China's New Formula by Peter Marsh

China's new formula

By Peter Marsh

Published: May 29 2008

The Financial Times

At a sprawling plant in Nanjing, engineers working for BASF are finalising ambitious plans. The site - a joint venture between the German chemicals manufacturer and Sinopec, the Chinese energy group - is set to receive $900m (€571m, £455m) in investment, a scheme intended to boost output by 25 per cent over the next three years. BASF hopes it will soon rival the huge production complex in Ludwigshafen as the focal point for its global operations.

But more than this, says Martin Brudermüller, head of BASF's Asia activities, the Nanjing operation will aim to gain expertise in combining China's famed low costs with the development of new design and production skills. If all goes to plan, this will involve importing ideas from BASF's operations around the world and linking these with concepts developed by BASF's 6,000-strong staff in China, including a team of 100 research and development engineers.

Such an approach, says Mr Brudermüller, is required as China's economy starts to mature. "A lot of our customers [in China] are switching from a copycat philosophy to [one that emphasises] more innovative product areas. This puts pressure on us to devise more advanced materials to meet their requirements."

BASF's strategy in Nanjing is part of a wider phenomenon. Known for its rapid progress to become the world's joint-second most productive manufacturing nation, China is now going through a more subtle phase. It is becoming a giant test bed for manufacturing ideas, building on its existing strengths in low-cost production by using the efforts of engineers and developers not just in China but from around the world.

Jimmy Hexter, a director at the Beijing office of the McKinsey strategy company, says the companies that work out how to do this most effectively - through "networking" approaches that link different groups in different countries efficiently - will be poised to gain substantial commercial rewards. They will, he says, find they are in a good position to push ahead competitively not just in China but in other parts of the world where marrying a decent level of technical sophistication with low costs is important - which means just about everywhere. "Companies will find they need to win in China - or risk losing globally," says Mr Hexter.

China has become a more stable environment for manufacturers over the past four years, according to David Chang, president of China at Philips, the Dutch electronics group. Mr Chang is referring to what he sees as a greater respect for intellectual property - which means western companies have to spend less time worrying about Chinese rivals copying their ideas - and tougher and more rigidly enforced government regulations in such areas as environmental protection and the hiring and firing of workers. "As a place for manufacturing, China has become more mature, more transparent and easier to predict," says Mr Chang.

Added to this is the growing expectation that for the remainder of this decade, China could be one of the few bright spots in the world economy, with gross domestic product continuing to expand at a healthy rate even as western economies deteriorate.

China has emerged as a manufacturing superpower only very recently. According to Global Insight, a US economic consultancy, it accounted for 5 per cent of global manufacturing value-added output in 1995; by last year, this share had risen to 14 per cent, putting the country in joint-second place - with Japan - in the world league table of manufacturers ranked by production. Both countries are well behind the US, which in 2007 accounted for a quarter of global manufacturing output, but a long way ahead of Germany and Britain, whose shares have dwindled to 7 per cent and 3 per cent respectively.

Much of China's manufacturing expansion has been built on low costs. Even after a period of strong wage growth, labour costs in the country remain up to 95 per cent lower than in high-wage nations such as Germany and the US. Many kinds of manufactured goods can be made 10-30 per cent more cheaply in China than in high-wage nations, giving China-based manufacturers a big competitive advantage.

Even so, company officials in China worry that a strategy based around low costs is becoming less tenable. Minoru Yokota, director of a plant in Wuxi near Shanghai run by Nichicon, a Japanese maker of specialist capacitors for electronics, says: "In 2004, the differential [in wages] between our Chinese and Japanese plants was 1:10. Now it is 1:7."

Rising costs are one reason why manufacturers in China - both domestic companies and inward investors - have beenputting a new accent on technology and design. These efforts have been largely successful, says Steve Bertamini, who has just stepped down from running the China operations of General Electric, the US industrial group, to become head of consumer products for Standard Chartered, the UK bank which does much of its business in Asia. "In the past four years, the technical competence of the Chinese manufacturing base - as manifested by the component suppliers that we deal with - has improved considerably," Mr Bertamini says.

The greater sophistication of GE's Chinese suppliers is one reason why it hopes that within five years, China-based manufacturers will be capable of supplying about 16 per cent of the company's worldwide requirement for manufactured parts, up from half this figure now. GE will gain the most use from these low-cost components, says Mr Bertamini, if the company can make the best connections between the suppliers of the parts and its product development staff in China and elsewhere. Then, he says, GE's competitiveness in a number of the products that it makes and sells around the world - from switchgear to hospital scanners - is likely to be considerably enhanced.

"Everyone thinks that low-cost products, which are perhaps less technically sophisticated than the top-of-the-range products made in the US or western Europe, are primarily of interest to consumers and industrial users in emerging economies," says Mr Bertamini. "But in reality there are a lot of potential customers for products made in this way in high-cost countries too."

Another company trying to yoke together product development and low-cost manufacturing at a number of centres around the world is Lenovo, the Chinese computer maker. While its manufacturing is predominantly in low-cost countries - it has five plants in China, two in India and one each in Poland and the US - the company employs 2,000 staff in design and development in three widely spread centres, in Beijing, Tokyo and Raleigh, North Carolina. Its effort in this field was helped by the company's acquisition four years ago of the personal computer division of IBM, the US technology company, which brought with it a cadre of mainly US-based development engineers.

Angela Qiu, the head of a 90-strong group employed by Lenovo in Beijing to inquire into long-term trends in fields such as new materials and software that could make computers easier to use and more versatile, says: "If Lenovo is to move ahead as a company, it's vital for the company to make decisive advances in design and innovation."

