005).1 As the second citation is ok.
largest IT importer (up from the seventh place in 2000), China has accumulated
bargaining power, especially for telecommunications equipment (both fixed-line and
wireless), computers, software and semiconductors (Hopfner, 2007).2
China’s success is due to a unique combination of competitive advantages (Ernst,
2006b; Ernst and Naughton, 2007). The rapid growth of the Chinese market encompasses
both high-end ‘lead customers’ (Beise, 2004) in Shanghai, Beijing and Shenzhen, as well
as ‘bottom-of the pyramid’ customers in lower-tier cities and rural areas (Prahalad and
Lieberthal, 1998) that require ultra-low-cost products and services. China also has the
world’s largest pool of low-cost and easily re-trainable knowledge workers.3 This has
attracted Foreign Direct Investment (FDI) on an unprecedented scale. For China, inward
FDI is more than ten times as important as during Japan’s and Korea’s high growth
periods – and nowhere more so than in high technology exporting. This has given rise to
a deep integration into Global Production Networks (GPNs), exposing Chinese firms to
leading-edge technology and best-practice management approaches (Ernst, 1997, 2002a;
Ernst and Kim, 2002; Borrus et al., 2000; Ernst, 2003, 2004, 2006f).4 This, in turn, has
created new opportunities, pressures, and incentives for Chinese firms to upgrade their
technological and management capabilities and the skill levels of workers.
Equally important for China’s success are aggressive, yet selective and continuously
adjusted support policies that have enabled domestic firms to exploit those opportunities
and to improve their positions in these networks. Of particular importance are concerted
policy efforts (both at the national and regional level) to strengthen China’s innovation
system and foster the emergence of sophisticated lead users and test-bed markets
(especially in wireless telecommunications).
But this ‘global high tech factory’ model is now confronted with new competitive
challenges, both from below and from above. From below, the rise of lower-cost
manufacturing sites in Vietnam, India, Bangladesh, Pakistan or Sri Lanka implies that
simply creating cheap-labour manufacturing jobs is not a viable development strategy.
And from above, China is now confronted with a more hostile international environment,
where established industrialised economies in the USA, the EU and Japan are seeking
new ways to protect their industries, and to recreate their competitive edge through R&D.
In addition, the ‘global factory’ model is also facing new challenges that arise from
shifts in the global innovation system, as globalisation transforms markets for technology
and knowledge workers. These challenges include the intensifying competition for a
limited global talent pool and profound changes in the innovation management of global
corporations that give rise to the geographic dispersion of research, development
and engineering jobs through global innovation networks (‘innovation offshoring’)
(Ernst, 2006a).
This has forced China’s policy makers and corporate strategists to seek new ways
to move beyond the ‘global factory’ model. Much of the debate has focused on a strategy
of IU through innovation. But most firms and policy-makers are still groping in the dark
Beyond the ‘Global Factory’ model: innovative capabilities 3

to understand what precisely that strategy requires; for the time being they are content to
adopt a pragmatic trial-and-error approach until they find something that works.
This paper seeks to establish what is necessary and feasible, using illustrative
examples from China’s IT industry. It starts out with a brief review of China’s ‘global
high tech factory’ model, highlighting its integration into diverse global network
arrangements, as well as achievements and weaknesses of the model. In part two, the
concept of ‘IU’, that links specialisation with firm-level and industry-level upgrading,
is introduced.
Finally, in part three of the paper the specific innovative capabilities which are
required to upgrade China’s IT industry are explored. It is emphasised that ‘soft’
entrepreneurial, management and system integration capabilities need to complement
‘hard’ R&D in order to create products and services that customers are willing to pay for.
It is argued that ‘technology leadership strategies’ that focus on ‘radical’ innovations are
not the only option. ‘Technology diversification’ can serve as a complementary, and
arguably less costly, option.

2 China’s ‘Global Factory’ model

A defining characteristic of China’s ‘global factory’ model is its integration into multiple
corporate and informal global networks of production and innovation. China is far
more integrated into global knowledge networks than were Japan and Korea at a similar
stage of their development.
Formal corporate networks link Chinese firms to global customers, investors,
technology suppliers and strategic partners through FDI as well as through venture
capital, private equity investment and contract-based alliances.5 And informal global
social networks link China to more developed overseas innovation systems, primarily
in the USA, through the international circulation of students and knowledge workers.

2.1 Formal corporate networks through Foreign Direct Investment (FDI)


China’s rise as the primary global electronics factory reflects its integration into global
production, sales and R&D networks that industry leaders (primarily from the USA) and
their Taiwanese junior partners have established through FDI. This has generated deep
integration with global customers, technology suppliers and strategic partners.
Since 2003, China is the world’s largest recipient of FDI, overtaking the USA,
traditionally the largest recipient. Incoming FDI has averaged 5% of GDP in China over
the past decade; during Japan’s and Korea’s high growth periods, incoming FDI was
never as much as one half of one percent of GDP. FDI is more than ten times as
important in China as in these earlier latecomers, and nowhere more so than in
high technology exporting. In 2005, Foreign-Invested Enterprises (FIEs) produced
58% of China’s total exports, but they produced 88% of high-technology exports.
And Taiwan-owned FIEs produced 60% of China’s exports of computers and handsets.
In addition, practically all global IT industry leaders have begun to conduct R&D in
China, as part of aggressive innovation offshoring strategies (Ernst, 2006a). A recent
survey of the world’s largest R&D spenders showed that by 2004 China had become
the third most important offshore R&D location after the USA and the UK, followed by
India (sixth) and Singapore (ninth) (UNCTAD, 2005).6 Much of the R&D offshoring to
4 D. Ernst

Asia is concentrated in the electronics industry, with China dominating hardware R&D
for hardware.
As for non-equity forms of R&D internationalisation (‘offshore outsourcing’), China
is now the third most important location behind the USA and the UK, but ahead of
Germany and France. The same survey projects that China will be a more attractive
location for future foreign R&D than even the USA.

