Issue: 2013: Vol. 12, No. 2

The China Standards Engine

Article Author(s)

Michael Murphree

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Michael Murphree is completing his Ph.D. in the Sam Nunn School of International Affairs at Georgia Institute of Technology. 
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MurphreeChina’s accomplishments in economic modernization, urbanization, industrialization, and science and technology are legion. The question to which China watchers, as well as the Chinese state, have now turned is how will China spur and sustain its future economic development? Research and media reports have shown that the low-wage, capital-intensive, and export-oriented strategies using China as a final assembly platform are providing diminishing returns. Future growth will be both slower and more difficult. China must therefore find new engines for economic progress.

China’s reckoning with its growth model has been long in coming. Indeed, the seeds of change in China have been visible since the mid-2000s. China’s output of high technology goods for export, mostly IT hardware, has soared, growing consistently at more than 10% per year (NSBPRC 2001-2013). Despite these achievements, other high technology statistics suggest existing incentive policies and business strategies are yielding diminishing returns. To provide one example, in the decade beginning in 1994, China’s share of high technology exports in its total export mix grew exponentially. Since 2005, however, this share has leveled off at roughly 30% of total exports (MoST 2012, NSBPRC 2001-2013). The inability to continue to increase the share of high technology goods in the overall export mix means the low-hanging fruit of high technology industrial development has now been picked, but new means of driving rapid innovation have not yet been found.

Figure 1

Figure I: Growth of High Technology Exports – 1991-2012 (Source: National Statistics Bureau of China)

Figure 2

Figure II: High Tech Exports as a Percent of Total Exports – 1991-2012 (Source: National Statistics Bureau of China)

The universal prescription for resolving China’s economic challenges is mastery of “innovation.” However, the exact definition of innovation varies within the Chinese state and economy. Some adopt a Schumpeterian perspective and argue that innovation is the application of knowledge to improve the development, sale, or production of goods and services. Others take a harder approach, saying that innovation is synonymous with invention and that only the creation of wholly new and wholly Chinese-owned technologies will yield sustained competitive advantage and economic growth. These competing perspectives have influenced the raft of policies adopted by China’s central, provincial and local governments to encourage technological upgrades by firms and greater technology independence.

Policies for Technology Upgrading and Innovation

Despite competing visions about the nature of innovation, the Chinese government at various levels has pushed incentive policies since the late 1980s and increasingly through the 1990s and 2000s intended to encourage firms to move up the value chain, become more innovative, and increase their investment in R&D. These promotional policies include major national plans such as the 15-year Medium-to-Long Range Plan for Science and Technology (MLP), the 863 and Torch programs, and the most recent Five Year Plans. Investment rules and joint-venture agreements in the 1990s and early 2000s often made the sharing or transfer of advanced foreign technology a prerequisite for investment permits. National incentive policies are complemented by a host of provincially and locally administered promotional policies such as R&D tax breaks, export promotion, duty-free imports of certain goods, and human resource policies granting legal residency (hukou) to new residents in different cities such as highly desirable Beijing and Shanghai (see, for example: Breznitz and Murphree 2011).

These policies appear to have been largely ineffective in encouraging Chinese firms to move “up” the value chain and become independently innovative. Many of the recipients of state incentives and investment have used the funds to expand productive capacity or diversify rather than make concerted efforts at R&D and technological upgrading. Requirements to transfer technology have not resulted in transfers of the most advanced technology and foreign firms remain reticent to move their most advanced production or research activities to their Chinese subsidiaries or partners. Seeing the limited efficacy of these long-running programs, the government has more recently pushed for an alternative innovation strategy: development of technology standards.

Since the early 2000s, China’s central government – most notably the ministries of Industry and Information Technology (MIIT) and Science and Technology (MoST) – has actively pushed the development of technology standards in order to upgrade and increase profitability of Chinese firms (Wang et al 2009, Linden 2004, Kennedy et al 2008, Suttmeier and Su 2004). Often couched in the language of “technology independence,” the broad goal of the standardization policy is to enable Chinese firms to produce goods with global demand and markets without having to pay licensing fees to foreign IP holders. Apart from this goal, pursuing the development of unique standards also has the potential to upgrade China’s overall innovation capacity as standardization requires sophisticated R&D, technology transfer and management capabilities – all skills China needs as it seeks to upgrade its economy.

To accomplish this, Chinese firms are developing alternative or wholly new technology standards-essential patents, often licensed at free or nominal rates. Preliminary research suggests that driving down the costs of intellectual property through this method, just as China has driven down the costs for other inputs, will make Chinese-manufactured goods even more competitive. Increased profitability for Chinese manufacturers should also provide resources for further investment in new technologies, enabling China to produce ever better and cheaper high technology goods for domestic consumption and export.

Concerning Technology Standards

Technology standards are agreed upon protocols that enable goods and services, regardless of supplier or country of origin, to work together. To illustrate, the Universal Serial Bus (USB) enables computers and peripheral hardware to work together regardless of operating system, computer brand or peripheral manufacturer. This facilitates consumer choice, enhances competition, and – according to many scholars – provides a platform for faster innovation. Without common standards, markets are fragmented, consumer choice is constrained, and the pace of innovation arguably is slowed down.

