~This Issue's Index~

Seeds of Sucess:
Building China's Information Technology Industry

By Kathleen Hartford

How do you build a world-class information technology industry? For late starters like China, the power of a handful of gigantic American and Japanese companies looms as both a challenge and a threat. China nevertheless intends to break into the big leagues early in the 21st century, and has been making great strides towards that goal.

Lately, the country's booming Internet and its spunky young entrepreneurs have captured headlines. This growth spurt may well accelerate the country's race into the information age, but it is far from sufficient to make China a global contender. World-class players need hardware and software capabilities to underpin the information economy. The roots of recent progress and potential future problems lie in these more traditional arenas.

Since China's big push for computer industry development began in the mid-1980s, the production and sales of computers, monitors, printers, and other peripherals have grown extremely fast. From 1989 to 1999, domestic PC output rose from approx. 57 thousand units to just shy of 4 million. Peripherals production grew far higher. Escalating output has made China into a new exporting powerhouse. By 1999, its computer hardware trade surplus with the U.S. had grown to over $3.6 billion.

But China's domestic market, too, has grown increasingly hungry for computer products-witness Shanghai Volkswagen's recent offer of a free Chinese brand PC with auto purchases. Last year Chinese buyers snapped up US$15.8 billion worth of computer hardware. Domestic brands have captured increasing shares of this market. By 1999, three of China's top five PC suppliers were Chinese companies. One of those, Legend, rose to third place as a PC supplier in the Asia-Pacific region, and aims for first place this year. Names like Legend, Founder, Start, HiSense, Great Wall, and Langchao may be unfamiliar outside of China, but they may have captured desktops internationally within the next five to ten years.

Birth of a Legend

Legend's origins are typical of many of the 1980s generation of high-tech startups. The company was created in 1984 as a spin-off of the Chinese Academy of Sciences' Computer Institute. In November of that year, a handful of institute researchers in Beijing set out to turn the institute's Chinese character input technology into a saleable product.

Alongside the company's "Chinese card," Legend also made handsome profits reselling foreign-made computers. Profits went into R&D and production facilities. When the first domestically produced 486s and Pentiums came out, they sailed out under the Legend flag. Legend's PC was the hottest selling domestic brand by 1995. By 1997, it claimed the largest share of any company in the Chinese market, and won nearly 22% of the domestic market by 1999. By 1998 the company was ranked as the number one electronics firm in China, with operations in computer resales, PC and board production, and systems integration.

In getting to that point, it went through several organizational metamorphoses. A crucial aspect of these was the establishment of a Hong Kong-based company that started selling shares on the Hong Kong stock market in 1994. Cumulatively, Legend's reorganizations have facilitated the raising of capital and allowed the distribution of ownership shares in the parent company to Legend employees, especially key managers. The Chinese Academy of Sciences, however, maintains the state's majority ownership.

Legend attributes much of its success to the leadership role played by its president, Liu Chuanzhi, and especially to his strategic choices. He is credited with insistence on using market demand to define development strategy-an approach that may explain the company's success in riding one after another wave of new types of demand. The company captured much of the household computer demand that surged in 1997-98, by introducing a line of PCs with a homey interface. By 1999 Legend was emphasizing the Internet as a new development track, and in early April 2000 announced a new reorganization of the company structure built around an Internet strategy.

Legend has cultivated a reputation for organization. Managers readily summarize the elements of a company culture explicitly formulated as a method for getting things done: forming teams, setting strategy, and leading the "troops." Employees attend frequent training sessions. Some managerial methods have been borrowed from companies like IBM and Hewlett-Packard, but the rhetorical flavor is sometimes reminiscent of the Chinese Communist Party in the glory days of the revolution.

The company has selected foreign partners with an eye to acquiring know-how. With its close partnerships with the likes of Intel and Hewlett-Packard, and its more ad hoc but no less strategic partnerships with others like Microsoft, Toshiba and Hitachi, Legend has dramatically sped its progress up the learning curve in key technologies.

