China's roster of technological achievements before and during the Imperial rule is among the most impressive in ancient times. It includes inventions that have literally changed the world, among them paper, gunpowder, the compass, and the abacus. The Chinese were the first to develop printing and iron casting, the first to use paper money, and the first to launch fireworks and fly kites. They also made major advancements in math and astronomy. Through long stretches of history, China was the most technologically advanced nation in the world.

Despite its impressive invention record, Imperial China failed to develop formal science, which prevented continuous technological development and undermined a diffusion of its inventions into broader spheres of life—particularly its economy. Technological skills were repeatedly downplayed, and, with minor exceptions especially during the Song dynasty, were not fully incorporated into the examination system that screened candidates for future bureaucratic positions. Technical experts, even in such crucial realms as control of water resources, were employed at the prerogative of Imperial officials with generalist training and never gained the prestige and power of officialdom. China had no ideological, administrative, or economic infrastructure to support technological innovation or to disseminate the new knowledge to economic or military activities. This legacy would come to haunt China when it collided with the technologically superior West.

China's military defeats in the nineteenth and twentieth centuries exposed the country's technological weaknesses and revealed that the price to be paid for falling behind technologically in the new global era was enormous. The humiliating defeat in the opium war made it clear that the technology slip translated into an inability to develop and produce the modern weapons that have turned out to be essential to becoming an effective combatant. China could no longer rely on sheer numbers of conscripts or creative generals to defend against the enemy; and could no longer assume that prevailing foreign powers would simply be absorbed and assimilated into its cultural milieu. To catch up, China had to set aside its feeling of superiority and start learning from the foreigners who had successfully put China's own inventions—gunpowder and the compass—to use in gunboat diplomacy and international commerce. Japan's success in importing modern technology and putting it to effective use in the Russo-Japanese war demonstrated that it was possible to absorb Western technologies without losing one's national character. The failure of Nationalist China to halt the Japanese onslaught in the 1930s proved, however, that absorbing technology was not a simple task and that Western style governance, in and of itself, was not a guarantee, and perhaps even a hindrance, to the achievement of technological and military parity. If China were to become strong again, it needed not only to aggressively court modern technologies, but also to learn how to develop its own and how to apply them in the real world.

Following the establishment of the People's Republic of China (PRC) in 1949, China embarked on a massive technology transfer from the Soviet Union. Although a technology borrower from the West and the defunct Third Reich, the Soviet Union had nevertheless displayed an ability to put the technology to use as well as engage in independent technological development in priority areas (mostly national security related), which were injected with massive amounts of capital and priority allocation of human and other resources. Innovation, to the extent that it happened, was dictated from above, with specialized research institutions put to work on projects assigned priority by the upper bureaucracy, a model that Chinese, with their Imperial legacy, were quite comfortable with.

Technology transfer from the Soviet Union was interrupted by Chairman Mao when he feuded with his former comrades and embarked on the disastrous Great Leap Forward. Launched in 1958, the campaign pushed technology away from large-scale enterprises toward amateurish operations in the countryside, resulting in economic chaos and massive starvation. China then retreated to its previous technological order, but marks remained: Technological institutes, like all major enterprises, were duplicated in multiple provinces so they could survive a foreign attack. A few years later, Mao embarked on a second campaign, the Cultural Revolution, which, among other things, targeted the “technocrats” and “elitists” who were holding China's technological infrastructure together. While espousing a “Red and Expert” ideal, Mao saw little value in technical expertise and was convinced that mass power would conquer any knowledge deficiency. China's military successes during the Korean War, although achieved at tremendous human cost, convinced Mao that his approach would lead China to economic, as well as military, successes; however, others in the Chinese leadership managed to insulate the military from the worst of the ideological onslaught. The military establishment continued to do the bulk of the country's research work, concentrating on showcase projects devoid of any economic or commercial considerations. By the 1980s, China, largely an agricultural economy and with an industry reliant on 1950s technology, was a member of the exclusive club of satellite-launching nations.