Standards are developed through either formal or market processes. Formal standardization is bureaucratically managed through established national, regional, or international standardization bodies such as the China Electronics Standardization Institute (CESI), the European Telecommunications Standards Institute or the International Electrotechnical Commission. In formal standardization, specific protocols for a standard are developed in working groups composed of experts in the technology or industry in question. Working group members debate proposals and competing technologies before sending their recommendations to technical committees under the formal organization for more debate, comment and adoption – usually by consensus. In formal standards, intellectual property holders declare potentially relevant IP and the terms under which they are willing to license the technology. Most frequently, incorporated technologies are licensed on the Reasonable and Non-Discriminatory (RAND) principle: firms agree to charge reasonable licensing rates and not restrict which firms or countries may license their technology in order to produce standards-compliant goods.

Market standards are produced by single firms or ad hoc industry consortia. These are not formally adopted by standardization bodies and become “standards” through their dominance of the market for their respective goods or services. The IBM PC became the standard for personal computers after achieving “critical mass” in the market for computers in 1984. Thereafter, computer firms either conformed to the IBM standard or else were relegated to niche status (as in Apple). China is using both the formal and market approaches to set new standards. Given the nature of China’s standardization system, however, even market approaches often include significant state support and influence.

Technology Standardization in China: Justification and Challenges

How can standardization benefit Chinese firms? Standards represent the means of completely changing China’s position in global production networks. Currently, Chinese firms generally operate at the lowest value-added level in many industries, particularly IT hardware. Chinese firms tend to specialize in the final assembly of imported high-value components or in the production of low-value commodity components such as plastic or metal cases. Indeed, the low value-added by Chinese manufacturers in such prize exports as Apple iPhones has been long recorded and reported in the media (Batson 2010). While many IT hardware components are increasingly produced in China — notably in Dongguan and Shenzhen — the highest value components — logic chips, digital signal processing chips, and software — are designed and manufactured overseas and imported by Chinese assemblers. Chinese firms have come to specialize in the integration of components from a highly disparate production chain consisting of hundreds of supplier firms. This is not to downplay the accomplishment or innovation characteristics of contract manufacturers and assemblers. Their skills and upgrading capabilities remain among the best in the world – making it difficult to find partners as capable when foreign firms show interest in diversifying away from Chinese manufacturing (Zhang et al 2013, Yao 2012). Nonetheless, the overall contribution of China to the wholesale price of products is usually only a few percentage points.

Stan Shih of Taiwan’s Acer Computer once described the difficulty facing firms that specialize in final assembly. He argued that the profits that accrue to different firms in a production chain form a “smiling curve” where the definers of product architecture and after-sales service or branding firms reap the highest profits. Assemblers and contract manufacturers are at the bottom of the “smile.” Shih argued that firms had to move away from low value-added manufacturing in order to survive. In China today, many companies find themselves at the bottom of the “smile.”

In electronics and information technology hardware, however, moving up from this low value-added position is difficult as the technologies being produced are subject to established and clearly defined technology standards. Having not contributed to the development of the standards currently in force in many sectors, Chinese firms are “standards takers.” In order to compete in these technology sectors, Chinese firms must accept internationally determined standards for various products and produce goods according to the terms of the standard. Producing goods such as mobile phones requires manufacturers to pay licensing fees for the raft of patents that establish transmission standards for the phone (such as CDMA). These license payments reduce the already low profits for Chinese manufacturers. Finally, standards define the basic features of large categories of products, leaving little room for innovation or improvements as the protocols of the most basic level have already been defined.

Were China to successfully develop new technology standards and have them adopted internationally, this situation could change. Chinese firms would be able to earn royalties and potentially limit the access of competitors to key essential technologies (as Motorola did with its restrictive licensing of patents for the GSM mobile telephony standard). China would thus be able to control the structure of an industry by determining which firms are allowed to participate. Chinese manufacturers would also owe less in licensing fees. Firms and research institutions would gain valuable experience conducting collaborative in-depth and sustained research toward a common industrial goal.

Since the mid-1990s, China’s research institutions and firms have developed dozens of unique information technology standards. Despite their promise, none has been internationally successful (Kennedy et al 2008, Kennedy 2006, Breznitz and Murphree 2013). China’s standardization system continues to face several problems:

