Master of Innovation?

China aims to close its technology gap with Korea and Japan

Wang Chuanfu is a little sleepy these days. The 37-year-old Chinese engineer has been jetting back and forth to the U.S., courting investors in Byd Co. This company, which Wang founded just seven years ago in Shenzhen to make cell-phone batteries, now employs 17,000 workers and has a market capitalization of $1 billion.

That's not the story Wang is selling, however. Byd aims to be the world's first major producer of cars powered by electric batteries. It's an attractive idea, but one so beset with challenges that most auto giants have given it up. Not least, it requires forging new standards for breakthroughs in technology and manufacturing that would sharply reduce the exorbitant cost of batteries. "So many companies have failed because they didn't have the right technology," says Wang. "But we have the strongest R&D team in the industry. We have a deeper understanding."

Some say Wang is a visionary. Others call him foolhardy. Either way, he's part of a movement that has transfixed other Asian nations and sent shock waves across the Pacific. Drawing on human and financial resources scattered across Asia and the West, China wants to reinvent itself as the home of innovation -- and wellspring of technical standards that will be adopted throughout the world. Already a production hub for PCs, televisions, and DVD players, the country now yearns to close its technology gap with Korea and Japan. It aims to achieve this by 2008, when Beijing hosts the Olympics. And there is more at stake than prestige: As war rages in Iraq, Beijing's generals are determined to burnish their military might with electronic weaponry, to preempt any future threat from the U.S.

To raise their stature in global high tech, the Chinese are pursuing a potentially risky strategy. The government is offering subsidies and other sweeteners to companies that come up with homegrown alternatives to Microsoft software (MSFT ), Intel microprocessors (INTC ), Cisco routers (CSCO ), and other standards that are the building blocks of an information economy. The twin risks are that China will alienate the multinationals it depends on for technology transfer while its focus on originality distracts local companies from the low-cost manufacturing they do best. Nonetheless, in a drive to reduce royalty payments on foreign technology and reward local innovators, Beijing seems intent on setting global standards for everything from digital TVs and DVD players to next-generation cell phones.

Many in the region believe Beijing's strategy will eventually succeed. While the best Chinese companies still lag far behind the likes of Sony Corp. (SNE ) and Samsung Group, that situation could change quickly. "China will go from being on the receiving side of technology to the generating side," predicts Frans van Empel, chief technology officer for Philips in Shanghai.

One example of China's quest to create homegrown standards is state-owned Datang Mobile's work with Siemens (SI ) of Germany to develop a standard called TD-SCDMA for third-generation cell phones. Some industry experts say that phones built to these specifications can transmit data in densely populated areas better than phones built to the standards of Europe and Japan (W-CDMA) and the U.S. (CDMA 2000), while consuming less power. But the new standard holds an even bigger attraction for China, says Tang Ruan, chief operating officer at Datang in Beijing: avoiding the royalties on existing cellular systems that China has had to pay to foreign companies that owned the intellectual property rights.

The only way to get around those payouts in the future is for Beijing to back a domestic standard. Despite predictions from many Western executives that China's standard will flop, Tang believes TD-SCDMA will win 30% of the market in China and another 10% overseas following its launch next year.

That may not be so far-fetched. "China is the biggest market, so once the Chinese government sets a standard, it will be a world standard," observes Jung Nam Cho, vice-chairman of SK Telecom Co. (SKM ) of Korea. Whether that turns out to be TD- SCDMA or some other local concoction, the principle is probably correct, says Rich Stomp, a vice-president in IBM's (IBM ) global telecom division. Within a few years, he contends, "we will see standards emerging from China that the rest of the world will adopt."

Consumer electronics is another area where China wishes to create unique intellectual property. And it's counting on help from local players such as Skyworth Multimedia International Ltd., the nation's third-largest manufacturer of TVs and a top producer of DVD players. Skyworth belongs to the Shanghai-based consortium of 20-odd Chinese companies developing "enhanced videodisc" (EVD) players. The EVD Forum hopes to supplant the current DVD standard. That won't be easy, but even a partial triumph would be sweet for Henry Lau, Skyworth's 38-year-old CEO. It would slash the royalty payments Skyworth now pays to Japanese competitors. "And if Sony and Philips (PHG ) want to sell EVDs, they will need to pay the EVD Forum for a license," says Lau.