2.2 Venture capital and private equity investment


More recently, venture capital and private equity investment have added a new and
critically important dimension to China’s integration into formal corporate knowledge
networks.7 Venture capitalists in Silicon Valley now require start-ups to present an
‘offshore outsourcing’ plan as a precondition for funding. The emerging business model
is to keep strategic management functions like customer relations and marketing, finance,
and business development in Silicon Valley, while increasingly moving product
development and research work to offshore locations (Ernst, 2006a).
A typical example is a start-up company in Shangdi Information Industrial Base in
Beijing’s Haidian District that specialises in mixed-signal chip design (Interview CA
092105). Chinese engineers, who hold PhD degrees from leading US universities and
have worked as senior project managers in leading US semiconductor companies, have
founded the company. The company has received venture capital funding for developing
chip designs in both China and the Silicon Valley. A fully integrated design team in
Beijing develops decoder chips customised for the new Chinese AVS (audio-video
signal) standard. Of the more than 60 engineers at the Beijing facility, 90% hold at least
Masters degrees. Five senior managers based in Santa Clara handle customer relations
and provide design building blocks (the co-called SIPs) and tool vendors for design
automation, testing and verification.
Since the turn of the century, fund raising in private equity has rapidly increased, and
is now also targeting China’s high-tech industries. Much of these new forms of network
integration take place behind the scenes, and, hence, are difficult to document.8 A recent
survey estimates that $ 1,300 billion has been invested in global private equity, a figure
set to rise significantly.9
Private equity investors are now firmly established as major global economic players.
Take Texas Pacific Group (TPG), one of the industry leaders that has played a key role
in Lenovo’s acquisition of IBM’s PC division (Ernst, 2006b). Its portfolio companies
employ around 300,000 people and generate annual revenues of $65 billion. Aggregating
these companies would create a business in the top 20 of the Fortune 500. In addition,
TPG has established a strong presence in Asia through its Hong Kong-based Newbridge
affiliate, well ahead of other leading players.
Viewed from the broader perspective of China’s economic development, the
expansion of VC and private equity investment is a double-edged sword. There is
concern that, as long as it remains unregulated, the expansion of private equity funding
may endanger the stability of financial systems. As they obtain important management
information in advance, private equity firms can use such information to avoid losses or
to unfairly take profits through insider stock trading, transferring losses to ordinary
shareholders.10 Yet, as shown in Ernst (2006b), both venture capital and private equity
investment may act, under certain conditions, as carriers of knowledge on markets,
technology and best practice management approaches.
Beyond the ‘Global Factory’ model: innovative capabilities 5

2.3 Informal social networks


Equally important is China’s growing integration into informal global knowledge
networks through the international circulation of students and knowledge workers. Since
the opening of its economy, China has become intricately linked to more developed
overseas innovation systems, first through a massive brain drain of its students and,
more recently, through a reverse brain drain that brings returnees and overseas Chinese
knowledge workers back to China.
The primary link of course has been with the USA and its universities, its high-tech
industries and its financial sector. In 2005, for instance, China had more than 61,000
students in US universities, more than any other country except India.11 Associations of
US-based Chinese engineers and managers such as Mount Jade, CASPA and NACSA,
play an important role in channelling back and forth information flows and knowledge
exchange between the USA and China. China is also deeply integrated with US-centred
professional peer group networks. In the IT industry, this includes IEEE and its many
specialised working groups, but also industry segment-specific associations like, for
instance, the Electronic Design Automation Consortium (EDAC).12
China’s integration into these informal global knowledge networks provides an
important enabling factor for the development of its innovative capabilities. Exposure
to professional peer group networks, China’s large diaspora of skilled migrants, and
‘IT mercenaries’ (from Taiwan, Hong Kong, Singapore, Malaysia, the Philippines,
as well as Japan, the USA and Europe) can all help to diffuse complex and often
tacit knowledge about technology and management. In addition, these informal social
networks can provide much needed experience and links with markets and financial
institutions, and they can become an important source of reverse brain drain.

2.4 Structural weaknesses


There is no doubt that the ‘global factory’ model will continue to be an important
source for China’s economic growth and capability development. However, both the
1997 financial crisis and the downturn in the global electronics industry in 2000 have
brutally exposed the downside of that model. A country is more vulnerable to external
disturbances; the higher the share of electronics in its exports, the greater its integration
into GPNs, and the more it depends on exports to the USA (Ernst, 2001).
China’s ‘global high tech factory’ model is now experiencing decreasing returns,
in terms of value added, profit margins and job creation. This limits funds available for
R&D and makes it difficult to sustain wage increases. These decreasing returns reflect
fundamental structural weaknesses that result from China’s unequal integration into
fragmented and hierarchical GPNs.
Furthermore, Chinese firms heavily rely on the USA, Japanese and European firms as
the dominant sources of new technology. This reflects the heavy concentration of R&D,
innovative capabilities and Intellectual Property Rights (IPR), much of it centred on
the USA (Dahlman and Aubert, 2001, p.34).13 For Chinese firms, this has resulted in
razor-thin profit margins owing to the hefty licensing fees charged by the global brand
firms. Hence, their capacity to develop new product markets and to shape technology
road maps and standards remains heavily constrained, and they struggle to improve their
branding capabilities.
6 D. Ernst

In response to these weaknesses of the ‘global factory’ model, a broad consensus


has emerged that China’s IT industry needs to upgrade to higher value-added and
technologically more demanding products, services and production stages, and that this
requires the development of strong innovative capabilities. To achieve this goal, China’s
government and IT companies are seeking to develop and improve the skills, knowledge,
and management techniques needed to create and commercialise successfully new
products, services, equipment, processes and business models.

3 Industrial Upgrading (IU) – an operational concept

The concept of IU can serve as a focusing device for China’s attempts to move beyond
the ‘global factory’ model and to unlock new sources of economic growth. The main
objective is to exploit the productivity-enhancing potential of innovation, in order to
avoid a race to the bottom that is driven solely by cost competition.
Hence, in general terms, IU must focus on improvements in specialisation, local
value-added, productivity, and forward and backward linkages, all of which necessitate
a broad base of knowledge and innovation (Ernst and Lundvall, 2004).
Two aspects of IU are of greatest policy relevance: ‘firm-level upgrading’ from
low-end to higher-end products and value chain stages, and ‘industry-level linkages’ with
support industries, universities and research institutes (Ozawa, 2000; Ernst, 2001).14
‘Firm-level upgrading’ is the key dimension – without it, there is little hope that
China can sustain and reinvent the success of its IT industry. In other words, Chinese
firms must develop the capabilities, tools and business models that will allow them to
address the weaknesses of the ‘global factory’ model. And it is the strength of such
firm-level upgrading that will decide whether Taiwan can cope with the new challenges
from shifts in the global innovation system.
But for firm-level upgrading to succeed, upgrading must take place simultaneously at
the level of ‘industry linkages’. To broaden the pool of firms that are fit for sustained
firm-level upgrading, strong support industries are required, so are dense linkages
with universities and research institutes. The challenge is to enable firm-level and
industry-level upgrading to interact in a mutually reinforcing way, so that both types of
upgrading will give rise to a ‘virtuous circle’.
IU in China also faces a second challenge. As its companies are integrated into
multiple global networks of corporate production and innovation and informal knowledge
communities, it is obvious that international linkages are critical for IU. Hence, we need
to distinguish domestic (‘local’) and international (‘global’) elements.
Finding the right balance between firm-level and industry-level upgrading, and
between domestic and international elements poses a continuous challenge for
policy makers and corporate planners – the ‘right balance’ is a moving target, it is
context-specific and requires permanent adjustments to changes in markets and
technology. All four elements hang together – a strategy that neglects one element to the
detriment of the others is unlikely to create sustainable gains. The stronger the links
between those four elements, and the better they interact, the greater are the chances that
Chinese firms can shape markets, prices and technology road maps.
The international dimension of IU will be addressed in a separate paper. Our focus
here is on the domestic elements. We know from the study of ‘national innovation
systems’ (e.g., Freeman, 1987; Nelson, 1993; Lundvall, 1992) that peculiar features of
Beyond the ‘Global Factory’ model: innovative capabilities 7