China of the mid 1970s had the contours of a technological infrastructure, albeit limited and fragmented. While lagging by decades behind the West as well as the Soviet Union, the country had basic technological capabilities and the ability to do industrial applications. This was especially true in heavy industry, where China developed considerable skills in utilizing, servicing, and adapting older technologies and in selected regions—in particular Shanghai—which would later become a driver in the nation's modernization. Technical expertise survived, but in an extremely narrow form and without the ability to connect across different specializations, let alone place them in the context of industrial application. Innovation was still supposed to happen by decree, in areas the government designated as a priority, through a vast network of research institutes, each with a narrowly defined mission and little if any contact with each other, with working enterprises, and with the outside world. The time range of science and technology plans (typically 10–12 years, double the 5-year-long economic plans) reflected not only the Communist penchant for long-term planning, but also little understanding of the fast pace of modern science and the rapid adjustments it necessitated.

To bolster the transfer of technology via foreign investment, special preferences and incentives were provided to technology-intensive ventures. Those who were ready to transfer more cutting-edge technologies and to hand in the underlying capabilities were amply rewarded: They were granted permission to locate in the most desirable areas; given preferential governance and equity terms; provided with prolonged tax holidays and duty exemptions; and, perhaps most importantly, given preferential access or the promise of access to the much-coveted domestic market. These preferences have survived 25 years of reform, multiple rounds of World Trade Organization (WTO) accession negotiations, and occasional pressure by China trade partners.

Today, of the five “encouraged” areas in China's Industrial Guidance on Foreign Direct Investment that receive the highest incentive level, three include the wording “new technology” and the fourth is about meeting the standards of the international marketplace, clearly a technology-driven imperative. (The fifth encourages investment in China's Western regions.) In contrast, projects that involve the mere importation of foreign technology (that is, no “real” technology transfer) are on the “restricted” list.^[1] During its WTO membership negotiations, China managed to avoid an explicit commitment to sever the link between foreign investment and technology transfer, although the agreement is supposed to make it more difficult to make the link. A 2003 report on China's WTO compliance notes that “…some of the revised laws and regulations continue to 'encourage' technology transfer, without formally requiring it” and that a new draft policy on the automotive industry sets specific targets for the use of domestic technology. (Despite market liberalization, targets still count, and more so in strategic or “pillar” industries such as automotive, petrochemicals, and machinery.^[2])

The incentive to transfer technology is especially salient in high-priority areas such as electronic chips. China, already Intel's biggest customer, wants to reduce its dependence on foreign suppliers for this most technology-intensive part of the product. To do that, it created a rebate system that the United States is now appealing at the WTO: While the value added tax (VAT) levied on imported integrated circuits is 17 percent, a rebate brings it down to 11 percent for locally produced but foreign designed circuits and to 3–6 percent (most often 3) for those designed and produced in China.^[3] In a global industry in which labor costs play a relatively minor role, such incentives make a difference and encourage foreign firms to transfer more design to China. In recent years, China has become bolder in its technology transfer demands from foreign investors. A retired executive recently recalled how General Electric conceded key technology to Chinese competitors to win a large turbine bid.^[4] While GE managed to retain the most confidential parts of the production process and is adamant that by the time the Chinese are capable of independent production, it will be far ahead with newer technologies, it is clear that at least the second tier of foreign firms is at risk of ceding key capabilities, which will hamper their long-term competitiveness.

In the meantime, the incentives encouraging technology transfer seem to have worked. The share of labor-intensive product lines among Foreign Invested Enterprises (FIEs) declined from 50.42 percent in 1995 to 41.44 percent in 1999. During the same time period, the share of capital-intensive enterprises increased from 22.73 to 25.35 percent, while the share of technology-intensive enterprises rose from 26.86 to 33.21.^[5] Today, foreign enterprises account for three quarters of China's sales of technology-related products abroad and, according to some estimates, more than 85 percent of its high-technology exports. As a whole, China is still a fairly minor player in high-tech exports. In 1998 (the most recent figures available), the country exported about $30 billion worth of high-tech goods, versus about $190 billion for the United States, $90 billion for Japan, and $60 billion for the United Kingdom. The Chinese are moving up, however (their high-tech exports were below $5 billion in 1990) and, considering their limited ability to innovate, they must rely on the technology leaders—especially the United States—for knowledge transfer.

