High Tech in China

Is it a threat to Silicon Valley?

Tang Tingao is apologetic as he guides a visitor through his lab at Fudan University in Shanghai. This is one of China's top institutions, and as head of Fudan's microelectronics institute, the 63-year-old Tang oversees some of the most advanced semiconductor research in the country. But by global standards, the conditions are primitive. The embarrassed scientist points to a row of old made-in-China furnaces for silicon preparation. In any other country, they would be obsolete.

Well, they will soon be passé in Shanghai, too. Despite a global technology slump, this city is in the middle of a high-tech spending binge. Government-linked Chinese companies and foreign multinationals are lavishing billions of dollars on new facilities. Chinese chip plants are mushrooming in a new science park just across the Huangpu River from the Fudan campus. In return for a toehold in the Chinese market, foreign companies are helping Tang upgrade the equipment in his institute and train his staff. Such assistance could one day help Fudan become a semiconductor research hub for Shanghai, Tang says--"just like Stanford or Berkeley in Silicon Valley."

A Chinese Silicon Valley. A few years ago, the idea would have been laughable. China was a place to make sneakers, not semiconductors. But to many of Silicon Valley's movers and shakers, the specter of Chinese competition is no longer a joke. Recent developments inside China--and a few beyond its borders--have reshaped the lens through which foreign multinationals view the world's most populous country. Over the next 10 years, China will become "a ferociously formidable competitor for companies that run the entire length of the technology food chain," predicts Michael J. Moritz, a partner at Sequoia Capital in Menlo Park, Calif., one of the Valley's premier venture-capital firms.

Consider some of China's milestones in science and tech:

-- Chinese universities granted 465,000 science and engineering degrees last year--approaching the total for the U.S.

-- There are plans to crank out chips from seven new semiconductor plants by 2004, putting China on track to be the world's second-largest chip producer.

-- A team at the Beijing Genomics Institute was among the first of several scientific teams to decode the rice genome, landing on the cover of the journal Science.

-- Two homegrown vendors of network switches, Huawei Technologies Co. and ZTE Corp., have opened offices in the U.S. and Europe and snatched contracts from the likes of Cisco Systems (CSCO ) and Nortel Networks (NT ).

-- China has been launching satellites for years and intends to begin manned space missions next year.

China's growing high-tech prowess, and its ability to apply its expertise to defense matters, are bound to be topics of discussion this month when Chinese President Jiang Zemin arrives in the U.S. for a summit at President Bush's ranch in Crawford, Tex. Beijing's tech stature adds a new element to its often-troubled relationship with Washington. Bush wants China's support in the war on terrorism and the campaign against Saddam Hussein. At the same time, GOP hawks see China as one of the biggest long-term threats to U.S. security and economic preeminence. The hawks are opposed, however, by many executives from Corporate America who regard China as a lucrative market and are eager to offer the equipment and expertise it needs to meet its technological goals.

Mind you, China's achievements don't make it a high-tech superpower today. Despite scientific coups like the rice genome, China's companies can boast of little useful intellectual property and no paradigm-bending industrial innovations. China's equity markets are still largely closed to private startups, starving entrepreneurs of capital. Its software industry pales beside India's, not to mention Silicon Valley, and its stunted pharmaceutical sector hasn't come up with a single blockbuster drug. The country has yet to curb widespread piracy, a step that is essential for innovation to flourish. It also continues to suppress free speech and censor the Internet. And even now, says Andy Xie, managing director of Morgan Stanley in Hong Kong, "America is sucking away all the best and the brightest in China."

Furthermore, by most standards of comparison, China's high-tech output doesn't measure up. Total research spending hovers at about $11 billion, vs. more than $233 billion for the U.S. China's semiconductor production came to $2.9 billion last year, compared with $71.2 billion in the U.S. PC ownership and Internet penetration both hover at 2% of the population--far below Japan, South Korea, and most Western countries.

