Lessons from Success & Failure: Indigenous Innovation in China

Exclusive excerpt from upcoming Routledge book by Yin Li at Fudan Univeristy

Pekingnology today presents an exclusive excerpt from the upcoming book China’s Drive for the Technology Frontier: Indigenous Innovation in the High-Tech Industry, due July 7, 2022, published by Routledge.

China has become an innovation powerhouse in high-tech industries, but the widely held view assumes the Chinese model is built on technological borrowing and state capitalism. This book debunks the myths surrounding the Chinese model with a fresh take on China’s strategies for technological innovation.

The central argument is that indigenous innovation plays a critical role in transforming the Chinese high-tech industry. Like any successfully industrialized nation in history, indigenous innovation in China allows industrial enterprises to assimilate knowledge developed elsewhere, utilize science and technology resources and human capabilities accumulated in the country, and eventually approach the technological frontier. The question is, how do Chinese businesses and governments engage in indigenous innovation?

The book features detailed case studies of two critical high-tech industries—the telecom-equipment industry and the semiconductor industry—and within them, the business histories of leading Chinese innovators.

The excerpt below summarizes Li’s observation that some successes are hardly a planned outcome of industrial policymakers. In other cases, the Chinese government has gone above and beyond to become involved in the expansion of advanced manufacturing capacities. However, there are limits to the developmental state’s ability to foster indigenous innovation.

The author is 李寅 Yin Li, Assistant Professor at the School of International Relations and Public Affairs, 复旦大学 Fudan University. His research interest focuses on the economics of innovation, industrial policy, and emerging technology governance. His research has been published in leading innovation study journals, including Research Policy, Technovation, and JASIST.

Li holds a bachelor in economics from Renmin University of China, a MA in Economics from University of Massachusetts, and PhD in Public Policy from Georgia Institute of Technology.

Book excerpt of 李寅 Yin Li’s China’s Drive for the Technology Frontier: Indigenous Innovation in the High-Tech Industry, due July 7, 2022. The publisher is Routledge. Here is the Amazon link.

If you are interested in reviewing the book or inviting the author for engagement such as a conversation, seminar, or podcast, feel free to reach out to yinli[AT]fudan.edu.cn. Or you can contact me zichenwanghere[at]gmail.com and I'll pass on a word.

On the Chinese Internet, there is a well-known story about a soap factory attempting to solve a production problem, in which some of the empty soap boxes on the assembly line have been left unfilled. Instead of investing in an expensive quality control device or reconfiguring the production line, the workers of the soap factory in the story devised an ingenious solution: use an electric fan to blow wind onto the line, and the empty boxes will be blown away.

The story is likely fictitious, but its purpose is clear: it celebrates the wits on the shop floors. But the story also illustrates that, if there is a lack of innovation in parts of China or in the developing world, it is not because of insufficient human inventiveness. It is, however, because of a lack of strategic investment in innovation. Unless the soap manufacturer wants to continue producing the same soap on the same scale forever, it would have to invest in solving the underlying problem of defected products (in this case, unfilled soap boxes).

On one hand, leaving the problem unsolved could lead to bigger problems down the line because technology development is accumulative: tomorrow’s products and technology build on those of today. Identifying and solving the problem, on the other hand, could improve the production routine, generate useful knowledge, and even acquire new capabilities that are potentially valuable to the upgrading of a factory in manufacturing more sophisticated products. The process of making strategic investments in problem solving, acquiring advanced capabilities, and entering new markets for higher quality, more sophisticated products is the essence of indigenous innovation.

Over the last two decades, Chinese companies have become increasingly aware that, in order to become global competitors, they have to engage in indigenous innovation. There are many factors in favor of Chinese innovators: a developmental government that eagerly promotes local innovation and invests heavily in physical infrastructure and human capabilities, a massive domestic market to access users and gain financial returns, and a period of globalization that allows the inflows of capital and knowledge.

However, none of these favorable factors would guarantee success unless the firms are willing to innovate and are capable of innovating. Ultimately, to engage in indigenous innovation, it depends on the innovating firms to make strategic innovation investments and sustain the organizational learning process for as long as it takes.

Therefore, central to understanding the indigenous innovation process are the organizational, institutional, and social conditions that enable innovative enterprises. The socioeconomic history of innovation and industrial development in the Chinese telecom-equipment and semiconductor industries, as illustrated in this book, shows that these conditions tend to be industry-specific and path-dependent. The emergence of indigenous innovation in Chinese industries must be understood through the analysis of dynamic interactions between firm-level strategic control, organizational integration, and financial commitment underpinned by the governance, employment, and investment institutions in China over the last 40 years of development.

