Huang Shaoqing: Why is the transformation of Chinese manufacturing so difficult?
Office of Alumni and External Relations 2019-11-07
With the economic transformation and industrial upgrading in China, manufacturing enterprises need to accelerate the change of the previous inefficient large-scale growth model and innovate the future development model in a new round of development; and in the global economic downturn and the highly specialized international labor-division system, Chinese manufacturers are increasingly difficult to adapt to the future development by relying on cost advantages and playing “the role of producers” to participate in the international competition. They must seize control of important links across the value chain and have the ability to lead the labor division in the global manufacturing industry chain.
The difficulties currently faced by China’s manufacturing industry are problems accumulated for a long time and to be solved after a long time in the future. What’s more, many of them are age-old problems, such as low labor costs, strong policy orientation and insufficient innovation capabilities. Why is the technical capacity of Chinese manufacturers difficult to improve? What is the impact of the changes in international environment, such as the global economic downturn and Sino-US trade disputes, on Chinese manufacturing enterprises? How should manufacturing enterprises develop in the future? Recently, Chief Executive China (CEC) interviewed Huang Shaoqing, PhD in Economics and associate professor of ACEM, SJTU, on the development of China’s manufacturing industry, in an attempt to explore the future development path of Chinese manufacturing.
Ineffective cost leadership strategy and inadequate innovation
CEC: In the past few years, Chinese manufacturers have had difficulties in the new round of economic transformation and industrial upgrading. What do you think is the main problem?
Huang: On the face of it, it is the inadequate innovation that makes it difficult for enterprises to make breakthroughs in the value creation of products and services. In particular, there have been some new changes in the global economy, to which the cost leadership strategy of Chinese manufacturing enterprises failed to adapt, i.e. it is increasingly difficult to support the sustainable development of enterprises by reducing manufacturing costs in various ways and gaining advantages in the processing and manufacturing links of products. At the same time, the ability to create profits through innovation has not yet been developed, which will lead to various problems in enterprises, so it is a common phenomenon that enterprises are struggling to maintain operations and are even eliminated. However, we should also see that there are other deep-seated reasons for the inadequate innovation of Chinese enterprises.
CEC: Transformation is a high-risk and difficult change for enterprises. Nowadays, multiple factors such as the global economic slowdown, the China-US trade disputes and industrial upgrading are making it even more difficult for the transformation of Chinese manufacturing enterprises. What do you think are the main challenges faced by Chinese manufacturers in the transformation today? How should enterprises respond to them?
Huang: There are two main reasons for Chinese manufacturers to maintain rapid development for a long time: the first is economies of scale, which achieves large-scale production by means of large-scale investment in equipment, and reduces costs to an extreme level through large-scale production, thus obtaining cost advantage. The second is that loose regulatory policies and standard requirements in China have also lowered the costs of Chinese manufacturing enterprises and created a competitiveness based on absolute cost advantages for China. In the context of the rise of global trade protectionism, it will be difficult to maintain these two elements. In addition, China’s demographic dividend is gradually disappearing, and the cost advantages built on it by enterprises are also disintegrating gradually.
Chinese enterprises mainly undertake production and processing links in the industry chain, so the added value is relatively low. The early development relied mainly on various cost advantages. This so-called cost leadership strategy is increasingly difficult to adapt to the current development requirements, but enterprises have no ability to rapidly improve their innovation in the short-term and lack the ability to lead the labor division in the global value chain, thus becoming more and more passive. As multinational companies shift production and processing links to Southeast Asia, it will become increasingly difficult for Chinese enterprises to just play the role of manufacturers in the global value chain, and this is a new challenge.
Today, the global market is becoming increasingly saturated, and the market competition between countries and between enterprises is becoming more and more fierce. From the perspective of the global environment, developed countries are using political means to crack down on some non-national enterprises and their products so as to protect the interests of domestic enterprises, i.e. they are introducing some protective policies to build economic barriers. This political power is currently intensifying globally.