economic structures and institutions offer quite distinct possibilities for learning
and innovation, and, hence, shape the technological (or economic) performance of
a country/region. The economic structure determines specialisation (i.e., the product mix
and the production process) and learning requirements (the breadth and depth of the
knowledge base, tools and capabilities). Institutions, on the other hand, shape learning
efficiency; they define how things are done and how learning takes place. An important
concern is the ‘congruence’ (Freeman, 1997, p.13) of different subsystems, which is
necessary to create a virtuous rather than a vicious circle.
This indicates that, on the domestic front, an essential prerequisite for IU are
institutions and incentives that facilitate innovation and the development of support
industries, and that provide a sufficiently large pool of experienced and re-trainable
knowledge workers with specialised skills. The role of institutions and incentives is well
covered in the literature (e.g., Naughton and Segal, 2001). But we know less about the
second, equally important, domestic element – how specialisation in products and types
of production may enhance the potential for IU.

3.1 Specialisation and upgrading potential


Specialisation is an important indicator of the degree of IU that a country or region can
realistically expect to achieve. Specialisation patterns reflect differences in product
mix (e.g., homogeneous vs. differentiated products), and in types of production
(where I suggest distinguishing between ‘routine’ and ‘complex’ production, and
between ‘modular’ and ‘integrated’ production). These differences in specialisation, in
turn, give rise to divergence in the complexity of technology, demand patterns and
market structures. Most importantly, differences in specialisation shape a country’s (a
region’s) upgrading potential, in terms of learning opportunities, capability requirements,
value-added and linkages.
For our purposes, a critical policy issue is to identify conditions under which
specialisation and upgrading potential are linked by a virtuous rather than a vicious circle.
In fact, a narrow specialisation on homogenous products or on ‘modular’ production
may well make sense at an earlier stage of development, as it matches with the then
prevailing competitive advantages. Yet, this very same specialisation may, later on,
hinder a transition to differentiated products or ‘integrated’ production.

3.2 Product specialisation


Table 1 shows how the link between product specialisation and upgrading potential
works. Homogenous products (‘commodities’) have only a limited upgrading potential,
in terms of learning opportunities, capability requirements, value-added and linkages.
The opposite is true for differentiated products.
For our purposes, it is useful to establish a link with the Product Life Cycle (PLC)
theory. Following Vernon (1966), differentiated products are typically associated with the
early stages of the PLC, while homogenous products are most likely to prevail during
the late stages. Take the PC industry, a typical example of a ‘late-stage’ industry, which
is an important sector of China’s IT industry. As a ‘commodity’, the PC has very limited
upgrading potential. The root cause is that Intel and Microsoft are in almost complete
control of the standards and technologies, with the result that return on innovation for
PC vendors is low, while the cost of innovation is high.
8 D. Ernst

Table 1 Product specialisation and upgrading potential

Variables Low specialisation High specialisation


Product specialisation Homogeneous (commodities) Differentiated

Mature technology New technology


Established design Fluid design
Easy to replicate Difficult to replicate
Predictable changes in demand Unpredictable changes
and technology
Limited interactions with Close interaction with customers
customers
Market structure Low entry barriers High entry barriers
Price competition Qualitative competition (customer
needs; integrated solutions)
Speed-to-market Premium pricing
Periodic over-capacity and price High profit margins
wars (‘commodity trap’)
Low profit margins
Upgrading potential Few learning opportunities Many learning opportunities
Limited capability requirements Demanding capability requirements
Low value-added High value-added
Limited forward and backward Extensive forward and backward
linkages linkages

By contrast, the scope for differentiation is broader for high-end handsets (especially
smart phones) and for the mobile network industry. Both are examples of ‘early PLC
stage’ industries. While entry barriers are high in both industries, in terms of investment
and technology, there are ample opportunities for new entrants to upgrade through
innovation.
High entry barriers are accompanied by qualitative competition. This requires
complex capabilities to understand customer needs and to provide integrated
solutions. Without policy support in ‘industry-level’ upgrading, Chinese firms would be
hard-pressed to cope with these demanding requirements.
At the same time, this is an industry where premium pricing is possible, at least in
some market segments. To the degree that this translates into high profit margins, this
facilitates investment in R&D. As system architectures and interface standards remain
fluid and are evolving rapidly, there are many learning opportunities and Chinese
firms are under considerable pressure to develop their capabilities. Furthermore, the
mobile network industry provides ample opportunities for creating value-added and for
developing linkages (both domestic and international) with customers, suppliers of core
components and technology, and private and public R&D partners.
Beyond the ‘Global Factory’ model: innovative capabilities 9

3.3 Types of production


The potential for IU also differs for different types of production. (I suggest
distinguishing between ‘routine’ and ‘complex’ production, and between ‘modular’ and
‘integrated’ production (Ernst, 2005b).)15

3.3.1 ‘Routine’ vs. ‘complex’ production


For ‘routine’ production, the upgrading potential is obviously lower than for ‘complex’
production that needs to combine diverse technologies and that may require
customisation, quick responses to changes in market and technology, and the provision of
integrated solutions. The rewards for a transition to ‘complex’ production can be high – if
a firm successfully implements complex processes, it may benefit from premium pricing
and significant profit margins, which, in turn, could provide sufficient funding for R&D.
The downside, of course, is the substantially higher up-front preparatory efforts that are
necessary for successful entry into the more knowledge-intensive complex production.
Take chip design, where ‘routine’ functions (‘design implementation’) are
distinguished from ‘complex’ stages of design that centre on conceptualisation, circuit
architecture and system specification. The requirements for making the transition
from design implementation to conceptualisation are quite demanding. Entry barriers
are extremely high, as design costs at the 90 nano-metre technology (the current
best-practice) can be as high as $20–30 million (Ernst, 2005a). Intensifying pressures
to improve design productivity, combined with increasingly demanding performance
requirements for electronic systems have produced an upheaval in chip design
methodology.16 ‘System-on-CHIP’ (SoC) design has moved design from the individual
component on a printed circuit board closer to ‘system-level integration’ on a chip.
These new challenges are likely to impose quite far-reaching changes on industry
structure, business models and firm organisation, illustrating again how closely
inter-related are firm-level and industry-level upgrading.