Technology transfer from foreign investors (or any technology transfer for that matter) depends not only on the willingness of foreigners to transfer but also on the ability of locals to absorb it. It is often argued that China is not ready to absorb advanced technology, but the argument does not rest on solid evidence. A recent study by Peter Buckley and his associates shows that with the exception of investment by overseas Chinese, foreign investment in China generated considerable technology spill-over, which collective firms, although not state-owned enterprises, are able to utilize.^[6] If we accept that the share of the state sector in the economy will continue to decline (it now accounts for less than 30 percent of gross domestic product [GDP] versus more than half in 1990), and most indications are that it will, then China will be increasingly able to absorb and apply the technology it receives from foreign multinationals.

Domestic players are now emerging in the most advanced areas. Chinese suppliers, who were not represented at all in the local market for Central Office Switches in 1987, gained a 10 percent market share by 1992 and a 43 percent share by 2000. The rest of the market was held by joint venture companies, while direct imports decreased from 89 percent of the market in 1987 to 54 percent in 1992 and 0 in 2000.^[7] In electronic chip fabrication, China is awash with start-ups. Those are often funded and provided expertise by Taiwanese entities but are quickly evolving into full-fledged operations from design to sales.

The priority given to technology-intensive foreign investment is also a direct result of China's failure to establish, so far, an effective indigenous network of technological innovation. While the number of patent applications and granted patents in China almost doubled between 1994 and 1999, the share of foreign nationals among them has actually increased to close to 20 percent, a figure higher than in most industrialized countries.^[8] Innovation patents were much more likely to be granted to foreigners than to Chinese nationals. The situation does not look much better as far as foreign patent registrations are concerned. According to the OECD figures, Chinese nationals filed merely 200 patent applications in 1995 and 299 in 1997. While these numbers are likely pulled down by funding constraints, they are still extremely small. This leaves foreign investment and the repatriation of Chinese scientists as major vehicles for technological innovation until China is in a position to build up a domestic innovation network. There are signs that indigenous capabilities are developing; for instance, the new R&D centers established by foreign firms have already generated dozens of patents by Chinese scientists, but China has a long way to go before it becomes an innovation hub. As Exhibit 4-2 shows, only a miniscule percentage of the patents granted to Chinese are for invention, which makes up the bulk of patents granted to foreigners.

Source: National Bureau of Statistics and Ministry of Science and Technology, 2002-2003.

Figure 4-2. Types of Patents Granted to Foreigners (2001).

While China's R&D expenditure more than tripled between 1991 and 1999, the growth was largely a function of economic growth. As a percentage of GDP, science and technology (S&T) and R&D expenditure went from 1.8 and 0.7 in 1991 to 1.57 and 0.83, respectively, in 1999. Basic research remained a relative rarity, accounting for a mere 5 percent of R&D expenditure in the 1995–1998 period versus 25 percent for applied research and 70 percent for experimental development.

To ensure that China gains the most important technological capability—the ability to do its own research—establishing R&D centers on Chinese soil has become a major priority for the Chinese authorities. A major factor in General Motors winning over Ford in the hotly contested Shanghai investment was its willingness to establish a large R&D center and transfer up-to-date technology to that center. Today, the list of foreign firms with China-based R&D centers includes the likes of Oracle, Siemens, Lucent, Nokia, Nortel, Agilent, IBM, and Hewlett Packard. All in all, more than two hundred such centers have opened up.

Some Western observers argue that the importance of the centers has been exaggerated, that they are not involved in actual innovation but are limited to implementation and especially product adaptation to local conditions. This may be true for now as Chinese staff still struggle with the idea of basic research on the one hand and enterprise linkages on the other. However, this may not be the case for long. Even adaptation research develops skills that can later be used for “core development” tasks. Besides, multinational enterprises have been consolidating and rationalizing their far-flung R&D centers and increasing their R&D outsourcing, suggesting further growth in scope and depth for the Chinese centers.