In order to find a countermeasure to effectively improve the technological innovation of enterprises, it is necessary to return to the root causes for the long-term inadequate technological innovation of Chinese enterprises and to solve them. According to the production function of technology, production technology requires a large amount of R&D funds and personnel input, but Chinese enterprises have been short of enthusiasm and will in R&D investment, and the efficiency of research and development is not high.
There are many reasons for this: firstly, the government’s export-oriented industrial policies in the past had some major side effects. Export processing itself does not require much innovative R&D. The government provided enterprises with low-cost land use, tax reduction and other preferential support, causing distorted production decisions made by most enterprises based on short-term interests, i.e. investing large amounts of resources in the expansion of production scale when the market environment is relatively loose, and making no basic preparations for the future innovative research and development, thus failing to form a strong innovation in the long run.
In recent years, this situation has not changed significantly, as in the global economic downturn, local industry supporting policies have only intensified rather than weakened, in an attempt to help enterprises reduce production costs and maintain business survival. Therefore, enterprises have been hard to make a determined effort to change the strategy and lacked sufficient motivation to increase investment in technological research and development.
Secondly, the protection of intellectual property rights is still not perfect in China, which is an old problem. The result of the imperfection is that products developed by enterprises will soon be copied by others, and most gains from the large amount of costs invested may be taken away by others. If it is impossible to obtain enough returns from research and development, enterprises will not dare to invest heavily in innovative research and development. However, I believe that after the China-US trade friction, China will speed up the improvement of the systems related to intellectual property protection.
Thirdly, basic scientific theoretical research is still very weak in China. There are two models in making breakthroughs in technological innovation. The first one is experience-based acquisition in the traditional sense, i.e. producers constantly accumulate experiences in the process of production and solve technical problems and create new value in the exploration. The four great inventions of ancient China were actually technological innovations based on experience. Nevertheless, experience-based technological innovation is discrete, unpredictable and unstable, and the progress is slow. The second one is science-based technological innovation. For example, the development processes of biopharmaceuticals and aerospace are all based on major scientific theoretical breakthroughs. China’s weakness in science and other basic theoretical research has restricted the ability of Chinese enterprises in making technological innovation.
Fourthly, Chinese enterprises are relatively weak in basic technology fields, such as the development of common technologies. China’s development of common technologies used to be undertaken by scientific research institutions, outsourced by the government. After the reform of the science and technology system, scientific research institutions were transformed into an enterprise-oriented operation model. The Ministry of Science and Technology of China has been trying to encourage a model in which large enterprises in various industries take the lead in forming strategic alliances for industrial technology innovation, but the results have not been obvious so far. Most enterprises have diverted the funds received from the government to the development of back-end technologies, instead of using them for the research and development of common technologies. The weakness of the research of common technologies has restricted the efficiency of Chinese enterprises in the development of back-end application technologies. At present, the government is promoting the model of National Innovation Center to solve the research of common technologies. Whether this new model will work remains to be seen.
These aspects are obviously related to government functions. Some people advocate that the market economy is to weaken the role of the government. Generally speaking, this statement is not accurate. The key is that the government needs to play an appropriate role in the market economy. I am not in favor of the general emphasis on “strong market, weak government”, but that the government must be strong and do the right thing when it is required to work; and the government should naturally be weak in things that should not be done. For example, the industrial policies that intervene and distort the cost structure of enterprises directly are not needed and should be withdrawn as soon as possible.
“Giving better play to the role of the government” as emphasized in the documents of the Central Government is crucial for Chinese manufacturers to upgrade their technological innovation. Enterprises themselves must redouble their efforts, as the strength in technological capabilities is actually the result of long-term accumulation. Each enterprise must now carefully plan for the future R&D strategy, and the R&D capability will gradually improve as it develops to a certain stage. The most fundamental thing is the willingness to invest and accumulate in technology development. Moreover, from the perspective of a country as a whole, the more resources it accumulates in R&D investments, the easier the dynamic comparative advantage can be gradually transformed into the innovative fields “from 0 to 1”.