3.3.2 ‘Modular’ vs. ‘integrated’ production


‘Modular’ production has played an important role for China’s ‘global factory’ model.
The PC industry has been an important breeding ground for this industrial organisation
model since the mid-1980s. Based on standard interchangeable components as well as
the widely shared Wintel architecture, modular design has rapidly eroded the economic
rationale for vertical integration (Baldwin and Clark, 2000).
Market-led standardisation (through technical standards and design rules) of the
interfaces between organisationally separate stages of production has made it possible
to transform PCs and related products into fully ‘modular’ or decomposable
building-blocks, enabling firms to focus on those activities (‘core competencies’) that
generate the highest margins and which are critical for sustaining the company’s
competitive advantage (e.g., Sanchez and Collins, 2001). This has created ample
opportunities for vertical specialisation (‘fragmentation’) of the PC value chain, giving
rise to the OEM/ODM arrangements discussed in this paper.
But modular production has been extended well beyond the PC industry. In the
semiconductor industry, this gave rise to the decoupling of design and fabrication that
culminated in the well-known symbiotic fabless/foundry relationship, a relatively simple
10 D. Ernst

structure. As with earlier forms of modular production in the PC industry, decoupling


between IC design and fabrication was based on shared interface standards and well
documented and automatically checkable ‘design rules’.
Yet, ‘modular’ production now seems to give way to more integrated forms of
IC production (Ernst, 2005b). In fact, decoupling of design and fabrication became
impractical once large, complex SoC designs had to be fabricated with 90 nanometre
process technology. This required a re-coupling of design and fabrication, giving rise to
much closer interaction between chip designers, design service providers, mask makers,
foundries, EDA tool providers and IP providers.
The important point for our purposes is that the shift to more integrated forms of
production may well enhance the upgrading potential of China’s IC industry.
For design teams, the recoupling of IC design and fabrication implies that they
now have to ‘design-for-yield-enhancement’. In other words, designers must now take
into account the effects of fabrication process variations, which make design even more
complex. The greatest upgrading pressures are on EDA tool providers which are forced to
come up with new integrated solutions under the heading of ‘design for manufacturing’
that would facilitate close interaction. And there will be a huge demand for design service
firms that have to fill the gaps left by global EDA tool providers.
As the established ‘fabless/foundry’ model is being eroded, it is not yet clear which
new model is likely to take its place (Ernst, 2006c). As a late-latecomer, China can
watch how IC firms at different levels of the global IC value chain are experimenting
with diverse upgrading approaches. Such an approach, which requires a bit of patience,
provides priceless learning opportunities about what is necessary and feasible.

4 Implications for innovative capabilities

What specific innovative capabilities are required to upgrade China’s IT industry?


To answer that question, we can draw on the concept of ‘IU’, developed in this paper.
In addition, however, we need to open the black box of ‘innovation’.

4.1 Conceptual building-blocks


To determine more precisely the nature of ‘innovative capabilities’, we can draw on some
building blocks provided in the literature.
The study of R&D expenditures has focused on econometric studies of panel data
that convey some useful ‘broad brush’ indicators, but provide only limited guidance on
firm-level innovative capabilities. However, the increasing sophistication of patent data
analysis (e.g., Jaffe and Trajtenberg, 2002; Granstrand, 1999) now makes it possible to
extend that analysis to the level of the firm.
In addition, patent data analysis can now be used as a proxy indicator for measuring
progress in Asia’s innovative capabilities, as “patenting activities in the region appear to
have grown to sufficiently high levels” (Wong, 2006, p.11). This is true at least for the
NIEs-4, China and India. Specifically, the analysis of patents filed at the USPTO can help
to identify the location of an invention (address of first-named inventor) and the
nationality of the patent owner (location of assignee). US patent data analysis can
also help to determine the quality and impact of patents (patent citations) and their
complexity (science-intensity); the clustering/geographic dispersion of patenting
Beyond the ‘Global Factory’ model: innovative capabilities 11

activities (by measuring ‘hot spots’); and the knowledge exchange between inventors at
different locations.
Especially useful for our purposes is research that, based on questionnaire surveys
and structured firm interviews, has developed operational data sets for measuring
firm-level innovative and R&D capabilities (Lall, 1992; Ernst and O’Connor, 1992;
Hobday, 1995; Ernst et al., 1998; Amsden and Tschang, 2003; Jefferson and Kaifeng,
2004)17. For instance, a comprehensive taxonomy of firm-level capabilities was
developed in a study, prepared for the United Nations Conference on Trade and
Development (UNCTAD), that distinguishes capabilities required for production,
investment, minor change, strategic marketing, establishing inter-firm linkages, and
major change (Ernst et al., 1998). This taxonomy, which suggested a sequential ordering
of priorities for capability formation, was largely confirmed in that study’s comparative
analysis of how electronics and textile firms have developed their capabilities in Taiwan,
Korea, Thailand, Indonesia and Vietnam.

4.2 A broad definition of ‘innovative capabilities’


Building on this literature, this paper suggests the use of a broad definition of ‘innovative
capabilities’ to emphasise that, in addition to R&D and patents, complementary ‘soft’
entrepreneurial, management and system integration capabilities are of critical
importance. It defines the ‘innovative capabilities’ to include the skills, knowledge
and management techniques needed to create, change, improve and commercialise
successfully ‘artefacts’, such as products, services, equipment, processes and business
models (Ernst, xxxx; Drucker, 1985, p.VIII).18
Innovations in the IT industry require R&D capabilities. Amsden and Tschang (2003)
provide a useful classification of the technological complexity of different categories
of R&D. They distinguish ‘process development’ (to reduce costs, uncertainties and
time-to-market of manufacturing, and to improve flexibility); ‘prototype development’
(to implement a product or system design as an engineered system through detailed
product design and engineering samples); ‘applied research’ (to transform, modify and
recombine known technologies so that they fit new applications); ‘basic research’
(to apply new knowledge for radically new marketable products); and ‘pure science’
(to uncover new scientific principles).
While R&D is essential, it is important to emphasise that complementary ‘soft’
capabilities beyond the fields of science and engineering are equally important. Research
on successful innovations demonstrates that “the technology is the easy part to change.
The difficult aspects are social, organisational, and cultural” (Norman, 1998).
Specifically, the following ‘soft’ innovative capabilities that need to complement
‘hard’ R&D, in order to create products and services that customers are willing to pay for
are emphasised:
• sense and respond to market trends before others take note (‘entrepreneurship’)
• recruit and retain educated and experienced knowledge workers who are the carriers
of new ideas
• global knowledge sourcing for core components, reference designs, tools, inventions
and discoveries
12 D. Ernst