Nevertheless, China's early tech successes have convinced many Western executives that there are greater--and more worrisome--things to come. Even without strokes of innovative genius, China's energetic engineers can continue to clone the world's most advanced telecom and computer gear, as Huawei has done so successfully with network devices, and market them globally at rock-bottom prices. The total cost of an engineer in China, including benefits, is about $15,000 per year, notes Michael E. Marks, CEO of contract manufacturer Flextronics International Ltd. (FLEX ). In Silicon Valley, the cost is 10 times that. For now, management at most Chinese companies is too weak for them to compete globally with Cisco, Intel, or Microsoft, Marks believes. Still, he says, "China has enormously talented engineers, and they all want to work. They are adding experience very rapidly. I would understand why U.S. electronics companies would be worried."

Most business folks already appreciate China's amazing achievement in manufacturing, raising itself from a Maoist backwater in the late 1970s to the world's most prodigious exporter today. And China isn't content to be a subcontractor. After more than a century of backwardness, the Chinese, who invented gunpowder, paper, and the compass, intend to regain their tech primacy. "You can't be economically very powerful but technologically very backward," says Wang Mingwei, head of the Chinese National Center for Drug Screening in Shanghai. "China is a proud nation and wants to have a say in the science arena, rather than be dominated by the Westerners and the Japanese."

Foreign companies privately might like to put the brakes on the Asian giant. But economics dictate that they do the opposite. To secure access to China's huge, growing market, dozens of foreign multinationals are entering research partnerships that are certain to upgrade the country's capabilities. Such pressure is frowned upon by the World Trade Organization, but try telling that to General Electric (GE ), Intel (INTC ), Matsushita Electric (MS ), and Siemens (SMAWY ), all of whom have shared valuable tech knowhow. Most recently, Microsoft Corp. (MSFT ) announced plans to spend $750 million on a far-ranging research and training program. "China has discovered its leverage," says Erhfei Liu, Hong Kong-based chairman of Merrill Lynch China. "The Chinese say, `If you want market access, give us technology."'

In public, executives at Western companies make no apologies for technology transfer. "China is the most vigorous market for the U.S. [and] its most vigorous competitor," declares Intel Corp. Chairman Andrew S. Grove. But behind closed doors in Silicon Valley, Brussels, and Tokyo, China's science-and-technology agenda has become a sort of Rorschach test. For every executive like Grove who looks at the inkblots and sees opportunities outweighing risks, another senses palpable danger to Western interests. This camp is influenced by a variety of disturbing defense issues. A July report by the U.S.-China Security Review Commission, a committee composed of a dozen congressional appointees, noted ominously that Beijing is hard at work acquiring "dual-use" technology that can not only boost the economy but also enhance the military and challenge American dominance in Asia.

Both responses to the Chinese Rorschach test--allure and alarm--are justified. And if there were only two viewpoints, the China-technology debate would be relatively clear-cut. But there are mitigating arguments that challenge the simple friend-or-foe construct. First, China's low-cost manufacturing base has driven down the price of consumer gadgets and all manner of industrial components. So shoppers in U.S. malls can take home $70 made-in-China DVD players, and industrial manufacturers such as GE can slash prices on everything from light bulbs to aircraft engines. Second, as the world's scientific community grapples with overwhelming problems such as cancer, AIDS, and global warming, China's armies of newly trained scientists will be an important asset.

Individuals may attach different priorities to each of these points. But however you rank them, they lead to the same conclusion: China is destined to become a science-and-tech superpower. It won't happen in 2003 or even 2005. But in the words of Gordon Astles, president of Asian operations for Cisco Systems Inc., China has "the sheer size, the will, the economic growth, and the openness to being part of the world. That says that they have a greater opportunity than ever before."

Beyond consumer gadgets and electronic components, China's impact on global technology is most evident in the ultracompetitive world of network equipment. Manufacturers such as Huawei and ZTE, which have long competed capably inside China, have targeted the breadbaskets of Western networking giants.

Huawei, which notched $2.4 billion in 2001 sales, recently won deals in Britain and Germany and in June launched a U.S. subsidiary dubbed FutureWei Technologies. Huawei's international revenues rocketed 210% in the first half of 2002--an otherwise dismal period for equipment vendors. The company is counting on overseas sales to offset disappointing results in China, where the reorganization of state-owned China Telecom has stalled demand. ZTE, meanwhile, has opened research and development centers in New Jersey, California, and Texas and is targeting sales in Russia, India, and other emerging markets that are still growing despite the telecom depression in the West. "We are not as sophisticated as Lucent (LU ), Ericsson (ERICY ), or Cisco, but the gap has shrunk a lot," says Sun Zhenge, director of ZTE's technology center in China. "We will have the ability to exceed them in three to five years."