At the same time, Legend has achieved a symbiotic relationship with the government. The company provides a handy model of success for the government's strategies in the high-tech sector. At crucial junctures, Legend has won huge state contracts that helped it develop new business lines. In the mid-1990s, it benefited from two crucial new opportunities. The first was the government's massive investment in the Golden Projects (see below). The second was the strategy announced in 1994 to cultivate China's potential global contenders. Legend was one of a handful of companies selected for special nurturing, including huge bank loans.

Some of the U.S. and Japanese IT giants received similar boosts from state spending or preferential policies at early stages in their development, but still had to win out over other, similarly favored companies by dint of better strategic choices or better management. Legend may claim similar credit for fighting its way to a leading market position not only against foreign competitors but also against new domestic competitors who have charged into the market with their own distinct advantages. One such new competitor is Start Group.

An Up-Start Group

Start Computer Group, based in Fujian province, arrived later at the central action in the computer industry. Founded in 1988, the company specialized in peripherals until 1997. When a new management team formed in 1994, they decided to risk a move into some new business areas in order to grow the company faster. Start brand PCs and VCD players first hit the market in 1997, and in 1998 the Group Company launched a software and systems integration subsidiary (SSI Company) in Beijing.

The Start PC in only a little over a year was among the five leading domestic brands, and held the number-two slot for household computers. From 86th place among China's electronics firms in 1993, the company rose to the number 26 spot in 1998. Despite intensified competition in the PC market in 1999 with the entry of some of China's largest household appliance manufacturers, Start still came in seventh among domestic PC makers, and third among domestic printer manufacturers. It aims for fifth place or better among information technology companies by 2001.

Unlike many high tech startups of the late 1980s, Start began as a shareholding company. Of the initial capital of RMB 250,000, state-owned entities held 70% but the sixteen "founders" held 30%. Managers and employees are encouraged to purchase shares in the company. Start Group shares have been traded on the Shanghai Stock Exchange since 1996, and the company has ranked among the high performers there.

Like Legend, Start Group has benefited from both state assistance and foreign partnerships. The company's relationship with Epson goes back to the dot-matrix printer years. In mid-1998 Start and Epson formed a new joint venture to manufacture bubblejet printers, which will give Start employees new technical know-how. The SSI subsidiary, within a year of its foundation, could already boast a long list of "cooperations" with foreign companies including IBM, Informix, and Cisco. Not all of those are close partnerships, but all hold the potential for ramping up the company's technical capacities.

Initially, Start Group could expect state assistance only at the provincial level. (Several companies owned by the provincial government are still major shareholders in Start Group, including an investment corporation that holds nearly 24% of the total.) But Start has proven adept at seizing the opportunities afforded by national policies and projects. A manager of the SSI subsidiary explained the decision to locate that firm in Beijing partly in terms of its qualities as a "policy center" close to ministries and offices making the decisions that spell the difference between success and failure for a company in landing large contracts.

The Start growth strategy has emphasized expanding capacity by buying, merging with, or investing in other companies. The company's merger with another Fujian peripherals factory in 1995 was pivotal in ramping up output. SSI Company's key function has been to identify successful small companies (some of them privately owned) in which to invest, with Start the majority shareholder in most.

SSI's investments paid off with the acquisition of several companies that made Start a major contender in systems integration virtually overnight. The company's clients by early 1999 included a long list of banks, insurance companies, share exchanges and investment companies, telecommunications agencies, and government departments at central, provincial and city levels.

Software Woes

Legend and Start are successful companies; others have limped through the 1990s and lost both standing and market share while their competitors surged ahead. For the sector as a whole, though, probably the most worrisome issue is the underdevelopment of the software and services side. Government and many companies share a concern over the dominance of foreign software companies in both operating systems and major applications. Another concern is the small size of China's software sector relative to hardware, which may handicap hardware development over the long run.

The root of the problem, many argue, is the high rate of software piracy. In value terms, China is far from the worst offender on this score. Business Software Alliance estimates put the dollar value of 1998 piracy losses in China at only 42% of those in the U.S. However, piracy rates in China remained among the highest in the world: 97%. Some foreign software companies question the adequacy of Chinese government efforts to publicize and police the problem, but it must be acknowledged that enforcement is impeded by the prevailing attitudes among Chinese users.