Become a leader in labor division and accelerate self-accumulation
CEC: In CEC’s previous interviews, larger Chinese manufacturers seemed to like to refer to “transform from product to service”, “transform into a software and hardware provider”, and “transform into a solution provider”. What do you think of this phenomenon? Is it a major direction of manufacturing transformation?
Huang: The integration of manufacturing and service industries is a major trend in global economic development, and global manufacturers are moving in this direction. This integration will increase the added value of the manufacturing industry, and after having more service capabilities, manufacturers will not only be producers, but also improve product performance in a timely manner to better meet consumer needs and create more value for consumers. Moreover, after the Fourth Industrial Revolution, technology has made it possible for enterprises to better integrate services, manufacturing and markets. This trend is becoming more and more obvious.
Although the general direction is very clear, it is not too easy for Chinese enterprises to change. Now the government is investing a lot of money in technology upgrades every year. For example, the investment in the infrastructure of new generation of communication technology is very large. China’s investment intensity in information technology is comparable to others in the world, but the effect of information technology on the efficiency improvement of enterprises is not very obvious.
The essence of service is “people dealing with people”, which is significantly different from the manufacturing process of “people dealing with things”. People dealing with people involves transaction costs and trust building. In the scenario of interaction between strangers, the most effective way to prevent degrading behavior and reduce transaction costs is to establish the rule of law, resolving disputes and forming the deterrent of the rule of law through an independent, impartial and efficient third-party judicial system. If China cannot make significant progress in this respect, the combination of service and manufacturing and even the development of the service industry itself will encounter the problem of hindered development due to the excessively high transaction costs.
To be “service-oriented” and become “solution providers”, Chinese enterprises must, first of all, make a series of changes, such as accelerating organizational changes, moving toward flattening, and responding to the market more quickly and accurately; accelerating the adjustment to the R&D strategy, and better responding to market changes in terms of innovative projects of technology development of enterprises; strengthening internal service awareness, and establishing and improving service mechanisms between departments and employees. Secondly, the government must accelerate the establishment of an institutional system for intellectual property protection, so that the innovation results of enterprises are more strictly protected.
CEC: As a traditional manufacturing enterprise, how to respond to the wave of new technologies?
Huang: In the face of the wave of new technologies, it seems inappropriate to look at the future development of industries and enterprises from the past view of traditional or non-traditional. The dichotomy between traditional and non-traditional is no longer applicable, because enterprises in any industry are likely to show new vitality through technological innovation.
From a market perspective, enterprises in different industries should only be differentiated as innovative and non-innovative. For example, the printing and dyeing industry deemed by us to be traditional can also be transformed into a high-tech industry, and even become an industry that is no longer highly polluting through water-free technology. In the process of technological innovation, what the government has to do is to formulate reasonable regulatory standards and solve various external problems, leaving the rest to entrepreneurs and scientific researchers. Any industry may undergo great changes through technological innovation, which is hard to predict. A sudden inspiration of R&D personnel may subvert the technical routes and technical models of an entire industry.
CEC: What do you think are the main impacts of the China-US trade disputes on Chinese manufacturers? Where should manufacturing enterprises start to deal with the currently complex and volatile international economic structure?
Huang: The obvious impact is the sharp reduction in overseas orders of enterprises. It is important to note that the China-US trade friction will not only result in partial loss of overseas markets, but also affect the use of economies of scale by China’s manufacturing industry, as the shrinking orders will lead to an increase in average production costs.
China is now in the period of economic transformation and industrial upgrading. As I mentioned above, it is necessary for enterprises to strengthen their technological innovation and make changes in research and development. The China-US trade friction has imposed more restrictions on Chinese enterprises in technology acquisition, which requires Chinese enterprises to make greater efforts and pay more attention to how to quickly shift to new cutting-edge technologies.
In addition, Chinese enterprises should also eliminate an inappropriate tendency in technological innovation, i.e. being so ready to improve the independent technological innovation capacity in an all-round way. As with any economic activity, in a freely competitive market environment, technological research and development should also be based on comparative advantages. It is not necessary for China to achieve independence in all technologies, as it is economically irrational and impossible within the capabilities. To achieve independent innovation in any technology is a self-enclosed way of thinking that excludes oneself from the international labor division. In fact, today’s China has been deeply integrated into the global economic system and is impossible to go back to the old road of self-enclosure.
