Innovation race

 

— By Scott Holbrook and Adam-Paul Smolak

This is Part 2 in what will be a long-running series by Scott Holbrook and Adam-Paul Smolak on how the United States and the rest of the world can take back much of the manufacturing they sent to China and thereby bring high-level manufacturing jobs to the United States and to allied countries.

 

THE US-CHINA COLD WAR NOW, THE EU-CHINA COLD WAR LATER

China and America are in a Cold War and innovation is the new Arms Race.

This can be seen by the nearly unlimited government resources China has put into areas where the United States (and to a somewhat lesser extent, the EU and Japan and a few others) have traditionally been the world leaders: Electronic Communications and Software, Space Exploration, Military Weapons, Energy and Biometrics. China’s actions to dominate the world in these areas include the following:

  • Decades of technological espionage
  • Installing global 5G networks by, among other things, using government subsidies to undercut pricing
  • Creating Beidou, the Chinese competitor to GPS
  • Launching a Mars rover mission
  • Developing electric vehicles (EVs) and Green Energy, with the benefit of government subsidies and few safety regulations
  • Developing A2/AD missile capabilities
  • Developing genetics and DNA identification techniques, with the benefit of government subsidies and minimal ethical or safety restrictions
  • Developing a COVID-19 vaccination, with the benefit of government subsidies and minimal ethical or safety restrictions
  • Using its Belt and Road initiative to expand its geopolitical footprint, entrench itself in the domestic affairs of member countries, and expand development and usage of its technology and military capabilities

In China Doubles Down on Industry Subsidies: No Exit, this blog described how China government subsidies are at the core of its efforts and at the center of its “Made in China 2025” Initiative:

After the trade talks with China broke down, the PRC government immediately announced measures designed to support the development of Chinese semiconductor manufacturing. On May 8, 2019, the [China] State Council under the guidance of Li Keqiang announced it would extend a long-standing series of Chinese government policies supporting development of the domestic PRC chipmaking capabilities. This group of policies is just the type of Made in China 2025 subsidy measures that have been at the core of the U.S. dispute with China. In fact, it has been reported that failure to resolve the subsidy issue is the primary reason the trade agreement collapsed. See Trade talks face moment of truth as US pushes China on subsidies: Beijing’s state support for core industries remain as sticking point in negotiations. So in other words, in response to U.S. complaints, China decided immediately to report that it would go full speed ahead on a collision course with the U.S.

To clarify, chip promotion policies are typical of the Made in China 2025 program. There are three core elements, all of which critics of China deem unacceptable:

1. Chinese chipmakers receive a tax benefit. The basic plan for general chipmakers is no taxes for 2 years and a 50% reduction for 3 years. For chipmakers that can break the 9 nanometer barrier, there will be no taxes for 5 years and a 50% reduction for 5 more years. This plan was initiated in 2011 in the (国务院关于印发进一步鼓励软件产业和集成电路产业发展若干政策的通知) here. The State Council apparently plans to extend the benefits of this old plan.

2. Creation of the government controlled and funded China National Integrated Circuit Industry Investment Fund (国家集成电路产业投资基金) under the lead of CBD Capital, a wholly owned subsidiary of China Development Bank. The plan of the fund is to invest billions in chip manufacturing R&D and manufacturing capacity. This fund was created in 2014 and it did a second round of fundraising in 2018. See China invites overseas investors to propel local chip ambitions.

3. Overal planning and control exercised by the central government. This plan is outlined in the State Council Guideline for the Promotion of the Development of the National Integrated Circuit Industry which was issued in 2014.

As you can see, The PRC semiconductor program is a textbook case of all the U.S. finds objectionable with China’ high tech industrial policy: central government direction and control, subsidies in the form of tax breaks and funding from central government sources (funding with “strings attached”).

What this means is that in the face of the failure of the trade negotiations and the subsequent Huawei Entity List sales ban, the PRC has “doubled down” on its Made in China 2025 subsidy program. Not only will the PRC not back down on the subsidy program, the notice from the State Council makes clear China will in fact redouble its efforts to ensure that the program meets its intended goal. This basic policy position was made clear in a recent announcement from Wang Zhijun of the Ministry of Industry and Information Technology (MIIT). Wang announced that the Chinese government will continue its support of its domestic chip industry and will expand that support to software and the high tech sectors. Mr. Wang announced that China welcomes the Huawei ban as a push from the U.S. on reviving the chip design and production program: “To offset the possible implications of the ban, the ministry said it would this year introduce a two-year waiver on corporate tax payments for software developers and integrated circuit manufacturers, and reduce the rate on subsequent payments to 12.5 per cent over the next three years.”

As the South China Morning Post concluded after reporting the comments of Mr. Wang, “Beijing’s role within Chinese industry, in particular its financial support for the state sector, has been a major sticking point in the trade negotiations between the world’s two largest economies. Washington complains it puts US companies at a disadvantage, but Beijing says the matter is one of principle and it has no plans to change.”

China’s heavily subsidized approach to dominating various critical global industries is a symptom of the world’s “fundamentally failed approach to China.”

