Feature

China: Moving Up The Value Chain

Factory

Professor Robert Flanagan, left, whose specialty is labor economics, chats with Max Yao, Sloan '03, during a tour of Focused Photonics in Hangzhou near Shanghai. Yao says he hopes his firm can benefit by tapping China's pool of engineering talent. Jennie Tung, MBA '04, looks on.


By Jennie Tung, MBA ’04

When Max Yao, Sloan ’03, started his business in Hangzhou in 2003, he wasn’t only eyeing the growing demand for his products in the domestic China market or trying to lower his manufacturing costs. The CEO of Focused Photonics Inc., a maker of toxic gas detection devices, was also eager to tap China’s growing engineering talent pool to help him develop new products. His company, now one of China’s largest industrial instrumentation companies, has customers in biomedicine, pharmaceuticals, and environmental protection. It competes with global giant Siemens, has distributors in China, the United States, Japan, Korea, and Taiwan, and has growth plans that include an upcoming IPO.

Leveraging opportunities in China to improve companies’ operations globally was a recurring theme of discussion between Stanford faculty and company executives during a faculty study trip to China in late March. As a recent GSB graduate and Chinese American who has spent several years working in China, I was hired by the School’s Center for Global Business and the Economy to develop cases on companies operating there, and so I was thrilled to accompany the 12 professors, experts in organizational behavior, finance, economics, and strategy, as they queried executives on the operating issues faced by companies in China’s rapidly developing economy during a faculty study trip designed and funded by the Global Center.

Over two dozen Stanford alumni from Palo Alto, Mumbai, Hong Kong, Beijing, and Shanghai helped the Global Center with logistics for the trip. Alums were so eager for the faculty to get a full picture of doing business in China that they offered to contact alums in competing firms. Stanford’s Beijing and Shanghai alumni chapters extended warm welcomes to the faculty delegation at alumni events held in both cities. From SAP’s ultra-high-tech development labs in Shanghai to the cozy meeting rooms of startup companies in Beijing and intimate meetings with Stanford alumni over cocktails, a consistent theme emerged: The country is moving from made in China to innovate in China.

We learned that a coherent China strategy is more than just shifting manufacturing production to the Far East and arbitraging labor costs. For global business leaders, a well thought out China strategy encompasses tapping a rapidly expanding end-market, managing a complex operating environment, attracting and retaining the best talent, and developing ways to more fully integrate China into their global value chains.

Some, like software giant SAP, find China a lower-cost site for R&D on global products while others look to tailor products for the distinctive Chinese consumer market. Still others are taking advantage of business incentives and increasingly liberalized business policies provided by the Chinese government in an effort to build domestic innovation capabilities.

In addition to its large manufacturing labor pool, China has many engineers. The exact number of engineering graduates in China is the subject of a heated debate at the moment because statistics from the Chinese government sometimes combine two-year vocational engineering degrees with the four-year degrees that are the standard for calling someone an engineer in the United States. However, most publications agree China produces at least twice the engineers that the United States produces annually, and the number is growing. This design talent is what attracted SAP to invest in a large design center in Shanghai.

“Rather than using China as a testing site, SAP China is now responsible for the development of all SAP’s small-to-medium-enterprise products,” said Markus Alsleben, director of strategic planning for SAP Labs China. “We work hard to ensure that China is fully integrated into our global product development effort.” With engineering costs a fraction of those at its Palo Alto site, SAP finds the economics compelling. SAP also has dedicated R&D teams in Shanghai and Chengdu developing China-specific products because developing markets require slightly different solutions.

As other companies start to sell to China’s large end-user market, they also realize that even seemingly universal products require tailoring to fit Chinese businesses and consumers. We were told several times that having an R&D team in China is the best way to design what is right for the target customers. Localization is as important in sports, we learned, as in software design.

During a visit to the National Basketball Association’s China headquarters in Beijing, Professor George Foster, who studies global sports organizations among other topics, asked Wendy Yu, senior director of NBA-China, to explain how China came to be the largest outlet for televised games and other products of the American basketball league. When Chinese basketball player Yao Ming got drafted by the Houston Rockets and became a superstar, he brought NBA popularity to China, Yu said. But she attributed the league’s continued success to the ability to localize production and distribution. For example, the NBA reproduces its games with a local commentator because U.S. humor and banter do not translate well into Chinese. At halftime, the NBA replaces cheerleading with performances by Chinese pop stars. The phrase “NBA China” is now among the top five most frequently searched terms on Chinese search engines, the organization has over 2 million daily visits to its website, and currently it is the largest NBA organization outside the United States.