Networking executives in the West should not dismiss such talk as empty bravado. Because of China's inexpensive, highly skilled workforce, its equipment vendors can beat Cisco and Nortel on price by 25 to 50 percentage points. And while their high-end networking gear still trails that of North American rivals, Huawei and ZTE can compete when it comes to small or midsize networking products. "They're very serious about North America and Europe," says Michael Howard, principal analyst at market watcher Infonetics Research. "At every turn, Huawei will compete with Cisco at a much lower price."

In most respects, China's tech trajectory differs from the one Japan mapped out many decades earlier. Instead of trying to shut foreigners out of the market, Beijing encouraged domestic stars such as Huawei and ZTE to embrace alliances and research collaborations with foreign companies. "There's no `not-invented-here' syndrome in China," says Zhou Zhen-hong, China managing director of Agere Systems (AGR ), the Lucent Technologies spin-off, which announced in May that it was forming an R&D partnership with ZTE. Thanks to such efforts, Zhou believes that Chinese companies will be able to catch up to foreign rivals faster than Japan's lumbering giants could. Cooperation "closes the gap between the local companies and the multinationals," he says.

Like the network-equipment makers, China's cellular-handset manufacturers hope to build on their strength in their immense home market to become global players. With more than 189 million subscribers, China has the world's largest population of mobile-phone users. That means companies that serve the market gain vast manufacturing economies of scale. Plus, they are in a position to pioneer novel phone-based applications--such as wireless instant messaging--that could have international appeal. For now, Motorola Inc. (MOT ) and Nokia (NOK ) dominate the Chinese market. Nonetheless, handset makers in the West have been steadily losing share in China to local rivals with names like Bird, TCL, and Konka.

Multinational manufacturers are responding by increasing their Chinese presence. Motorola has invested $3.4 billion in China, with a large part going to finance a giant chip plant in the northern city of Tianjin. Nokia has opened a sprawling industrial park for itself and its suppliers outside Beijing. German giant Siemens makes some 35% of its cellular phones in Shanghai and early this year shifted a big chunk of its R&D team from Germany to Beijing. Siemens also is working with Chinese partners to develop a new standard for third-generation cellular service, aimed at the mobile Internet. "If China makes it, it will be a world standard," says Peter A. Borger, president of Siemens Shanghai Mobile Communication Ltd. Certainly, Siemens benefits. But a win in global-cellular standards would also vault China's players onto the international playing field.

Taiwan figures prominently in Beijing's tech strategy. Although the island's government remains at odds with Beijing's leaders, Taiwanese businesses have invested about $70 billion in China, and more of those investments are going toward big-ticket items such as semiconductor plants. In September, Taiwan Semiconductor Manufacturing Co. announced plans to invest $900 million in its first China fab. The Chinese market "may take off pretty rapidly," says TSMC Chairman Morris Chang. In addition, Taiwan's chip execs are now managing several contract-manufacturing plants in the Shanghai area. From this base, Taiwan-educated Richard Chang, a Texas Instruments Inc. (TI ) veteran, wants to take on the world's silicon giants. He heads Shanghai's Semiconductor Manufacturing International Corp., a well-connected newcomer that includes among its investors Goldman Sachs (GS ) and Toshiba Corp.

With support from Beijing, ethnic Chinese from around the world are following in the footsteps of Taiwanese and forging new links to China. Shoucheng Zhang, 39, holds joint professorships in the physics departments at Stanford and at Beijing's Tsinghua University. The latter post was funded by Hong Kong billionaire Li Ka-shing, who aims to entice more overseas Chinese scientists to spend time on the mainland. Zhang has been bitten by the same bug: He's vice-president of Hua Yuan Science & Technology Assn., a San Francisco nonprofit that promotes academic and commercial exchanges between the U.S. and China. The association boasts about 2,500 members in the U.S., including academic scientists as well as partners in prominent venture-capital firms such as IDG, Walden International, and WI Harper.