Already, U.S. affiliates in China are among the most R&D-intensive overseas affiliates. National Science Foundation (NSF) data show that by 2000, China was the eleventh largest host for overseas R&D expenditure by U.S. firms, up from thirtieth in 1994. A measure of R&D intensity, R&D-to-gross-product ratios among U.S. China-based Foreign Invested Enterprises or FIEs (wholly and majority owned) increased from 1 percent in 1994 to 9.2 percent in 2000. China-based U.S. affiliates invest more in R&D compared to U.S. affiliates in other countries. For the aggregate of all U.S. affiliates abroad, the ratio is a mere 3.3 percent, just over one-third the figure for China. At over 2 percent, the average published by the Organization for Economic Cooperation and Development (OECD) is even lower. In dollar terms, R&D expenditure by U.S. affiliates in China rose from 7 million in 1994 to over half a billion in 2000.^[9]

To ensure that technology is transferred even where foreign manufacturing is absent or not welcome, research partnerships are encouraged. By the end of the century, Chinese firms had established 90 such partnerships, about three times the number for India and more than Taiwan, Hong Kong, and Singapore combined. Among the leaders in establishing such partnerships were Sinopec, with seven; CATIC (China Aerotech), with four; and China Aerospace, with three international partnerships.^[10] In addition, many business alliances had a significant R&D component. Based on Thomson Financial data, the NSF identified 105 such partnerships between U.S. and Chinese firms in the 1990 to 2001 period.^[11] Another, emerging venue for obtaining technology is the procurement of R&D abroad either directly or by the overseas subsidiaries of Chinese firms. There is some evidence that this is occurring, although for now it's on a small scale.

The Chinese leadership started from a dismal point, where an educational system that left a lot to be desired during the best of times was literally torn apart during the Cultural Revolution. With some of China's brightest scientists and professors working the fields in the countryside, the technological community was cast away from the outside world and missed on the technological advances of the time. It also lost its facilities, equipment, and motivation to conduct scientific work. The reforms have gradually restored the educational infrastructure, its importance cemented (as is often the case in China) with the establishment of a high-level committee: a working group on science and education, chaired by the Chinese premier.

Traditionally, education in China has been the reserve of the select few. The Imperial examination system screened a relatively small number of candidates, and few of those passed and became eligible for bureaucratic appointment. The Communist system, while professing to equalize education, permitted only a small fraction of the brightest and well connected to attend institutes of higher education. It was relatively late into the reform effort that authorities came to realize that sustainable technological progress required broadening the higher education base. By 2000, gross enrollment in “tertiary education” stood at 11 percent—twice as many as in 1990. Still, this represented a mere 2.4 percent of total enrolment in education. In comparison, the average enrollment in tertiary education in the OECD countries is 14 percent, despite the fact that those nations allocate a similar portion (22 percent) of their overall educational expense to higher education.^[13]

What has not changed in China over the years is the high regard accorded to education and the readiness of families to invest enormous resources to promote the educational success of their offspring. In Imperial times, a series of arrangements (such as the collectively toiled “book lamp fields”) funneled resources to support the studies of the most promising clan members. Now, it was the turn of families to support their “little emperors” (the term used in China to denote the pampered children born under the one-child policy). This explains why despite a relatively modest national expenditure on education (less than 3 percent of GDP, which is lower than that of several developing countries), there has been an impressive expansion of educational activities, many of which are paid in part or in full by the parents.

Another important reform concerned curriculum content and pedagogy. Ironically, while both Confucius and Mao advocated the use of generalists, a central planning system and lack of transparency (virtually anything the government did was classified at some level) created narrow specialists with little understanding of how their jobs were nested in broader systems and processes. One of China's main problems during the early reform years was unawareness of the need for integration across functions and departments; therefore, a key education initiative has been to cluster fields of study around an industry, especially if it is considered advanced, such as telecommunications.