Government incentives also play an important role in infrastructure development for new business and in getting existing businesses to move up the value chain. Recently improved foreign investment policies encourage companies to set up permanent offices in China. For example, the Chinese government continues to liberalize its traditionally closed banking sector, and in April granted additional commercial banking licenses to non-Chinese banks, including HSBC and Standard Chartered. These licenses prompted global banking giants such as Citigroup to establish China offices instead of serving clients in China from Hong Kong and to move experienced bankers in the region to China to kick-start the business.

“The infrastructure development in China is simply amazing even compared to what I saw seven years ago,” said Professor Glenn Carroll as we gathered to have lunch at the food court of Beijing’s crowded airport. We reflected on the impressive skyscrapers that are reshaping the skyline of China’s old capital, the fresh paint smell encountered in many of the boardrooms, and the miles of elevated highways connecting the various sections of Beijing. In fact, from 2001 to 2005, China added 15,350 miles of expressways, more than doubling the total to 25,480 miles. The government’s ambitions include overtaking the United States’ 46,000 miles of interstate by 2020. As infrastructure continues to develop, it will drive growth in related industries; for example, China’s automobile market is the world’s second-largest auto market after the United States with almost 6 million units sold in 2006, and fast-food chains such as McDonald’s are planning to add outlets near highway stops.

Rapid development does not stop at top cities like Beijing, we were told, because regional governments also are aware that infrastructure sustains economic growth. Hangzhou, a city three hours outside of Shanghai, is a good example. During an elaborate 10-course Chinese lunch for the GSB delegation hosted by local officials, I learned that the local government not only provides subsidies for real estate and infrastructure development, it also provides tax breaks to attract companies to set up shop in the historic city. A Hangzhou official told me that one of the benefits for foreign companies in setting up shop in Hangzhou’s high-tech development zone is that these new companies can be tax free for five years if they re-invest their profits in the city. Hangzhou, known for its natural scenic beauty and classical Chinese garden architecture, has been a tourist attraction for centuries—it was a favorite imperial retreat for Chinese emperors and royal consorts. The influx of investment by multinational corporations has added to local attractions a modern technology development zone just minutes away from the ancient city. This impressive new area contains clusters of low-rise office buildings surrounded by grassy areas that look similar to campuses of technology companies in the Silicon Valley.

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At the same time that China’s economic growth has led to the rapid development of such “hardware” as mushrooming skyscrapers, world-class highways, fast broadband connections, and the seemingly ubiquitous Starbucks cafes and a dozen or so imitators, companies are still tackling “software” issues. For many of the companies we visited, managing China’s vast and growing talent pool is the most difficult. On the bus ride back to the hotel after visiting PetroChina in Beijing, labor economics Professor Robert Flanagan started an animated discussion on human resource issues facing Chinese companies: “In this rapidly growing economy, companies are still not strategically looking at human resource issues,” he said. Others agreed, commenting that the function of the HR department in many Chinese companies was to manage employee information—in stark contrast with more developed markets, where a clearly articulated HR strategy in recruitment and retention can drive business growth. Among the HR challenges they noticed were a shortage of managerial talent, high employee attrition rates, and a lack of a comprehensive, China-appropriate management education.

Company representatives also described an extreme shortage of managerial talent. “The supply of experienced managers has not kept pace with economic growth, and many companies are asking employees to do jobs that they are not qualified to do,” said Frank Hawke, a Stanford alumnus who is chairman of Kroll-Greater China, a full-service global risk consulting firm with over 60 offices worldwide. Chinese returnees with their new MBA degrees in hand are in high demand, but there are still times when companies find Western-trained MBAs not 100 percent effective, given China’s complex operating environment. For example, Gary Dirks of BP-China told the faculty delegation: “In working and negotiating with the Chinese government, understanding what is not said at the negotiation table is sometimes more important than what is said.”

Chinese senior executives such as Liang Xinjun, chairman of Fosun Group, a Shanghai-based private investment group, said he has chosen to attend a Chinese-based executive MBA program rather than one in another country because he wants to hone his management skills in a program that he believes blends the rigor of Western-style executive MBA education with teaching materials relevant to China, such as case studies of companies currently operating there. Working with the Chinese government is such a complex topic that Professor Carroll said he could have spent the entire week of the visit just probing the nature of the political economy and the ways companies interact with the government.