• raise money required to bring an idea quickly to the market (the litmus test
of innovation)
• deliver unique and user-friendly industrial designs (which is of critical importance
especially for fashion-intensive consumer devices, like mobile handsets)
• develop and adjust innovation process management (methodologies, organisation
and routines) in order to improve efficiency and time-to-market
• manage knowledge exchange within multi-disciplinary and cross-cultural innovation
projects
• participate in and shape global standard-setting
• combine protection and development of IPR
• develop credible and sustainable branding strategies.
Each and every of these ‘soft’ capabilities is important in its own right. But they are also
inseparable. For instance, a narrow focus on brand marketing is insufficient. Branding
efforts need to be supported by a broad mix of ‘soft’ and ‘hard’ innovative capabilities.
This implies that a capacity to provide ‘integrated solutions’ is arguably one of the most
important prerequisites for IU based on innovation.
According to Davies et al. (2001, p.5), ‘integrated solutions’ encompass four sets of
capabilities:
• system integration: to design and integrate components and subsystems into a system
• operational services: to maintain, finance, renovate and operate systems through the
life cycle
• business consulting: to understand a customer’s business and to offer advice and
solutions that address a customer’s specific needs
• finance: to provide a customer with help in purchasing new capital-intensive systems
and in managing a customer’s installed base of capital assets.
By and large, US, Japanese and European electronics firms have sophisticated and
proven strategies in place that can provide simultaneously these four complex ‘integrated
solutions’ services.
A few large Chinese IT firms (like Lenovo, Huawei, ZTE and Haier) are now making
serious efforts to catch up in the mastery of these most critical innovative capabilities.
They are seeking to develop less over-engineered and expensive products that address
effective customer needs that market leaders have neglected. Two examples are Huawei’s
integrated IP phone services platform ME60 (discussed below) and Lenovo’s Tianxi
laptop, a decisively low-tech model introduced in the mid-1990s that single-handedly
created the Chinese PC market for private consumers and small businesses (Ernst, 2006b,
2006d; Ernst and Naughton, 2007).19
In addition, a few Chinese chip design start-up companies (such as Verisilicon,
Chipnuts, Vimicro, RDA, Jade) have made efforts to build a broad portfolio of ‘soft’
innovative capabilities and to provide unique and lower-cost integrated solutions
(Ernst, 2006e). But these efforts still have a long way to go. This requires conscious
efforts of industry-level upgrading. The challenge for policy-making is to foster
Beyond the ‘Global Factory’ model: innovative capabilities 13

‘integrated solutions’ capabilities on an industry-wide level so that individual firms


can access these capabilities without encountering the extremely high cost burden of
developing them in-house.

4.3 Technology leadership is not the only option


There is no doubt that, despite its impressive achievements, China continues to
lag behind advanced nations in the development of a broad-based science and
technology system. Structural weaknesses of the ‘global factory’ model add an additional
important constraint. These constraints are hardly surprising – they reflect China’s status
as a late-latecomer to industrialisation.
At the same time, however, being a late-latecomer also conveys important
advantages. Not only can China learn from the experience of earlier latecomers, but it can
also seek to benefit from recent shifts in the international technology system, especially
deeper integration into global innovation networks.
The ‘global factory’ model has helped Chinese firms to perfect ‘fast-follower’
strategies that aim at entering a product market right at the beginning of its high-growth
stage (e.g., Mathews and Cho, 2000). But which model should follow next?
Research on innovation strategies in industrialised countries (e.g., OECD, 2000)
points to ‘technology leadership’ strategies that focus on ‘radical’ innovations that
involve the use of, both, new component technology and changes in architectural design
(Henderson and Clark, 1990). The objective is to become a prime mover of knowledge
creation, by setting global standards during product introduction. Radical innovations
challenge established market leaders, since they destroy the usefulness of the leaders’
capabilities. This requires the creation of new ‘IPR’, especially a broad portfolio of
frequently cited ‘pioneer’ patents connected with important inventions and discoveries.
In the literature on China, there is a tendency to discard ‘technology leadership
strategies’ out of hand as a retreat to old-fashioned ‘techno-nationalism’. This neglects
the needs of a large quasi-continental economy and its growing role within Asia and the
global economy. Whether one likes it or not, there is no doubt that China will seek access
to best-practice technologies that provide solutions to its military and space programmes.
Given the restricted nature of these technology markets, the Chinese government believes
that it has to develop its own technologies, simply to develop sufficient leverage for
international technology cooperation20. Similar pressures to develop a critical mass of
own technologies exist for complex technology systems in energy, environment, climate
prediction, although the scope for international collaboration is certainly larger, once
China has established itself as a serious player.
‘Technology leadership’ strategies, however, come at a horrendous cost. It is
important to emphasise that attempts to compete head-on with global technology leaders
necessitate a massive upgrading of innovative capabilities. To become a ‘technology
leader’, a firm needs to have access to a broad set of capabilities in applied research,
basic research, as well as in ‘pure science’. To develop such a portfolio of demanding
capabilities needs time. It also needs very deep pockets to finance the massive increase of
R&D. This in turn necessitates high profit margins based on premium pricing.
Most importantly, ‘technology leadership’ strategies are extremely risky and market
prospects are highly uncertain. The new products may reflect ingenious radical
innovations. Yet, this does not guarantee that customers are willing to pay for these
innovations. In fact, the more complex the technology, the more difficult to use are the
14 D. Ernst

