Major Tian Authors

Shaun Rein on How China Will Become an Innovative Economy

August 25, 2014


China is not known to be an innovative economy, but Shaun Rein, author of The End of Copycat China, believes that will change sooner than we know.

Can you name one innovative project, one innovative change, or one innovative product that has come out of China? That was a challenge posed by US Vice-President Joe Biden, while addressing a crowd of graduates of the US Air Force Academy in May. While one can easily beat Biden by referring to the four great inventions of ancient China, the challenge will become much more difficult if the question is narrowed to: can you name one significant innovation in modern China?

Since the 1700s, when China slammed its door on the west, the Middle Kingdom has been struggling to keep pace with new technologies. Trapped in the feudal system, China missed the Industrial Revolution and was gradually reduced to a semi-colonial country, where wars and political unrest wrecked its people for more than a hundred years. It’s only in recent decades that China truly started to heal: it started rising from sheer poverty and the world witnessed its tremendous economic growth, the fastest ever in human history.

But for the bulk of this period, China remained a barren land for technological innovations. The world’s factory was also the world’s cheapest copycat, whose products were widely perceived as low quality or fake. Even the most optimistic China bulls have to admit that despite being an economic wonder, China hardly had any innovations, making it extremely difficult for the country to climb up the global value chain. Failing to do so can lead to a so-called middle-income trap, where an economy’s old resource-driven model loses steam and its growth stagnates.

But the debate now, which is highlighted in Biden’s remarks, is whether China has begun to change its course toward a more innovative and creative society.

Shaun Rein, founder and Managing Director of China Market Research Group, thinks it has. A China business veteran and the author of The End of Cheap China (and the upcoming book The End of Copycat China), Rein is a firm believer that Chinese entrepreneurs and capitalists have woken up to the fact that in order to grow and compete globally, they can no longer simply rely on copying western countries’ technologies and business models. Instead, they have to build their own innovative products for the Chinese market, before eventually innovating for the global market.

“It would be wrong to underestimate China as Joe Biden did,” Rein said during a recent interview with CKGSB Knowledge, where he shared his thoughts on why China has failed to be innovative in the recent past, and what would potentially make China an innovation leader in the future.

Q.What do you think are the key reasons why China has produced little innovation in the past decades?

A. Because there is so much low-hanging fruit in the marketplace there is really no need to innovate. So rather than being a government, regulation, [or] cultural problem, the issue is that there [had been] no need to be innovative.

If you [were] well connected in the 1990s, you could get a plot of land for below market price and put up a skyscraper; you could go out and get a monopoly delivering wine to a ministry and you could make tens of millions of dollars on very low-end production. There [was] simply no need to innovate. Entrepreneurs had to be very shortsighted because of the market condition on the way to make money.

But that’s all starting to change now. What we started to see in the last two to three years is that [the] low-hanging fruit is starting to disappear. It’s still there, but it is starting to disappear. It’s not quite so easy to make money anymore. The market is maturing, competition is going up, and companies are moving up to value chain. So a lot of entrepreneurs say: “How do we stay ahead? How do we beat the competition?” Now it’s not about low cost. It’s not about sales and distribution. It’s about… innovation. That’s one major part of why you are seeing the shift from a low-cost copycat, business environment to an innovative environment—they have to [change] in order to survive.

The second change is that the venture capitalist themselves see that innovation in China can make a lot of money. So frankly, whenever I talk to entrepreneurs, I ask, “What’s one of your major barriers to innovation in China?” They tell me that it is the source of capital. They said that in the 1990s and 2000s, venture capitalists were too scared to operate in China. When they operated, they wanted easy wins. So they wanted to invest in the Google of China or the eBay of China, because the venture capitalists themselves didn’t always know how to operate in the country. A lot of them didn’t speak Chinese, they didn’t have connections, and they didn’t trust the Chinese.

Q. Why do you think that Chinese companies cannot continue with their old model?

A. China’s growth model in the last three decades is broken. The country smartly built up the economy by relying on low-cost labor. Companies like Apple, Gap, etc., were able to source their products here at a fraction of the price. That business model is no longer sustainable. Wages are increasing in the blue-collar sector [at the pace of] 15% to 20% a year; rents are still going up in double digits. So China is no longer a cheap place to manufacture. China is already starting to lose manufacturing operations in light industry to countries like Sri Lanka, Cambodia and Indonesia, where wages are a quarter to half of those in China.

China is not going to lose its manufacturing dominance anytime soon. But the type of manufacturing is going to change in China. It’s going to have to go more up the value stream. So instead of producing trinkets, the country is going to focus more on high-end aeronautics, or autos, or high-end consumer electronics. The lack of workers and rising costs in China mean that the only type of manufacturing that would exist here is higher-margined. That’s why so many of the industrial companies are focused on innovation.

The second part of the question is that companies like Huawei are ambitious. They don’t want to be OEM (original equipment manufacturers) manufacturers. They want to create their own brands and become global players. They have access and support from the governments and banks in terms of capital, and they want to plough ahead. Huawei actually spends more on research and development than one of their main competitors Ericsson. When we speak with buyers of telecom equipment, they say they buy Huawei not only because it’s of good prices, but also because its quality is as good if not better than Ericsson and Cisco.