Still another change in the educational system was increased internationalization. This involved importation of content (such as translation of foreign textbooks)—mostly in science, technology, law, and management—and the establishment of exchange programs for students and faculty. (China had almost 45,000 foreign students from 164 countries in 2000.) A key element in the internationalization effort, devised to prepare Chinese students for the global economy, was the encouragement of study abroad, especially in science and engineering. By 2000, Chinese students were attending universities in more than 100 countries across the globe.^[14] In the United States, Chinese students became the largest group.

Finally, China's top universities and research institutions (the government designated a “top 100” group, eligible for special funding and research initiatives) benefited from the help of many multinationals, which wanted to show good will while preparing a cadre of skilled graduates they could use. The importance of this cooperation for a country that started its university reform the same way it started its manufacturing revival—by wholesale importation of the textbooks used in America's premier institutions—cannot be overestimated. The multinationals not only help in providing up-to-date curriculums and funding new equipment, but crucially in providing a linkage between research and application—a key weakness of the Chinese system and one that is even pinpointed to be in need of improvement in the United States.

The strategy of sending students abroad was initially suspected by the more conservative elements in the Chinese leadership. No one could guarantee the students would return (indeed, most did not), and those who did were suspected of importing undesirable ideas, such as democracy. Eventually, however, a lower level of paranoia combined with a realization of how difficult it was to launch innovation from within convinced the leadership that here was an opportunity they could not miss: The “turtles” (as they are called in China to denote the tendency of the species to return to its birthplace) could play a key role in China's technological transformation. A recent reception for returning students by the Chinese president at Beijing Great Hall of the People shows how much the attitude has changed.

The stakes are huge. The United States alone counted almost 65,000 Chinese students in the 2002–2003 academic year, with 36,000 more from Taiwan and Hong Kong. In total, according to a Singapore-based scholar, Cong Cao, 160,000 PRC students went abroad in 2002.^[15] Many of those students are specializing in technology-related areas. According to the National Science Foundation, more than 21,000 Chinese students have earned science and engineering doctorates in the United States in the period from 1986 to 1998, accounting for 7.5 percent of all science and engineering doctorates awarded during that period.^[16] The China contingent is especially visible at the doctoral level, which encompasses skills critical in research and development. In 2002, according to the NSF, 2,395 students from China were awarded science and engineering doctorates. In addition, 469 and 42 students from Taiwan and Hong Kong, respectively, also received such degrees. By comparison, India had 678 graduates, about a quarter the Greater China number.^[17]

True, 85 percent of the 1986 to 1998 students planned to stay in the U.S., and 48 percent of 1998 graduates accepted offers from U.S. employers by graduation time; however, this is down from the 88 percent figure reported in 1995. According to Cong Cao, Chinese estimates for actual return rates were considerably higher, ranging from 25 to 30 percent. It is reasonable to assume that as China continues to modernize, many graduates will be enticed back home. This has happened before in South Korea, where only 11 percent of science and technology PhDs were working in America in 1995.^[18] Given the large number of Chinese graduates, even a modest increase in the repatriation rate will bring home hundreds of doctoral-level Chinese scientists and engineers who could disseminate their expertise to others. Such an increase is not unreasonable to expect given the perception of increased opportunities back home and the array of government-sponsored programs to entice them, including, for instance, the National Science Fund for Distinguished Young Scholars, the One Hundred Talent Program, and the Cheung Kong Scholar Program.^[19] Many of the programs target not only new graduates, but also senior scientists. (The Cheung Kong program is partially modeled after Singapore, which allows researchers joint appointments in foreign and domestic institutions.) There is also evidence that more experienced Chinese scientists and engineers are returning, bringing with them not only technological know-how, but also the executive and international savvy that are essential in the global marketplace. Even those who stay can make a contribution to the motherland. In a study cited by the National Science Foundation, H. Choi notes that Asian-born faculty and researchers in the United States—particularly in science and engineering—tend to advise and disseminate information to their home countries.^[20]