The failed approach is the idea that after its accession to the WTO, the PRC would gradually transform into an open, market oriented system along the lines of the U.S., Europe and Japan. The policy is what the Germans (and much of the EU as well) call “change through trade.” See EU’s China policy is no longer just carrots. That policy failed. That failure is permanent. Ten years ago, many believed China would change. Few believe that now and that is why so many who have dealt with China for 10+ years are so frustrated. Fool me once….

The proper way to look at China is the approach taken by German industry in its recent report on China issued in January, 2019.  In the Report, China is identified as “systemic competitor” to the open market economies. As the Report states:

For a long time it looked as if China would gradually move towards the liberal, open market economies of the West by integrating into the world economy and reshaping its economic system. This theory of convergence is no longer tenable. China is no longer developing structurally in the direction of a market economy and liberalism but is in the process of consolidating its own political, economic and social model. At the same time, China as an emerging economic power is shaping other markets and the international economic order. The Chinese model of an economy marked by substantial state control thus enters into systemic competition with liberal market economies.

The Report concludes that China has developed an integrated set of policies in direct opposition to and competition with the liberal open market system. Countries with open market systems must deal with China’s policies as they are and without any hope those policies will change. This characterization of China a systemic threat is a remarkable change for German industry which had until 2019 been reluctant to speak out against the Chinese system. See Germany Industry Comes Clean on China  

Though China has mostly failed to develop at anything beyond a fairly low level most of the industries it has been heavily subsidizing and for which it has been stealing IP, it has no intention of of ending either of these programs that so offends a large part of the world:

Stated bluntly, China is reviving a set of policies that completely failed. As James Lewis bluntly stated in a recent report, “despite 40 years of effort, investment, and espionage, China is unable to make advanced semiconductors.”(See China’s Pursuit of Semiconductor Independence. The tax breaks were a scam, as they always are in China. The chip fund investments, if they were made, were a waste of money. The brutal fact faced by the State Council and the MIIT is that China has made no meaningful progress on chip manufacturing over the past two decades. China makes cheap memory chips, but sophisticated chips still come from Taiwan. China has made little to no progress on chip design. Without design technology from ARM and testing technology from various U.S. companies, no Chinese entity (Huawei included) has any real hope of building a new advanced chip. China is stuck with bulk memory chips or copies of foreign designs. .

The whole policy has been a colossal failure and the Chinese authorities know this. The reports of revived and redoubled efforts are typical of the Chinese bureaucracy: don’t worry, we will do it right THIS TIME. But they won’t. So we should view the PRC for how Germany describes it and how pretty much everyone in the semiconductor industry sees it: a systemic competitor that cannot compete in the world of high technology. Low end, low margin, high volume manufacturing is the world from which China seeks to escape. Nothing from its recent announcements (or the realities on the ground) suggests this escape will ever occur. This means that as the U.S. accelerates cutting Chinese companies off from U.S. technology, the impacts will be far more severe than is generally understood. The Chinese authorities know this. But they are in a box from which there is No Exit.

Like it or not the Cold War between the United States and China (and soon Europe and China as well) is here and if you are not already looking to have your products made somewhere other than China — might we suggest Thailand or Vietnam or Taiwan or Mexico or the Philippines or Indonesia or wherever — you should start. See The US-China Cold War Starts Now: What You Must do to Prepare.

Though China is dead set on winning the innovation race, few Americans yet know we are in a new Cold War with China that will likely soon include the EU against China as well. However, Americans are beginning to awaken to the crisis, due largely to recent event involving China, such as all that happened in just this past week:

 

NECESSITY IS THE MOTHER OF INVENTION/INNOVATION 

First, “Innovation” is more than a buzzword to Americans. It’s deeply tied to the self-reliance internalized by early settlers. Self-reliance and innovation were necessary for survival. It is a way of life ingrained into America’s DNA before there even was a United States. Innovate or die.

This same sense of self-reliance inspired Thoreau to live at Walden Pond for two years and write his magnum opus, Walden. This mixture of self-reliance and innovation was responsible for Thoreau experimenting with different ways to measure the depth and shape of the bottom of the supposedly “bottomless pond.” It was this self-reliance that led the Wright Brothers, whose lack of a university education “and little money never stopped them in their mission to take to the air. Nothing did, not even the self-evident reality that every time they took off, they risked being killed.” We could go on and on describing similar such American inventors, but suffice it to say that this streak of innovation still runs strong today. That is why the quintessential American “homestead” includes a workshop/shed/garage or some place where tools are stored and artifacts are built. Everyday, Americans put their self-reliance and innovation to work in these home-based workshops where they “tinker” and build solutions to problems they face in the course of their everyday lives.

DIVERSITY IS KEY  

Second, a key component of innovation is having access to the problems you are innovating to solve. This means users and manufacturers need to be able to work together to innovate new products or processes. This feedback loop is critical.