  1. Lack of coordination: While many Western observers continue to view China through the lens of a centrally coordinated “China Inc,” there is significant complexity and lack of coordination. While the Ministry of Industry and Information Technology and the Ministry of Science and Technology remain the most active government ministries in standardization, and formal national standards remain the sole responsibility of the Standardization Administration of China, recent standards efforts have been fragmented. In electric vehicles, for example, different cities have established their own regional standards for charging stations, thus making equipment from different regions incompatible. Standards created by organizations under one government ministry —such as MIIT —may face challenges from standards created by groups under other bodies. At the same time, industry has become increasingly active in standardization and frequently seeks to adopt international standards rather than push for unique Chinese standards that are unlikely to be adopted internationally. These conflicting interests and proposals make for a confused standardization environment. A common result is that many firms in China take a “wait and see” attitude toward standardization, preferring to let the situation resolve itself rather than getting actively involved.
  2. Lack of core innovation: Technology standards codify the state of the art in technology at a given point in time. They ideally embody the most sophisticated, basic and essential technologies necessary for a given system to work as a platform for other products and services. To create technology standards, a country or firm needs to have strong core innovation capabilities. To date, many of China’s leading indigenous standards efforts have relied heavily on foreign core technology. Using foreign technology is a pragmatic means of addressing weaknesses in China’s innovation system as well as enabling new standards to be released quickly. However, use of core foreign technology undermines the potential benefits of lower licensing fees since expensive foreign technology remains at the core of the standard.
  3. Strong role for government in standards: like all areas of the Chinese economy and society, there is a major role for the state in the standardization process. This role is mandated through the 1989 Standardization Law of China, which gives the state sole responsibility for setting the agenda and legitimizing standardization efforts. On the one hand, the state is able to marshal resources and direct industry to invest in standards development, perhaps where it hitherto had been disinclined. On the other, the state has historically been such a strong force in the economy that many firms are hesitant to standardize without first receiving a direct order or clear signal from the state that a new standard is desired. This makes the state responsible for initiating standardization, a difficult process to master, as it requires intimate familiarity with technology and technology trends in order to start processes when opportunity presents itself. State leadership in standards is generally considered inferior to industry leadership (Funk and Methe 2001), yet it remains the norm in China.

Potential Benefit from Technology Standardization

Despite these challenges, China’s approach to standardization has yielded benefits for Chinese firms and may become internationally influential. Unlike American and European firms, which emphasize the monetization of intellectual property as a core business strategy, Chinese firms generally see intellectual property as a means to improving the value of manufactured goods and not primarily as an opportunity for monetization. For technology standards, this is highly significant. In most internationally accepted standards today, there are thousands of “standard essential patents” (SEP). U.S. and European firms frequently seek to maximize their returns from SEPs by setting “reasonable” licensing fees as high as possible. Alternately, firms with major SEP patent portfolios enter technology-sharing agreements with other major contributors, lowering mutual licensing rates. Chinese firms have to date contributed relatively little to major international standards (the contributions of Huawei and ZTE to 4G LTE are an important exception) and thus must license technologies to produce standards-compliant goods while also being excluded from technology-sharing agreements.

In China’s indigenously developed technology standards, there is a movement toward the demonetization of intellectual property. In the Chinese model, intellectual property is just another factor input in the production of goods and services. Like all components and resources, it is in the interest of firms to reduce the costs of this input. For indigenous standards, Chinese firms increasingly have made the intellectual property they contribute available at extremely low rates. Ideally, Chinese enterprises will license their standard essential patents on a free or nominal price basis. For Chinese firms interested in selling more goods, offering intellectual property for free is a means of helping to widely disseminate their technology while keeping costs low and thus encouraging adoption of their products. China’s standards-making bodies have begun establishing patent pools for core standards-essential patents that will make one-stop licenses available at a nominal basis.

In Chinese standards for home networking (IGRS) and audio-video encoding (AVS), the standardization consortia have set low or nominal rates for technologies licenses. Firms seeking to produce compliant goods thus reduce their production costs, increasing profitability while maintaining low final consumer costs. China’s Electronics Standardization Institute (CESI) has begun discussing how to make low-cost patent pools standard procedure.

While it remains to be seen whether this approach will successfully change global approaches to intellectual property and its economic value, China’s inexpensive IP model has already had some successes in forcing foreign holders of standards-essential IP to lower their licensing fees (Breznitz and Murphree 2013). In several cases, low-priced Chinese standards have been created and adopted by China’s standardization authorities. Shortly thereafter, the licensing rates charged by foreign IP holders to Chinese manufacturers have decreased. This occurred for DVD, Blu-ray, MPEG and 3G mobile. While China may not yet change the world’s perspective on IP, its economic and industrial power is already sufficient to force the rest of the world to pay attention to China’s moves in this area and perhaps act to preempt them. Again, this lowers the costs for Chinese manufacturers, making them more profitable and able to further drive down global costs for desired technologies.

Concluding Thoughts

China faces real challenges to its economic development model as it seeks to upgrade its technological capabilities and find new sources of sustained competitive advantage. The Chinese leadership has targeted development of technology standards as a means of improving the competitive position of Chinese firms and developing all-around technology innovation capabilities. Many of the standardization efforts to date have been unsuccessful, as they remain underutilized – or even wholly ignored – within Chinese or global markets. At the same time, China has realized two important benefits from its standardization activities. First, China may be changing the global perspective on intellectual property. Just as China’s scale and incremental innovation capabilities have redefined global manufacturing and sourcing of goods, China may also be able to significantly lower the cost of intellectual property for manufacturers. It may do so either through creation of low-priced alternative technologies or through pressuring foreign IP holders to lower the licensing fees for standards-essential patents. In either case, China’s firms improve their profitability while also remaining focused on their core capabilities in manufacturing. It is likely that China will continue its development of technology standards, meaning we should anticipate even great price and normative influence from China in the coming years.

Works Cited

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