resultant products, and the more they are prone to breakdowns due to unproved
technology. The IT industry is full of examples that show that only very large, cash-rich
firms can cope with such high risks21.
In China’s IT industry, only very few companies can master this game. But even they
are sometimes forced to stretch their resources to the limits. An example is the super
computers. China’s decision to develop, by herself, high performance computing
technology, as well as some other key technologies such as those in telecom equipment,
was largely due to the technology export control imposed by organisations of the most
developed countries, such as the Coordinating Committee for Multilateral Export Control
(COCOM). In a way, China was forced to choose the ‘technology leadership’ option.
That strategy did produce some tangible results. China’s most powerful
supercomputer, Dawning’s 4000A, was ranked as 10th in the world as early as in 2004.
Its grid-oriented AMD 64 PC-Cluster design uses some unique features, which allows for
a theoretical peak performance of 22 T Flops. This is quite an achievement for a company
that pales in size relative to global industry leaders and that has only limited financial and
human resources. Of critical importance were close links with the Institute of Computing
Technology of the Chinese Academy of Sciences (CAS), whose president chairs the
board of Dawning. But to keep up with the accelerating pace of high-end computing
technology will require increasingly large resources.
A similar story of impressive, yet costly achievements emerges from Lenovo’s
super computer projects (Ernst, 2006b). The first project was the DeepComp 1800
supercomputer, introduced in 2001, which, based on 526 Intel Xeon processors, was
ranked 51st by 2002. This was followed, in November 2003, by the DeepComp 6800
model that was ranked 14th worldwide, and was jointly funded by the Ministry of
Science and Technology and the Chinese Academy of Sciences. There were expectations
that a commercialised version of this machine could be used during the 2008 Beijing
Olympic Games for a precise 36 h weather forecast on a specific area within just 30 min
of computing work (which now requires 40 h). Markets were also expected to exist for
computing data from oil fields, in disease control centres and physics labs. It is unclear,
however, to what degree these expectations will materialise.
Finally, the most recent project, the 1000 TFLOPS supercomputer, which was started
in 2005 and scheduled for completion before 2010, is supposed to be nearly ten times
more powerful than the world’s fastest supercomputer. But resource requirements are
also growing. The underlying rationale was clearly more political than commercial,
driven by the perception that China cannot rely on other countries to develop
a supercomputer that meets its needs.
In short, for Chinese IT firms, ‘technology leadership’ based on ‘radical’ innovations
pose a difficult challenge – investment requirements are huge and require substantial
government support, while markets are likely to be limited. There may, however,
be indirect commercial benefits, as successful completion of a radical innovation project
may help to establish a company as a serious player and foster its brand image.
Nevertheless, the future of China’s IT industry critically depends on quick access to
radical innovations, especially in generic technologies. For instance, Chinese firms need
core component technologies and insider information on interface standards, in order to
compete in the mobile network industry. The same is true for in SOC design for wireless
and optoelectronics systems and for embedded processors. And quick application of
nano-technology research is critical for the upgrading of China’s semiconductor and
optoelectronics industries.
Beyond the ‘Global Factory’ model: innovative capabilities 15

To move ahead in these areas obviously requires concerted industry-level upgrading


efforts by the government and industry. Such efforts are needed to reduce the very
substantial barriers that individual firms face when they try to move to technology
leadership strategies. China has significant policy initiatives in each of the above areas22.
The question is how quickly these initiatives will enable firms to develop successful
products.
But even then, the risks are high. This implies that an exclusive focus on technology
leadership strategies is unlikely to support a broad-based upgrading through innovation
strategy.

4.4 Technology diversification as a complementary option


In short, ‘technology leadership’ strategies are not the only option for China’s attempts
to move beyond the ‘global factory’ model. ‘Technology diversification’ can serve as
a complementary and arguably less costly option (Ernst, 2005c).
Defined as ‘the expansion of a company’s or a product’s technology base into
a broader range of technology areas’ (Granstrand, 1998, p.472), technology
diversification focuses on products that draw ‘… on several... crucial technologies which
do not have to be new to the world or difficult to acquire’ (Granstrand and Sjoelander,
1990, p.37). It requires strong research capabilities, but it is much more focused than
‘technology leadership’ on applied research that feeds directly into product development.
Empirical research on Japanese, US and Swedish companies has demonstrated that
technology diversification plays a more important role than technology substitution,
as seen from the larger number of old technologies in a current product generation,
compared to the number of obsolete technologies (e.g., Granstrand et al., 1997). Japanese
firms, in particular, have played a pioneering role in the development of technology
diversification strategies (Kodama, 1995). Japanese firms pursued this strategy to
compensate for the decreasing returns of their existing manufacturing exports. They also
used it to develop generic technologies that could form the base for penetrating future
growth markets, and to avoid the high cost and uncertainty of ‘technology leadership’
strategies.
For China, ‘technology diversification’ promises several advantages. By recombining
(mostly known) component and process technologies, it generates technology-related
economies of scope. ‘Technology diversification’ could thus avoid the high cost and risk
of a ‘technology leadership’ strategy. Second, technology diversification can also build
on China’s existing strengths in process development, “prototyping and electronic design,
as well as on recent progress in the development of ‘integrated solutions’ capabilities”.
Third, Chinese firms can build on their accumulated capabilities to implement, assimilate
and improve foreign technologies, as technology diversification often involves the
exchange of knowledge with foreign parties.
This brings us to the last, but critical, advantage of ‘technology diversification’.
By focusing on ‘architectural’ innovations, this strategy allows Chinese firms to extract
greater benefits from deeper forms of integration into global innovation networks.
‘Architectural’ innovations are “innovations that change the architecture of a product
without changing its components” (Henderson and Clark, 1990, p.9). These innovations
use existing component technology, but change the way components are designed to
work together, thereby breaking new ground in product development.
16 D. Ernst

Capability requirements are demanding, but they are within reach of Chinese
companies. By definition, late-latecomers like Chinese IT firms continue to lag behind
industry leaders in the breadth and depth of their R&D and innovative capabilities.
Their strength, however, is that they are familiar with peculiar characteristics of China’s
markets and institutions, and that they are exposed to user requirements that global
industry leaders have neglected. Having started as distributors of foreign products and
services, Chinese firms have been exposed to China’s insatiable but largely untouched
demand for products and services that are not over-engineered and hence are less
expensive, but provide essential performance features.
Chinese firms can use this knowledge to penetrate China’s large mass markets, not by
following but by breaking new ground in product development. Of critical importance is
the capacity to develop products and services that are less over-engineered and expensive
than those of global market leaders, and that address ‘effective customer needs’23 that
incumbent global market leaders have neglected. This requires a change in the
architecture of a product or service.
And barriers to implement that new architecture are limited. In fact, Chinese firms
do not need to develop the necessary components, nor do they have to change them.
Integration into multiple global production and innovation networks enables
Chinese firms to buy in the relevant component technology from specialised suppliers.
As demonstrated by Iansiti (1997), global markets for technology imply that a firm’s
competitive success critically depends on its ability to monitor and quickly seize external
sources of knowledge. Hence, Chinese firms can leverage basic or generic technologies
developed elsewhere. Chinese firms might also engage in collaborative development of
some of these components.
An early example is the development of China’s electronic switching system HJD04
– the innovation consists in developing a system architecture that optimises performance
features in line with the specific features of the national telecommunications network
structure and the specific needs of the service providers (Shen, 1999). Other examples
include: the development of Chinese-language electronics publishing systems by the
Founder Group Company, a spin-off from the Institute of Computer Science and
Technology of Beijing University (Lu, 2000, Chapter 4); and the development of the
unique Chinese Video Compact Disk (VCD) technology and the successful transition to
Chinese DVD system technology.
While these architectural innovations use existing component technology, they,
nevertheless, introduce substantially new and distinct features to existing system
architectures. Another more recent example is Huawei’s development of a new integrated
IP service platform ME60. This is the first integrated multi-service platform on the
market that enables telecommunications operators to substantially improve the quality of
service and the security of their IP services at a reduced cost of operation.
Current IP networks do not offer the security and quality of service that operators
request, while traditional networks are incapable of supporting bandwidth-hungry
multimedia services such as IPTV. Operators have a number of consumer and business
products in the market, such as DSL, cellular, Asynchronous Transfer Mode (ATM) IP
VPN24, and central office exchange services. To improve service quality and security,
these products need to be aggregated and run over a common IP core25. The ME60 is the
‘Swiss army knife’ that enables operators to aggregate multiple services from various
networks into one IP core and that improves the operators’ real-time control over these
services.
Beyond the ‘Global Factory’ model: innovative capabilities 17