Leading firms in the telecom-equipment industry and the semiconductor industry are critical cases to analyze the indigenous innovation process in China. The telecom-equipment industry is a case of exceptional success in China’s indigenous innovation, in which leading firms were among the first group of global competitors from China. The success of the non-state-owned Huawei in telecom-equipment was hardly a planned outcome of industrial policymakers, at least not until the government shifted to indigenous innovation policy in the 2000s.

On the contrary, the Chinese government has been cultivating technologically advanced, market-competitive semiconductor firms since the 1990s. But the leading Chinese chipmakers have struggled to catch-up with the technological frontier, and as a result, the supply of high-performance chips has become a chokepoint of China’s vast electronics industry in the emerging U.S.–China rivalry. Comparing and contrasting the telecom-equipment industry and the semiconductor industry to understand the process of indigenous innovation, or lack thereof, shed light on the institutional foundations of indigenous innovation in China.

In the telecom-equipment industry, Huawei’s technological innovation and market successes are outcomes of the company’s strategic innovation investments in acquiring and integrating user knowledge in the innovation process, in the accumulation of knowledge and capabilities that are transferred across technology standards and markets, and in maintaining a motivated and flexible workforce through widely distributing gains from the company’s success.

Through sustained organizational learning, Huawei utilizes these high fixed-cost investments in innovation and transforms the technologies into competitive advantages in the global market. However, Huawei’s investment strategy and organizational learning have been supported by a set of rather unique institutional conditions.

Strategic control in Huawei is enabled by employee ownership, ensuring its top executives, including the founder Ren Zhengfei, rotating CEOs, and board members, have the willingness and abilities to allocate corporate resources into innovation activities until the investment generates returns over a long period of time. While there is controversy surrounding Huawei’s employee ownership, such an institutional arrangement has protected capable Huawei executives who formulate innovative investment strategies with autonomy, setting the company apart from its Western competitors that have outsourced corporate governance to the stock market or its domestic peers operating under the influence of the government.

To implement the innovation strategy that emphasizes user interaction and indigenous R&D, Huawei achieves organizational integration by building an engineer-dominated organization to facilitate the collaboration between R&D engineers, service engineers, and sales managers, who are motivated by profit-sharing mechanisms baked into the employee ownership arrangement.

The financial commitment required by sustained organizational learning is fulfilled at Huawei by setting a high priority on innovation over profitability. By raising capital internally through employee contribution in the early days and retained earnings later, Huawei provides “patient capital” to its innovation activities while maintaining autonomy and integration.

In the semiconductor industry, the changing leadership in the domestic industry has marked three phases of industrial evolution: the state industry (1970–99), globalization (2000–14), and the current phase under the new industrial policy since 2015. In the era of the state industry, the leading state-owned firms and their joint ventures (JVs) with multinational corporations were assisted by the government to upgrade through state-sponsored technology transfers, such as Projects 908 and 909.

However, the state industry’s achievement in technological upgrading has been limited, owing primarily to a lack of strategic control in state-owned enterprises. On one hand, because these state-owned semiconductor firms had the least control over their investment strategies, they struggled to meet the high goals of advanced technologies targeted by the government. Project 908 was such a failure in upgrading from a base of weak capabilities without a viable strategy at the state-owned Huajing.

On the other hand, the JV semiconductor firms have lost strategic control by relying on foreign partners for technology access. Without an investment strategy for indigenous innovation, the JVs would not utilize their capabilities for innovative activities even when they were deployed. Because technology transfers are one-off agreements and the technological change in semiconductors is dynamic, the JVs without strategic control would have persistent dependence on foreign partners for technology upgrading.

The emergence of Semiconductor Manufacturing International Corporation (SMIC) and other Chinese semiconductor firms since the 2000s has transformed the industry from a state-owned backwater to one with the potential to close technology gaps and compete globally. This transformation was enabled by allowing globally recruited managers and engineers to take strategic control of leading firms; fostering organizational integration through attracting and retaining overseas talent using competitive pay and stock-based compensation; and increasing channels to access capital provided by local government subsidies, foreign direct investment, and the stock market to enable financial commitment. The results were the rise of Chinese pure-play foundries and fabless design houses that are deeply integrated into the global value chains.

The transformation to indigenous innovation in the semiconductor industry has been, however, an unfinished project. Since 2009, the pace of technological catch-up at SMIC has been slowed down by legal disputes on intellectual property rights, internal managerial turmoil, and most recently, export controls imposed by the U.S. government.

Since 2015, state funding from China’s new industrial policy has been a significant source of SMIC’s recovery. And more recently, strong demand for semiconductor chips during the COVID-19 pandemic fueled SMIC’s expansion. However, it is not yet clear whether the company will successfully transit from the catch-up stage of absorbing foreign technologies to a new stage of indigenous innovation. SMIC depends heavily on leading international suppliers for specialized machinery and materials, although such dependency is not unique to Chinese foundries. Being cut off from American technology, SMIC will be forced to innovate without the assistance of international suppliers. SMIC will need to collaborate closely with domestic suppliers and formulate a viable strategy, most likely starting from a mature technology node, to develop indigenous technology and a local supply chain.