The Chinese government must work hard to maintain a trade system that helps Chinese enterprises integrate into the global competition so as to form an international economic environment that enables Chinese enterprises to better participate in the international labor division system. On the one hand, we must put the issue of innovation on the agenda and accelerate the process of accumulating technological innovation; on the other hand, we must also recognize the difference in comparative advantages between countries in terms of technology development and rely on foreign power to help China improve the entire industry chain system. China and the United States should resolve trade disputes through negotiations and maintain the WTO framework system to ensure free competition in the global market.
CEC: What is the level of management of Chinese manufacturers according to your research? How to break through the management system and promote the transformation of enterprises?
Huang: There are scholars in the world who have studied this issue. A few years ago, Prof. N. Bloom of Stanford University scored the management effectiveness of enterprises in different countries through surveys of thousands of enterprises around the world. The results showed that the management effectiveness of Chinese manufacturing enterprises was relatively low in the world, probably 26% lower than the US. In other words, if Chinese enterprises can reach the same level of management effectiveness as US counterparts, China’s GDP will increase by 26% without capital increase.
Management breakthrough is indeed worth great efforts of Chinese enterprises, since there is still so much room for them to improve the management effectiveness. I think there are many channels for enterprises to improve their management effectiveness. For example, they may improve management effectiveness by improving on-site management. About 10 years ago, when I was an MBA thesis defense expert at CEIBS, I was very impressed with a thesis on how to enhance effectiveness by improving on-site management of Chinese enterprises. Its core point of view was that there is a lot of room for Chinese enterprises to learn from the Toyota model of Japan to achieve just-in-time (JIT) management in the on-site management. Nowadays, the management circle still pays great attention to this point, especially with the help of various information technologies, the conditions for enterprises to realize JIT management model are more mature. Moreover, the need for JIT management is even higher, as customized and flexible production is becoming more common, which is helpful to the potential of JIT management to increase production efficiency.
CEC: According to your research, are there any commonalities for reference among outstanding enterprises at home and abroad that have achieved transformation successfully?
Huang: I will give you an old, but still valuable reference case, and that is the transformation of Hong Kong Li & Fung Group. Originally a trader, Li & Fung Group later was successfully transformed into a “global supply chain manager” and an “outsourcer”, which established a highly efficient supply chain system around the world through actively outsourcing businesses to manufacturing enterprises. Li & Fung Group combined raw materials, manufacturing, assembly, transportation and other links to create a unique supply chain business model, expanding its market to the world, sourcing raw materials from around the world and seeking customers from all over the world. Li & Fung Group successfully transformed itself by controlling the outsourcing right in the market.
To summarize a commonality among enterprises with successful transformation, we should see whether they can gain an upper hand in the industry chain or supply chain, which is an ability that all enterprises with successful transformation have. This is also related to the future development of Chinese manufacturers. From this perspective, the ultimate goal of Chinese manufacturers is to move from a simple processing manufacturer to the upstream of the industry chain and value chain, and gradually become a role in the entire industry chain and value that has the outsourcing power.
Specifically, Chinese manufacturing enterprises should further consolidate the competitiveness of funds in the manufacturing process, which is the foundation of existence. In the context where overseas markets are subject to various impacts, China may consider relying more on the expanding domestic market to consolidate its production scale, maintain economies of scale and cost advantages, thereby further strengthening its manufacturing ability. Utilizing the profits generated in the low-end market in China, Chinese enterprises should be committed to developing their own R&D capabilities, thus extending to the upstream links of the industry chain and even to the middle and high-end market of the industry. In this process, Chinese enterprises should gradually improve the service capabilities so as to gradually transform into the role of managers and controllers in the value chain and supply chain in the future, and ultimately become dominant in the global economy. I believe that this is completely predictable through the unremitting efforts of Chinese enterprises.