In technical terms, this system is quite an achievement. As a 10-Gigabit multi-service


control gateway26, the ME is an edge router that sits between the IP core and the access
network (which may be fixed or mobile).
But equally important is the systems’ capacity to provide, at reasonable cost of
operations, customised solutions to problems that thus far have obstructed the progress
of IP networks. A defining characteristic of the ME60 is its ability to deliver tailor made
products as a response to customers’ specific needs. This is quite unusual in the network
equipment industry, where incumbent industry leaders typically provide standard
solutions.27
Huawei’s approach is very different. The key to the success of the ME60 system is
Huawei’s capacity to integrate multiple system components into a versatile and flexible
system. A distinguishing feature of the ME60 is its high level of integration through
a single software system. This makes it possible to integrate the capabilities currently
separated in different network parts (like broadband remote access server and fire walls)
which until now had no common communication standards.
This capacity to provide integrated solutions does not seem to be widely shared in the
network equipment industry. According to industry experts, Cisco, the industry leader,
could only build such a system by teaming up with other companies like Ericsson.28
While Cisco has major advantages in market reputation and product quality, its products
apparently lack the integration of multiple functions that is characteristic for Huawei’s
ME60 system.29

5 Conclusions

This paper has explored what innovative capabilities are required for upgrading China’s
IT industry. To answer that question, the achievements and weaknesses of China’s ‘high
tech global factory’ model have been highlighted.
In addition, the concept of ‘IU’ that links specialisation with firm-level and
industry-level upgrading has been introduced. At the centre of this concept is the need to
find the right balance between firm-level and industry-level upgrading, and between
domestic and international elements. This poses a continuous challenge for policy makers
and corporate planners – the ‘right balance’ is a moving target, it is context-specific and
requires permanent adjustments to changes in markets and technology.
The paper culminates in a discussion of specific innovative capabilities that are
required to upgrade China’s IT industry. ‘Soft’ entrepreneurial, management and system
integration capabilities need to complement ‘hard’ R&D in order to create products and
services that customers are willing to pay for has been emphasised. It has been argued
that, as ‘technology leadership’ strategies are extremely costly and risky, only few
companies in China’s IT industry can master this game. As the future of that industry
critically depends on quick access to radical innovations, especially in generic
technologies, this requires concerted industry-level upgrading efforts by the government
and industry. Such efforts are needed to reduce the very substantial barriers that
individual firms face when they try to move to technology leadership strategies.
Hence, ‘technology leadership strategies’ that focus on ‘radical’ innovations are
not the only option for China’s ‘upgrading through innovation’ strategy. ‘Technology
diversification’ can serve as a complementary, and arguably less costly, option. It is
18 D. Ernst

emphasised that the most important bottleneck to technology diversification right now are
‘soft’ entrepreneurial, management and system integration capabilities.
This has important implications for the design and implementation of China’s
upgrading strategy. First, as a late-latecomer, China has to develop her own idiosyncratic
approach to policies, support institutions and business strategies. The experiences of
other countries, in Asia, but also in the USA and Europe, can provide important insights.
But, in the end, China has to come up with her own solutions, based on its own peculiar
strengths and weaknesses.
Second, given the rapid pace of change in the global electronics industry structure,
upgrading the country’s electronics industry involves multiple moving targets; hence,
solutions have to be constantly adjusted. Of critical importance is the choice of
appropriate sequencing patterns for developing innovative capabilities. Equally important
is a sufficient degree of flexibility in policies and institutions that allow for quick
response and adjustments to abrupt changes in markets and technology, and to
unexpected outcomes of upgrading policies.
Third, and finally, multiple international linkages are considered to play an important
catalytic role in facilitating and accelerating the upgrading of China’s electronics
industry. The focus, however, has moved away from an earlier heavy reliance on
technological capabilities developed within affiliates of global flagships, and their
eventual spill-overs into local firms. Also, earlier attempts (especially in the car industry)
to trade market access in exchange for access to technology may not be sustainable any
longer.
China needs to expand and deepen international knowledge sourcing through multiple
linkages with foreign universities, research institutes, and consulting firms, and by
tapping into the vast informal global peer group networks of overseas Chinese
researchers, engineers and managers. A progressive integration into these diverse global
innovation networks can help Chinese IT firms to bridge existing gaps in specialised
skills and innovative capabilities. Most importantly, it can catalyse changes in
organisation and procedures that are necessary to develop these capabilities locally.

Acknowledgement

I gratefully acknowledge ideas, comments and suggestions from Calestous Juma, Greg
Shea, Clark Duncan, Richard P. Suttmeier, Barry Naughton, Ron Wilson, Xielin Liu,
Xudong Gao, Chintay Shih, Kane Wang, T.C.Tu, Shin-Horng Chen, Pang Eng Fong,
Wong Poh Kam, Ted F. Tschang, Xiaobai Shen, Boy Luethje and Adam Segal. At the
East-West Center, I am grateful to Charles Morrison and Nancy Lewis for supporting this
research, and for discussions with Ray Burghardt, Carol Fox, Dick Baker and Mark
Borthwick. The Volkswagen Foundation provided generous funding. Kitty Chiu, Peter
Pawlicki and Rena Tomlinson provided excellent research assistance. I am grateful to
Brenda Higashimoto for her constructive suggestions in editing the manuscript.
Beyond the ‘Global Factory’ model: innovative capabilities 19