Attracting and retaining qualified workers is also a major task in China. The wealth of opportunities for skilled workers means that companies face high employee attrition. Alsleben of SAP China described how even though SAP Labs’ 281 new hires in 2006 were gleaned from 27,000 applicants, 6 percent of the new hires didn’t show up for their first day of work. In the world of China recruiting, having a signed acceptance from a candidate does not automatically translate into headcount. This and similar examples helped faculty members such as economist Andrzej Skrzypacz learn about the idiosyncrasies of the Chinese marketplace and workforce.

According to Mercer Human Resource Consulting of China, the yearly attrition rate of employees for most companies is around 15 percent, with multinational companies reporting higher rates because Chinese nationals are quick to move on if they perceive a glass ceiling. The management teams of multinationals are aware of the opportunities open to Chinese employees and are beginning to focus on retaining good, experienced employees to improve company performance. Keith Davey, MBA ’76, vice president of planning and development at Ford-China, summarized the shift: “Most multinational corporations in the nineties relied mainly on expatriates to run the China operations. The new strategy is to aggressively localize senior management teams. In addition to cost management, it gives strong signals to Chinese employees that there is no glass ceiling. More than anything, it is a motivational tool to inspire Chinese managers to believe that one day they can also run a global Fortune 500 company.”

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As China shifts its focus to innovation, companies face a number of HR challenges that are not easily resolved, but we observed a number of promising examples. Worksoft, an R&D outsourcing startup based in Beijing, came up with a creative HR system to manage both cost and attrition. COO David Chen explained: “In hiring, we don’t fight for top engineering talent from top universities in tier-one cities. Instead, we hire top graduates from top universities in tier-two cities. In general, they are still very well trained, are lower cost, and there is less competition for them. When it comes to retention, we have a clear career roadmap for each individual technical staff member, and we offer them the opportunity to work abroad. For example, in the current Microsoft project, our engineers are in the U.S. working with some of the best engineers in the world. Most Chinese engineers value the opportunity to work abroad and consider this part of the compensation.”

Other positive trends included a report from former state-owned PetroChina that it was seeing an increasing number of Chinese nationals choosing to come back from abroad. Several top venture capital firms—Sequoia Capital China and Chengwei Ventures—are run by Stanford GSB graduates who are Chinese returnees, bringing back global venture and operating experience from their time at Stanford and in the Silicon Valley. (See sidebar) China’s explosive growth also is attracting overseas ethnic Chinese and Taiwanese, who bring with them their Chinese language skills, cultural linkage, and world-class educations. Some work in multinational companies and serve as the bridge between the China operations and headquarters, while others pursue more entrepreneurial opportunities.

Over the course of the trip, faculty members had a chance to take a closer look at issues facing businesses in China’s rapidly developing economy: from the complex environment within China to how Chinese operations play into the global strategies of multinational corporations. They had a chance to examine, question, and learn from a range of companies and institutions. Finance Professor James Van Horne was interested to learn of activities at the People’s Bank of China to stimulate consumption and felt that his visit to the bank on this trip provided the background for comparison with other central banks: “A lot of this experience will definitely make it into our teaching,” he said. Carroll, whose research is in organizations, found that his visit and tour of Wal-Mart in China provided him with additional details on the Wal-Mart case discussion in the GSB classroom. Jeremy Bulow appreciated seeing a business like Google from a different perspective, facing different competitors. Hayagreeva Rao, interested in organizational behavior and human resources, observed that “Chinese companies are definitely seeing themselves in the global context. Chinese companies in high tech, for example, see their competitors as Google and Infosys rather than just local competitors.”

Just as China has shaped the global manufacturing landscape in the last decade, it will no doubt make its impact on the global innovation landscape in the years to come. This means any global manager will find China an inevitable agenda item. The impact of China on many global companies will be profound: a large end-market, a low-cost location for innovation and production, and emerging Chinese competitors rising to challenge established global competitors. The faculty agreed that the trip gave them a great deal to think about, and they began to wonder how the perspectives gained on the trip would affect their research. Some initiated contact with executives for the development of case studies, and I am now working with faculty on cases on Worksoft, Lenovo, and Integrated Design Services. Others are hoping that more of the Chinese companies we visited can be convinced to engage in the development of candid cases on human resource management before and after China’s entry into the World Trade Organization. I’ll soon find out if I can break cultural barriers by getting Chinese executives to talk about managing human resources in companies where Chinese Communist Party members are on the board.