Diversity is one of America’s core strengths. Ethnic diversity, racial diversity, religious diversity, diversity of activities, diversity of cultures and views. China is far more homogeneous, especially in its most developed regions. The United States (despite Trump’s anti-immigration push) pulls in the best and the brightest from all over the world. “More than half of the top American tech companies were founded by immigrants or the children of immigrants.” Apple, Amazon, Google, and Facebook were all founded by first or second generation immigrants. Add in that Microsoft CEO Satya Nadella comes from India and one can quickly see that America’s largest and most influential tech companies (with a combined market capitalization of nearly $7 trillion) all are where they are due in large part to immigrants. How many non-Hans can you name in any true leadership role in China?

What this means on a practical level is there is more opportunity for innovation in America than China. Every ethnicity, activity, culture, view, etc. represents an opportunity to innovate China lacks. All of these American tech companies have employees from at least 150 different countries. If any need help figuring out how to localize a product for Ethiopia, Egypt or the Ukraine, they can tap in-house employees for assistance. If any need help figuring out what Jordan, Ghana or Portugal need, they can tap in-house assistance. If any need help in buying a business in Ireland, or Kenya or Mexico that is developing cutting edge products, they can tap in-house assistance. The closest China comes to doing the same is sending its best and brightest to be educated overseas and even that is being restricted.

 

THE NEED FOR SPEED

Third, accelerated innovation requires accelerated design processes and product cycles — from ideation to prototyping to the final commercial product.

Chinese factories take months to develop new products. Jigs must be designed, tools must be built and machinery must be calibrated. The prototype then must be taken to the field for use — which is usually not in China. Then feedback must be relayed between three or more parties. And any changes usually require new jigs, new tools and new calibrations. The whole process is time-consuming and expensive because it’s not what Chinese manufacturing was set up to do.

Manufacturing in China has been optimized to take advantage of certain elements present in China that America lacks. Massive amounts of cheap labor, a lack of rigorous safety and pollution laws, homogeneity throughout the society and an aversion to creativity. Perfectly suited to mass producing widgets based on designs provided by others. Innovating under such conditions is mostly detrimental to the process.

 

AMERICA’S HEAD START 

Fourth,  America already has the “bones” required for immediate feedback loops, drastically shortened design processes and simplified supply chains.

Companies like Stratasys have been working with American manufacturers for years to help them implement advanced manufacturing tools and techniques in their operations. Using tools like 3D printers, companies such as GM, Ford, Lockheed Martin and others have been able to reduce production costs in half, while simultaneously reducing the time required for prototyping from months to days, sometimes hours. Imagine being able to create and test three prototypes/week. This is not happening in China.

In addition to rapid prototyping, American companies are almost invariably better at controlling inventory than Chinese companies.  For example, if an American company finds a defect in a product it manufacturers, it is far less likely to be stuck with tens of thousands of products of dead inventory. This ability to produce products and components according to need (rather than per a Chinese MOQ), allows companies to save money, thereby increasing the resources available for innovation projects.

 

AN UPHILL BATTLE — INNOVATION AND COMMERCIALIZATION 

China did not want an innovation war with the United States this soon; it would have preferred to wait another five to ten years, but that war started early. Nonetheless if the United States does not move quickly and with alacrity and with cooperation from allies to utilize the advantages it possesses, it will not necessarily win this war.

Even if China cannot win the innovation battle it can do enough to win the commercialization battle and here is how, in three steps, China could make that work.

Step One: Convince the West to keep transferring its technology to China and allow what is not transferred voluntarily to be stolen.

Step Two: Allow China to continue using its standard technique of commercializing technology within its closed market, free of foreign competition.

Step Three: After perfecting commercial applications in China, sell the commercialized product back to the West at a subsidized price. If the West won’t buy from China (unlikely absent legislation or tariffs/duties), sell to the captive countries in the Shanghai Cooperation Organization and to Belt and Road countries.

In other words, China will win the commercialization battle if the West continues to support China’s system with tech transfers and funding. This is an international issue: action by the U.S. is not enough. More deeply, it is fairly certain China can win the innovation battle with Step Three alone. In very basic terms, even if China’s product is one generation behind, if it is “good enough” and subsidized enough to be 30% to 50% cheaper, then for most of the world, China will prevail.

Rational Western government policy needs three parts: One, support for Western innovation. Two, Positive action to neutralize China’ commercialization advantage. And three, international support to shut down China’s commercialization advantage.

China will not change so Western measures must assume no change and involve direct action. No tech transfers to China. No transfers of capital to China. No China contract manufacturing. No purchasing of any Chinese made product that incorporates critical technologies. This only works if done on an international basis. Ramping up U.S. competitiveness within the U.S. is essential for beating China head to head, but it will be difficult to prevail under this strategy if we continue to transfer tech and capital to China and to the other members of the SCO and the Belt and Road.

In our next post we will take a deeper look at what advanced manufacturing is, why it is perfectly suited to the American way of life and business, and the resources already available to companies that wish to reduce their dependance on a China so filled with risk. See Has Sourcing Product From China Become TOO Risky? and The Top 14 China Wild Cards/Future Risks.

 

Scott Holbrook and Adam-Paul Smolak together operate a number of product and manufacturing companies and they both have a long history assisting educational institutions in developing and enhancing manufacturing and logistics programs and events.