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22 D. Ernst

Notes
1
The importance of lead users for innovation is demonstrated by von Hippel (1988, 2005).
2
Rapid growth of mobile, internet and broadband subscribers, together with still vibrant PC
sales, drive massive investments in IT infrastructure and generate a voracious demand for
semiconductors. Together with Japan, China now dominates Asia’s semiconductor market, well
ahead of South Korea, Taiwan and Singapore (Hopfner, 2007).
3‘
Knowledge workers’ are defined to include science and engineering personnel, as well as
managers and specialised professionals (in areas like marketing, legal services and industrial
design) that provide essential support services to research, development and engineering.
4
For the concept of global production networks, see Ernst (1997, 2002a) and Ernst and Kim (2002).
For case studies, see Borrus et al. (2000) and Ernst (2003, 2004, 2006f).
5
An additional important development, not addressed in the paper, is the integration of Chinese IT
firms into international standard-setting alliances.
6
The UNCTAD sample consists of the first 300 firms of the R&D scoreboard of the 700 top
worldwide R&D spenders, published by the UK Department of Trade and Industry (DTI).
7
Private equity investment is medium- to long-term finance provided in return for an equity stake in
potentially high-growth companies that are not listed on a major public stock exchange. According
to the British Venture Capital Association, it encompasses both ‘venture capital’ (from the seed to
the expansion stages of investment) and management buy-outs and buy-ins.
8
Sources include the US and the UK National Venture Capital Associations and consulting firms
like Greenwich Associates, Private Equity Intelligence (PEI) and Shanghai-based Zero2IPO for
China.
9
Courtesy of Private Equity Intelligence (PEI), a London-based specialised consulting firm
(July 6, 2006).
10
An example is the recent indictment of Warburg Pincus’s Korean office on charges of insider
trading (‘Warburg Pincus faces Won 26 bn fine’, FT, 19 April 2006, p.16).
11
Data, courtesy of the US Council of Graduate Schools, March 2006.
12
China apparently now also relies on a growing circulation of students and knowledge workers
with other Asian countries (especially Taiwan, Japan and Singapore), as well as with the EU,
Russia and Eastern Europe (Interviews Beijing 05 24 06).
13
In 2000, 85% of global R&D expenditures were concentrated in only seven industrialised
countries. The USA occupied the leading position with 37% (Dahlman and Aubert 2001, p.34).
14
The other three forms of ‘industrial upgrading’ discussed in the literature are:
• inter-industry upgrading proceeding from low value-added industries (e.g., light industries) to
higher value-added industries (e.g., heavy and higher-tech industries)
• inter-factor upgrading proceeding from endowed assets (i.e., natural resources and unskilled
labour) to created assets (physical capital, skilled labour, social capital)
• upgrading of demand within a hierarchy of consumption, proceeding from necessities to
conveniences to luxury goods.
See Ozawa (2000) for discussion of upgrading taxonomies. Most research has focused on a
combination of the first two forms of IU, based on a distinction between low-wage, low-skill
‘sun-set’ industries and high-wage, high-skill ‘sunrise’ industries. Such simple dichotomies
however have failed to produce convincing results, for two reasons (Ernst, 2001): First, there are
low-wage, low-skill value stages in even the most high-tech industry, and high-wage, high-skill
activities exist even in so-called traditional industries like textiles. And second, both the capability
requirements and the boundaries of a particular ‘industry’ keep changing over time. An example
is the transformation of the personal computer industry from an R&D-intensive high tech industry
to a commodity producer that depends on the optimisation of supply chain management.
15
I use these distinctions to move the research agenda beyond the popular, but somewhat
schematic dichotomy of ‘Fordist mass production’ vs. the ‘Post-Fordism Flexible Specialization’.
For a detailed theoretical discussion, based on evidence from chip design, see Ernst (2005b).
Beyond the ‘Global Factory’ model: innovative capabilities 23
16‘
Design methodology’ is the sequence of steps by which a design process will reliably produce
a design ‘as close as possible’ to the design target, while maintaining feasibility with respect to
constraints.
17
Important contributions include Lall (1992), Ernst and O’Connor (1992), Hobday (1995),
Ernst et al. (1998), Amsden and Tschang (2003) and Jefferson and Kaifeng (2004).
18
This broad definition is in line with Peter Drucker’s classic statement: “The test of an innovation,
after all, lies not in its novelty, its scientific content, or its cleverness. It lies in its success in the
marketplace” (Drucker, 1985, p.VIII).
19
For case studies on Lenovo and Huawei, see Ernst (2006b, 2006d) and Ernst and Naughton
(2007).
20
Presentation by Ltd. General Wen Xisen, President of China’s National University of Defense
Technology (NUDT), at the Asia-Pacific Center for Security Studies, Honolulu, 18 June, 2007.
21
A telling example is Sony’s third-generation PlayStation that is based on radical, but still unstable
Bluetooth technology which causes lengthy delays in its market introduction.
22
For IC design, the government has established two national multi-project wafer (MPW) service
centres (one in Beijing, and one in Shanghai) that provide access to foundries and assembly
companies, both from Taiwan (for sophisticated design rules) and from China. And seven
government-supported Research Centers for Integrated Circuit Design (in Shanghai, Beijing,
Suzhou, Wuxi, Hangzhou, Xi’an, and Chendu) provide a variety of knowledge-intensive services,
including subsidised access to leading-edge EDA tools, that help to overcome constraints that
individual Chinese design houses face when trying to transform their designs into silicon. Equally
important are attempts to develop standards that could leverage China’s large market and its
peculiar characteristics, such as TD-SCDMA, a third generation (3G) digital wireless standard.
23
I define ‘effective customer needs’ as those customers are willing to pay for.
24
Virtual Private Network – allows secure remote connection within an organisation’s network over
the internet.
25
The IP core, also sometimes called backbone, is the primary path of an IP network traffic.
It connects smaller segments of a network and has a high concentration of traffic.
26
A gateway is the entrance to another network. The gateway allows equipment with different
protocols to communicate.
27
The main explanation for the incumbents’ focus on standard solutions is their very high
development costs. This reflects the fact that global industry leaders have their major R&D
operations located in high-cost industrialised countries. In addition, many of their products are
over-engineered – they provide leading edge technology that exceeds by far the needs of most
users. These high R&D costs necessitate a business model that seeks to reap economies of scale
through ‘mass-manufacturing’ of standard and fairly inflexible solutions.
28
Huawei unveils god box, Unstrung, 21.06.2005, http://www.lightreading.com/document.asp?
doc_id=76055.
29
According to the same source, Alcatel, another global industry leader, may only be able to build
a similar system if it had the capacity to develop broadband remote access servers.

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