Q. During your interactions with Chinese CEOs and entrepreneurs, how do you think their opinions on innovation have changed over the years?

Shaun Rein, founder and Managing Director of China Market Research Group

A. I’ve been in China since the mid-90s and I was investing in tech start-ups in around 2000. When you spoke to entrepreneurs then, they were very desperate.. There were so many obstacles to innovation and making money in China that the entrepreneurs just wanted to go for quick easy wins. They just wanted to copy technologies and tweak [them] for the local market. For example, Sohu and Sina looked at Yahoo and the other portals at the time and said, “We can do that for China. We don’t need to focus on technological innovation. Let’s just take that business model and tweak it for the country directly.” It was safer, it was easier, the government approved it and you can get money from venture capitalists.

Now when you talk to entrepreneurs, especially in the mobile space, people are not looking into the US or Western Europe for the technological lead; people are now saying, “Let’s develop the coolest, best stuff in China”, especially mobile devices, because there is a much larger mobile device community in the country. The entrepreneurs want to create innovative companies for China right now. They are still not looking at going global, but that’s going to happen in the next couple of years.

Q. How will innovation in the mobile sector drive up innovation in other areas?

A. It is going to help. But the issue is that there are still a lot of low-hanging fruit out there. There are still many ways to take technology from the western world to China and localize it. That’s not technological innovation, but business model innovation.

For instance, Xiaomi didn’t invent the mobile phone, but there is massive business model innovation and that’s why they are doing well. I think the mobile space is going to see a lot of the best innovation, because it’s cheaper to produce. So when you get into some of the industrial innovation, which is happening in China, you need tens of millions or hundreds of millions of dollars and hundreds of engineers. In the mobile space, you can have four programmers, and because the market is so new, you can put something together in months, rather than years or decades.

But I think overall you are going to see that many industries are going to improve from that. It’s going to happen for one major reason.When you see a mobile company like 91 Wireless, sold for $1.9 billion just a couple of years after it started, then everybody says, “Wow, we can innovate and make money.” So it’s going to create a sea change within entrepreneurs and venture capitalists, who now are not looking for the easy wins, but innovative deals because that’s where the most money is right now.

Q. What challenges do you think China faces as it tries to become more innovative?

A. There are a couple of areas; the first is intellectual property protection. A lot of entrepreneurs and investors are cautious that if they were to make the product, somebody would steal it… the damages [to pirates] are very low.

The second part is the regulation. Regulation doesn’t necessarily stifle innovation. Very often people innovate precisely because of too much regulation. So for instance Tencent and Alibaba have done very well on Yu’e Bao and their financial products precisely because consumers don’t like the state-owned banking system. The Bank of China, the ICBC (Industrial and Commercial Bank of China) are not consumer, retail-oriented at all. They focus primarily on state-owned enterprises. So that is a great opportunity for private companies. The problem is that entrepreneurs would like to have clear transparency in the laws. The laws don’t necessarily need to be improved, but entrepreneurs want to know what they can really get into.

For instance, if you are allowed to stream The Good Wife and The Big Bang Theory, like Sohu did, that’s good. But all of a sudden they get knocked off even though they paid for it, even though they were doing the legal thing. It showed everyone that it’s better to infringe copyright, because then you don’t have the high upfront costs. You get fined a little bit money from the government [for pirating] rather than paying for the rights to the show..

The third thing is that the government needs to improve at the local level. A lot of the local officials are so focused on building real estate construction or attracting multinationals that they are not geared to help small enterprises. So that is a big problem. It’s still too difficult to operate in China as an SME (small and medium-sized enterprises) from a bureaucratic standpoint.

Q. During your research on innovation in China, was there anything that surprised you?

A. Yes, [the first is] biotechnology. Biotech costs a lot of money and [takes] many years. So I thought that the biotech sector would be something very weak in China, but when I went out interviewing entrepreneurs in the sector, they were the most optimistic. [The government is] giving tax breaks, access to resources, and they are pushing for collaboration with universities. The government is being extremely supportive of biotech.

The second thing that surprised me was the pace of the increase in innovation in technology and so many sectors. Even two to three years ago, very few entrepreneurs were talking about innovation. Very few venture capitalists were talking about it. But when I went out and talked to venture capital companies and entrepreneurs in the last three months, that’s all that they could talk about. That really surprised me. I think I would not have been able to write this book three years ago—it would have been ridiculous.

I developed a model, stage one: the copycat; stage two: innovation for China; stage three: innovation for the world. Right now we are in stage two, which is a mix of innovating for China and copycatting for China. But I think China is going to hit the stage three in five to 10 years when Chinese firms are going to innovate for the rest of the world.

Q. Five to 10 years is a very short amount of time. Can it happen so soon?

A. Yes, WeChat, for instance—I went to Indonesia in the beginning of 2013 for research, and then everybody was talking about Facebook. I went back at the end of 2013 for more research, and people were talking about WeChat. That adoption can be really quick in mobile. When I was in South Africa, everybody was using WeChat there. You don’t need that much time in mobile because it’s relatively cheap to create something and to distribute.

It’s really an exciting time for entrepreneurship in China on the high-tech level. It would be wrong to underestimate China as Joe Biden did. He said, “Name one innovative product” from China. People are going to be surprised at how quick [innovation will] happen.

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