Fountain Set Holdings, a Hong Kong textile maker which runs four plants in China, now employs 100 people in design and development, compared with none a decade ago. The team - based in two Chinese factories and a plant in Sri Lanka - works in areas such as new knitting, printing and dyeing techniques, as well as the development of novel fabric that absorbs odours for use in clothing in hot climates. Gordon Wen, director of Fountain Set, says: "In the past, customers [in the clothing industry] would come to China with a specification of what they wanted to be made. Now they are coming and asking: 'What have you got for us [in design and development]?' They are interested in buying the products that we've made using our own design resources."

Mindray, a maker of medical equipment, is another Chinese company to have moved in this direction. The company has 1,000 development engineers, many of them involved with "cost-down" projects, in which they study, for example, patient monitoring systems sold in western countries for about $6,000 and work out how to make the equivalent product in China for as little as $1,000.

"We look at what parts we can standardise, where we can reduce the level of technical sophistication without comprising quality, and in what instances we can substitute software for electronic components," says Joyce Hsu, Mindray's chief financial officer. The result, she says, is often a low-cost product that may not have so many features as an equivalent piece of equipment made in western Europe or the US but which satisfies requirements in hospitals - in China and elsewhere - that are trying to cut back on costs.

Following a similar line is Candy, an Italian company that is one of Europe's biggest makers of domestic appliances. Two years ago it set up its first factory in China, through purchasing a plant in the southern port city of Jiangmen. Aldo Fumagalli, Candy's president, admits the company has found adapting to China more difficult than he imagined. "It's all so different; we've found we can apply [to Candy's China operations] very little of what we already knew from [our experiences in] Europe." But, he says, the eventual pay-offs promise to be large. He reckons the plant will give Candy a base for designing and selling low-cost washing machines and other products that will prove valuable not just in China but in other parts of the world where the market for these products seems set to grow, for example South America.

Luxembourg-based Element Six, the world's biggest maker of artificial diamonds used in industry, which is part owned by De Beers, the South African diamond miner, is another company trying to learn from China's experiences in low-cost production. In 2006 it set up a plant in Suzhou, near Shanghai, expressly to copy the techniques of Chinese rivals in making artificial diamond, produced through compressing graphite under high pressures. Christian Hultner, Element Six's chief executive, says: "Most manufacturers are concerned about the Chinese taking their ideas; we decided to do things the other way round. [In the Suzhou plant] we used Chinese management, Chinese workers and Chinese machines. We put into this plant not an iota of technology [from outside China]. But we succeeded in finding out a lot about the Chinese way of organising manufacturing in this field, which has been highly useful in the rest of our worldwide production operations."

By deliberately not putting its best global technology into its China plant, Element Six has avoided the risk of its best secrets leaking out (see below). Mr Hultner says the company takes a far from sanguine view on this. He admits that he would never sanction the shift to China of Element Six's most technically advanced production processes for artificial diamond - which are located in a small production facility in the Isle of Man, off the coast of northern England. "I feel that on this island the technology is fairly safe," he says.

For all such concerns, it seems the approach for most global manufacturers will be to push on with marrying their own design concepts with ideas developed inside the country. It will probably become all the more vital to tap into the engineering potential of China as the country's economic development widens and deepens, particularly as infrastructure investments in its less developed western regions bear fruit. In this environment, the companies that do most to make a success of the manufacturing test bed that China is turning into may indeed find they have produced an advantage when it comes to competing globally.

Innovators avoid the copyright risk

A big worry for many western and Japanese manufacturers in China is that their technical secrets developed in other parts of the world might be copied by China-based rivals. That prompts companies to hold back from making their most advanced products in China or putting a big engineering development effort into the country. The inhibitions linger on in spite of reforms over the level of intellectual property protection in China, many of them linked to the country's 2001 accession to the World Trade Organisation.

Nichicon, a Japan-based maker of electronic capacitors, is one. It refuses to site in China a top-secret production process for refining the aluminium foil used in these devices - even though by having its Chinese plants import the foil from Japan, where the process features in several of the company's home-based plants, costs of its Chinese production are significantly increased. "This technology is important to us," says Kazuo Nakamura, deputy director at Nichicon's plant in Wuxi, near Nanjing. "By keeping the process in Japan we feel we can protect it better."

Some multinationals are, however, finding different and creative ways to get around the problem. Trumpf of Germany, one of the world's two biggest makers of machine tools, is for instance setting up in China not one but three plants to make some of its top-of-the-range laser-cutting equipment. "We feel that if we split up our parts production and manufacturing processes in three centres around China rather than put them all in one place, it will be harder for competitors to find out about them and replicate our technical concepts," says Nicola Kammüller-Leibinger, Trumpf's president.

According to Charles Ingram, managing director of the Chinese operations of JCB, the UK construction equipment maker, many Chinese companies are "desperate" to increase the technical sophistication of their products. But the way most of them go about this, he adds, is not by stealing other companies' designs but through alliances with those western businesses commonly regarded as leaders in technology and design. Partnerships of this kind feature in many areas of Chinese manufacturing, including in construction machines.

David Michael, head of the China practice at Boston Consulting Group, says that although the fear of copying is a legitimate concern for many companies, often the best way to confront this is to "participate fully" in developing products in China, coupled with a policy of robustly defending legal rights over intellectual property when it appears copying has taken place.

Failing to engage in product and process development in China because of the worry about violations of intellectual property is not the way to proceed, says Mr Michael. "For many companies it is vital to be present in China, not just in sales but in engineering development. If they do not do this, they will find their global competitiveness is affected."

Copyright The Financial Times Limited 2008