Ultimately, Chinese software manufacturers are probably the biggest losers. Chinese users preferred to go for the (perceived) best in pirated software, and foreign brands captured the share long before they got the market. In the late 1980s and early 1990s, there was often no legal Chinese version of these brands available to mainland users, and they had to get pirated versions or none at all. Later, when Chinese versions were more readily available, users were inclined to upgrade to legal versions of the foreign applications they already had. At least one major foreign software manufacturer based its China marketing strategy on this tendency.

Although foreign software prices are high for Chinese budgets, Chinese software companies' prices sometimes ran higher still. Chinese companies often tried to recoup development costs by pricing their packages quite high, under the assumption that they could sell very few packages before the pirated versions hit the market. The high prices of course made this a self-fulfilling prophecy. More recently, many companies have changed their pricing strategy.

There are some software industry successes. Founder Group, a company started as a spin-off from Beijing University, became one of the biggest IT companies in China by the early 1990s largely on the strength of its desktop publishing system, which captured the lion's share of China's market for such products, and then began selling abroad. On the whole, though, success stories like Founder's have been more the exception than the rule.

The bright spot on the horizon is that the software and services sector has begun growing even faster than hardware. Rapid Internet and intranet growth in the past several years has sparked much higher demand for software and systems integration services. The government's nudges towards adoption of the Linux operating system may augment demand for indigenously developed software using that system, while relieving some of the nationalistic fears about foreign dominance. But there is still a long way to go, and the domestic software industry will remain handicapped until sufficient intellectual property protections are in place.

The Government's Role

The success of China's IT firms and their prospects for future growth are closely linked to measures taken by government. At certain key junctures, decisions made by the central government have opened the road to rapid development for the whole sector. The first key point of departure came in 1984, when the government chose to shift towards microcomputer development, and the PC architecture beckoned new aspirants with its standardized components and low startup capital requirements. Since the Ninth Five-Year Plan period began in 1995, the government has stressed "informatizing" the whole country, with attendant commitments to massive investments in infrastructure.

In the late 1980s, the government permitted high-tech zones where high-tech startups could enjoy five years of significant tax breaks. And the state has provided significant seed money for new technologies. For example, the "863 Project" has funded efforts to develop a Chinese operating system and a number of computer-integrated manufacturing systems applications.

Initially, the government also provided considerable protection to the domestic industry. Foreign companies seeking to sell their products or to manufacture in China faced requirements that they seek Chinese "channel partners" or create joint-venture partnerships. Coupled with tariffs, these requirements encouraged in-country production and transfer of technology to Chinese firms. In recent years, China has reduced such barriers in hopes of joining the World Trade Organization.

Paradoxically, the government has greatly enhanced the market for IT purchases and information services even as its own share in these has declined. Until the early 1990s private and household purchases remained negligible, and most large customers were government agencies and state-owned companies. In the 1990s, the state sponsored three "Golden Projects" aimed at creating a networked infrastructure and applications in several sectors. In 1999 a highly publicized campaign got nearly all central government departments and many lower ones online. The publicity and the availability of useful content have helped fuel the Internet boom, which in turn has fueled the growth of the domestic PC market.

The Roads Ahead

Information technology is a complex and fast-changing industry, with sudden shifts in markets and technologies. The Chinese government has shown wisdom in providing fertile soil for growing the industry, and watering it judiciously. Many tasks still lie ahead, including further improvements in intellectual property rights. Internet use might more rapidly amplify economic growth if the government more quickly reduced connection fees and allayed anxieties over the rules governing online content.

Chinese IT companies face new challenges in the coming era, when WTO membership may spell both more intense competition from foreign companies and more opportunities for Chinese companies in foreign markets. E-commerce is bound to take hold, and offers myriad new opportunities. Chinese companies enjoy cultural advantages in capturing the Chinese market in this new era, and may find foreign companies eagerly soliciting partnerships.

In the end, however, the larger questions remain. Will all of China march into the Information Age, or will most of it stand on the down side of a digital divide watching a fortunate minority?