It will be a challenging task for SMIC, even if it had less restricted access to foreign technologies. The government could provide subsidies and support to SMIC’s efforts, but the success of indigenous innovation ultimately depends on whether SMIC can develop a coherent strategy and execute it with integrated organization and committed finance.

A comparison between the telecom-equipment and semiconductor industries and the leading firms within them provides insights into the indigenous innovation process in China. Both cases highlight the role of a developmental state in investing in an array of productive resources available to the business. Some of these resources, such as education, physical infrastructure, and science and technology (S&T) system, are clearly public goods that only the state can provide.

However, the Chinese government has gone above and beyond to become involved in the expansion of advanced manufacturing capacities in attracting, negotiating, and coordinating foreign investment and in fostering the inflows of talent and knowledge. Such investments have formed the foundation of the nation’s technological learning. Furthermore, to foster innovative business enterprises, the government often has to step in to provide “patient capital,” which otherwise would not be available through the financial markets.

However, there are limits to the developmental state’s ability to foster indigenous innovation. Since the 1980s, the Chinese government has mobilized massive resources to invest in strategic industries with the goal of developing world-class innovative industries. In both the telecom-equipment and semiconductor manufacturing industries, the government adopted aggressive investment policies to propel its enterprises toward the technological frontier.

Yet, state enterprises widely adopted the importation of world-class manufacturing equipment and product blueprints to meet the government’s localization goals, in the hope that local firms would assimilate the embedded foreign technologies through increasing local production of imported technologies. The government’s emphasis on rapid catch-up might have actually hampered indigenous innovation at the firm level; in chasing the “latest” technologies, local firms have been under pressure to constantly import new equipment and blueprints for upgrading, undermining the accumulative process of technological learning required for indigenous innovation.

The semiconductor industry clearly demonstrates policy failures of this type in that government initiatives targeting new technologies have repeatedly led to the abandonment of older programs and firms (e.g., Huajing), resulting in discontinuities in technological accumulation and limited progress. But similar failures have been observed in many industries under heavy government intervention, especially the well-known problems of foreign technology dependence in China’s JV automobile industries.

Therefore, the two cases of industry studies demonstrate that the success of the developmental state in fostering a dynamic of growth eventually depends on the emergence of innovative enterprises in indigenous innovation. From the perspective of the theory of innovative enterprise, the importance of indigenous innovation derives from the concept of “strategic control.” Companies that seek to become global competitors in the technology industry have to go beyond technology learning from abroad to develop superior productive capabilities at home.

The keys to indigenous innovation are, first, the devolution of strategic control to autonomous business enterprises that can engage in domestic and global competition, and second, the exercise of strategic control by business executives who have both the ability and incentives to allocate corporate resources to investment in innovation.

A distinctive feature of China’s industrial governance has been the wide range of governance structures, from 民营 minying, employee ownership, JVs, state-owned enterprises, to venture-backed start-ups. The key issue is not the governance structure per se but rather the abilities and incentives of those who exercise strategic control, given a governance structure. Not all Chinese firms possess these strategic capabilities, but the most successful Chinese companies have been those in which senior executives have the autonomy, ability, and incentive to invest in innovation.

While securing strategic control is a necessary step toward indigenous innovation, maintaining strategic control can be a bigger challenge for many innovative Chinese firms. That challenge could come from the state, whose industrial policy with ambitious goals will inevitably influence firm strategy. Maintaining strategic control in sectors crucial to China’s industrial policy will depend on the ability of corporate managers to align their goals with the state without compromising the innovation strategies of their own firms.

The above is from 李寅 Yin Li’s China’s Drive for the Technology Frontier: Indigenous Innovation in the High-Tech Industry, due July 7, 2022. The publisher is Routledge. Here is the Amazon link.

If you are interested in reviewing the book or inviting the author for engagement such as a conversation, a seminar, or a podcast, feel free to reach out to yinli[AT]fudan.edu.cn. Or you can contact me zichenwanghere[at]gmail.com and I'll pass on a word.

More book excerpts are available in Pekingnology:

China's Land Finance, from Embedded Power: Chinese Government and Economic Development《置身事内：中国政府与经济发展》by 兰小欢 Lan Xiaohuan

How Academic Research Contributes to China's Decision-Making, from Academic Autobiography of Jiang Xiaojuan《江小涓学术自传》by 江小涓 Jiang Xiaojuan

Former Deputy Secretary-General of State Council on foreign investment, WTO, industrial policy, etc. from Academic Autobiography of Jiang Xiaojuan《江小涓学术自传》by 江小涓 Jiang Xiaojuan