In short, Beijing is learning to harness Chinese intellect outside its borders and turn it into a competitive advantage. This has already contributed to strides in technical fields such as superconductivity, nanotechnology, and optics. Says Zhang: "China has been investing very wisely in the sciences. They are doing the right thing." And while no one has attempted to measure the overseas brain trust China could tap, it is clearly sizable, says Juan Enriquez-Cabot, director of the Life Science Project at Harvard Business School: "When you go into laboratories throughout the world, some of the brightest people are Chinese." Among the foreign-born scientists and engineers working in the U.S., nearly 40,000 hail from China, more than from any other country.

The talent pool demonstrated its ability when China took on the arduous task of sequencing the rice genome, a feat that could one day lead to a cornucopia of hardy bioengineered crops and lay the groundwork for advances in genomic medicine. More than 500 researchers affiliated with the Chinese Academy of Sciences (CAS) worked on the project. But it might not have come to fruition without Seattle-based Gane Ka-Shu Wong, a 41-year-old Canadian physicist and post-doc at the University of Washington School of Medicine who was one of the project's instigators and lead scientists. The Cornell University-educated Wong and his colleague, Jun Yu, realized their task would require a team of skilled but inexpensive technicians. So in 1998 they persuaded CAS to set up the Beijing Genomics Institute, which housed the rice project. "We needed people to turn the cranks," explains Wong. "It's factory work."

One area where China clearly lags the West is the field of computer software. But Beijing has adroitly applied pressure on U.S. companies to help it catch up. For example, Microsoft's mammoth financial commitment to upgrading China's skills was prompted partly by the need to play in the world's largest potential consumer-software market. There was also, however, a concern that the Chinese government would throw its might behind "open-source" programs such as Linux, which could be a disastrous blow to Microsoft's Windows franchise.

Microsoft isn't the only one feeling the heat. China's population gives it extraordinary leverage in the design of next-generation programs. Take the area of network standards and operating systems. The Internet wasn't designed to support today's teeming cyberpopulation. Now, the global network is running out of "Internet protocol" addresses--a problem that is especially acute in the Chinese-speaking world. So Beijing is pushing for a rapid transition to a new generation of Internet hardware and software known collectively as Internet Protocol Version 6, or IPV6.

The U.S. has dragged its feet in this area because, among other things, the transition requires ripping out a lot of existing infrastructure and could render some of today's widely used computer and network software obsolete. But when it comes to the current generation of software, "China doesn't have a significant installed base," says AT&T software maven Steven M. Bellovin. "If China goes ahead and deploys Version 6 first, they could be the first to write new software while the rest of the world plays catch-up." This scenario meshes nicely with China's larger strategy. Developing a world-class software industry "is absolutely at the top of the agenda," says Derek Williams, Oracle Corp.'s Hong Kong-based executive vice-president. And in the case of IPV6, even if U.S. companies don't choose to help China, others will. Nokia has already connected 10 Chinese universities using a router platform and software developed partly at its R&D center in Beijing.

Certainly, the country has a lot of ground to make up. China's software industry generated revenues of just $850 million last year, compared with over $6 billion for India's. But market researcher Gartner Group (IT ) estimates that the Chinese industry's revenue will reach $1.9 billion this year. And if Beijing gets results from its efforts to build software parks, provide incentive packages for programmers, boost English training programs, and enforce protections on intellectual property, the country could achieve parity with India in commercial software by 2006. At that point, in Gartner's admittedly bullish estimate, both India and China will be reaping more than $27 billion a year in sales of software and application-service revenue. That's close to $60 billion in annual revenues not booked in Silicon Valley.

This thought shouldn't elicit dread or dismay from Western executives. China is not demonic, and it is not monolithic. But it is poised to move up the technology ladder at a pace unprecedented among nations. The global industrial landscape will be permanently recast, as will the competitive balance among countries and companies. And no leap of technological imagination, threatening or benign, will be beyond China's reach.

Read a Letter to the Editor about this story.

By Bruce Einhorn in Shanghai, with Ben Elgin, Cliff Edwards, and Linda Himelstein in San Mateo, Calif., and Otis Port in New York

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