The results of China's effort to upgrade its educational system while enticing home the best and the brightest are already visible. Data compiled by Jon Sigurdson and Olle Persson show that China's global share of scientific articles rose from 0.63 percent in 1986 to 1.83 in 1997 and 3.54 in 2001. Articles by China-based scholars in the prestigious Science and Nature journals rose from 11 in 1986 to 93 in 2001. In material science, China ranked fourth globally in 2001, with a 1.6 percent citation rate (versus 5.5 for the U.S.); in engineering, China was ninth with a respectable 1.5 percent citation rate (versus 3.6 for the U.S.). Progress has been especially impressive in cutting-edge areas such as nanoscience, where China's share rose from 5.5 percent in 1995 to 11.2 percent in 2001, placing it seventh in the world; still, its citation rate was low.^[21]

The growth in the R&D and S&T capabilities of Chinese enterprises is intricately related to their attempt to transcend their traditional roles as “factories to the world” and become well-rounded firms able to develop a product and eventually sell it under their own name. Chinese manufacturers typically start as component suppliers to foreign buyers and as Original Equipment Manufacturers (OEMs), like the group of manufacturers who recently agreed to make flat screen television sets for Motorola. Such firms produce to the specifications of foreign firms who distribute and sell the product in their home or other foreign markets or embed it in one of their end products. The arrangement provides Chinese firms with substantial growth opportunities despite limited technological capabilities; no less importantly, it allows them to incrementally upgrade their skills by studying customer requirements and by receiving direct technological support from the buyer in terms of machinery, technical assistance, and the like. A Chinese (or a joint venture) company that supplies components to a U.S. car maker (as is increasingly the case) receives detailed specifications necessary for the production of the components that also tell something about the new product development plans and standards of the buyer. Often, the relationship grows and develops, as in the case of France's Thomson merging its television business with that of China-based TCL, a deal that will inevitably trigger significant technology transfer.

As they gain knowledge and experience, Chinese firms are developing the design capabilities to turn them into Original Design Manufacturers (ODMs)). They can receive a rough sketch of a product and perform the design work in house or in nearby Hong Kong or Taiwan. This was initially true for simple products such as plastic toys but is now expanding to more technology-intensive products with the help of the foreign buyers who find the Chinese designs cheap and of good quality. Chinese firms often say that they are forced to develop design capabilities by the relentless pricing pressure exerted by foreign buyers as well as by domestic competitors, as this enables them to capture some of the higher margins available in design and development. Once the OEMs have developed design capabilities, they are in a position to bypass the middleman and go directly to the end buyer. The shift from an OEM to an ODM requires significant technological upgrading: more and higher-level engineers, mastery of the latest technologies, creative thinking and problem-solving abilities, and an understanding of how the various functions of management relate to each other and to the outside world. These qualities are not found in abundance in China now. That is where educational reform, foreign education, and the transfer of skills from foreign firms to domestic players come in. This explains why those areas are accorded high priority by the Chinese leadership.

Successful Chinese ODMs seek to move up further and become OBMs (Original Branded Manufacturers), although few establish themselves as such from the start. OBMs not only design and manufacture but also sell their products under their own name. (Some, in fact, farm out the manufacturing to other Chinese firms.) So far, a number of Chinese firms (such as Haier and Huawei Technologies) have established recognized brand names abroad. These firms face not only marketing challenges but also the need to develop independent research capabilities by which to differentiate their products. Such firms make a major effort to recruit promising graduates and returnees as well as experienced expatriates, usually on short-term assignments.

As China remains dependent on foreign technologies, the way in which it procures and pays for new technology is of increasing importance to its future competitiveness, as well as to technology leaders and owners, such as the United States. As long as China's bargaining power remains strong, it is likely to continue to find ways to condition foreign investment on the transfer of technology. The country will also continue to tolerate expropriation of technology and other property rights by way of piracy, counterfeiting, and other violations. This expropriation has been a critical element in keeping development costs down and is one explanation why Chinese manufacturers are able to sell at a cost that seems absurd even when one factors in cheap labor and various rebates and subsidies. Chapter 5, “The Two-Dollar Rolex,” discusses the issue of piracy and counterfeiting in greater detail.