If China succeeds in launching important new standards, many secondary benefits would flow. For example, such technology leadership would likely spur the growth of semiconductor design businesses, which typically enjoy higher profit margins than the contract chip-manufacturing facilities China has built so far. The standards-and-design synergy is real: Beijing plans to endorse a new digital-TV standard, and the government-owned Shenzhen State Microelectronics Co. is already working on a circuit design for the new set-top boxes.

China's chip-design companies are still tiny players on the world stage. But last year, Beijing began setting up seven design hubs around the country that will provide startups with financial support. Results could come quickly. Design revenues are already growing at a 30% annual clip, says U.S. market researcher iSuppli Corp. Moreover, the industry is increasingly becoming integrated with its more mature counterpart in Taiwan. Combine the two, and this "Greater China" chip-design industry will surpass that of North America in about six years, accounting for a 40% share of global revenues, according to iSuppli.

On the mainland alone, the range of China's state-sponsored chip-design work is impressive. Last year, the Chinese Academy of Sciences launched a homegrown microprocessor, dubbed the Godson. Now, Beijing-based engineers are refining that design and aim to unveil a low-cost microprocessor that they hope will become as popular for all sorts of electronic gizmos as Intel Corp.'s chips are for PCs. And in March, university researchers in Shanghai unveiled the first locally developed digital signal processor, a type of chip used in cellular phones and other wireless communication equipment. Today such chips are supplied largely by Texas Instruments Inc. and other Western companies.

Setting standards in computer software is also a government goal. And, as in chip design, Beijing is seeking to close a yawning gap with the West. In 2001, Chinese companies exported just $720 million in software -- much of it programming work contracted out by U.S. companies. By 2005, Beijing hopes to raise software exports to $5 billion.

To overcome its shortage of software engineers, Beijing has initiated a $2.4 billion plan to open 35 software colleges. And at least one goal will be to generate original PC software, including operating systems. Of course, Beijing can't dictate the success of these products, but the country's immense size confers some advantages. "It's only a matter of time before it surpasses everybody" and becomes the world's largest PC market, says William J. Amelio, Dell Computer Corp.'s (DELL ) president for Asia Pacific. If homegrown software is available, Beijing will expect to see it pre-installed on Chinese PCs -- and companies such as Dell will have no incentive to resist Beijing's wishes.

China's military leaders are especially interested in becoming more self-reliant in software, says Jerry Huang, head of Hewlett-Packard Co.'s (HPQ ) industry standard servers division for China and Hong Kong. When it comes to encryption and other security uses, "China is ahead or on par with the developed world," he says, adding that the People's Liberation Army generals were among "the earliest adopters of Linux, building systems from the ground up." One reason the PLA has been active in boosting Linux is that sales of supercomputer hardware and software to China is restricted under U.S. law. Linux facilitates alternatives to conventional supercomputing. "They are using Linux to do large-scale clustering -- over 100 servers [working together] in one system," says Huang.

Many factors could inhibit China's efforts to become a technology pioneer, including the absence of mature capital markets and almost no brand recognition for any of its products outside China. Even in chips, a strong suit for China, there are some troubling signs. Beijing is counting on greater integration with Taiwan's chip industry to smooth the way to a lucrative future in chip design. But the Taiwanese themselves are struggling to keep pace with industry leaders such as Intel and IBM (box). The risk for Beijing is that it will throw a lot of resources at homegrown standards that end up with little commercial value outside China, while failing to upgrade the nation's all-important manufacturing base. Even if China's chip-design industry rockets ahead by 2006, as iSuppli predicts, "two generations of technology will still remain between most local integrated-circuit companies and major foreign counterparts," notes a recent iSuppli report.

China's shortcomings bring relief to other Asian nations. As much as Korea and Japan count on China as a manufacturing base and a market, they have no desire to compete with it in the upper reaches of electronics, software, and emerging fields such as nanotechnology. Ironically, their struggles to stay a few steps ahead of the giant are bound to inspire China's best minds to reach even higher. The inventions, technical standards, and scientific ideas that emerge from this arms race of innovation will inevitably reorder the corporate hierarchies within Asia's borders -- and beyond.

By Bruce Einhorn in Shenzhen

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