Gauging the strength of Chinese innovation (continued series on China)
McKinsey authors Erik Roth is a director in McKinsey’s Shanghai Office; Jeongmin Seong is a senior fellow of the McKinsey Global Institute, and Jonathan Woetzel is a director in the Shanghai office, as well as a director of the McKinsey Global Institute, evaluate the strength of Chinese innovation. In this framework we present additionally to you some important data from a December 16, 2015 study by Strategy & pwc on “Winning in China’s changing economy: A strategy for managing complexity by John Jullens, Krishnan Narayanan, Keat Lai, Tong Zhang. The third feature offered by TextileFuture in the series on Chinal, was written by the McKinsey authors Wouter Baan and Christopher Thomas and with the title How China country heads are coping “ and gives the view of western executives
China does well in customer- and manufacturing- oriented innovation, though not in the more advanced varieties. The country will need them to sustain growth.
The events of 2015 have shown that China is passing through a challenging transition: the labour-force expansion and surging investment that propelled three decades of growth are now weakening. This is a natural stage in the country’s economic development. Yet it raises questions such as how drastically the expansion of GDP will slow down and whether the country can tap new sources of growth.
New research1 by the McKinsey Global Institute (MGI) suggests that to realise consensus growth forecasts—5.5 to 6.5 percent a year— during the coming decade, China must generate two to three percent- age points of annual GDP growth through innovation, broadly defined. If it does, innovation could contribute an estimated USD 3 trillion to USD 5 trillion a year to GDP by 2025.2 China will have evolved from an “innovation sponge,” absorbing and adapting existing technology and knowledge from around the world, into a global innovation leader. Our analysis suggests that this transformation is possible, though far from inevitable.
1 To download the full MGI report, The China effect on global innovation, see “Gauging the strength of Chinese innovation,” October 2015, on www.mckinsey.com
2 The estimated increase in total factor productivity is USD 3 trillion to USD 5 trillion. We use this figure as a proxy for innovation’s macroeconomic impact. Total factor productivity is growth that does not flow from factors of production such as labour and capital investment. In our research, we found that about 40 percent of the increase in total factor productivity could come from innovations in higher-level manufacturing and services enabled by the Internet. Other innovations could come from catch-up activities that bring Chinese enterprises up to global best practices as well as breakthroughs yet to emerge.
To date, when we have evaluated how well Chinese companies commercialize new ideas and use them to raise market share and profits and to compete around the world, the picture has been decidedly mixed. China has become a strong innovator in areas such as consumer electronics and construction equipment. Yet in others— creating new drugs or designing automobile engines, for example— the country still is not globally competitive. That is true even though every year it spends more than USD 200 billion on research (second only to the United States), turns out close to 30000 PhDs in science and engineering, and leads the world in patent applications (more than 820000 in 2013).
When we look ahead, though, we see broad swaths of opportunity. Our analysis suggests that by 2025, such new innovation opportunities could contribute USD 1.0 trillion to USD 2.2 trillion a year to the Chinese economy—or equivalent to up to 24 percent of total GDP growth. To achieve this goal, China must continue to transform the manufacturing sector, particularly through digitization, and the service sector, through rising connectivity and Internet enablement. Additional productivity gains would come from progress in science- and engineering-based innovation and improvements in the operations of companies as they adopt modern business methods.
To develop a clearer view of this potential, we identified four innovation archetypes: customer focused, efficiency driven, engineering based, and science based. We then compared the actual global revenues of individual industries with what we would expect them to generate given China’s share of global GDP (12 % in 2013). As the exhibit on the next page shows, Chinese companies that rely on customer-focused and efficiency-driven innovation—in industries such as household appliances, Internet software and services, solar panels, and construction machinery—perform relatively well.
However, Chinese companies are not yet global leaders in any of the science-based industries (such as branded pharmaceuticals) that we analysed. In engineering-based industries, the results are inconsistent: China excels in high-speed trains but gets less than its GDP-based share from auto manufacturing. In this article, the authors will describe the state of play and the outlook in these four categories, starting with the two outperformers.
1. Customer-focused innovation: The Chinese commercialisation machine
China benefits from the sheer size of its consumer market, which helps companies to commercialize new ideas quickly and on a large scale; even a relatively small market like online gaming is bigger than the auto industry in Turkey or Thailand. Chinese companies have learned how to read the requirements of their rapidly urbanising country and to scale up new products and services quickly to meet them.
Manufacturers of appliances and other household goods dominated the first wave of customer-focused innovators in China. Their innovations were “good enough” products such as refrigerators and TV sets. These offerings no longer suffice to gain a growing share of consumers. Companies like smartphone manufacturer Xiaomi are responding with cheaper and better products designed to offer hardware features as good as those from global brands but priced for the Chinese market. Like other customer-focused innovators in China, Xiaomi also uses the massive consumer market as a collaborator, rapidly refining its offerings through online feedback. Internet service providers are another hotbed of customer-focused innovation. Alibaba, Baidu, and Tencent have become global leaders in online services, largely thanks to their success in the enormous Chinese market.
Customer-focused innovation could reshape large swaths of China’s service sector, where productivity lags behind that of its counter- parts in developed economies. The government already is pushing to modernize traditional businesses through its Internet Plus initiative, announced in early 2015. Innovations are needed in order to expand access to services (for example, remotely monitoring the health of rural patients), to improve the quality of offerings (greater choice and customisation in financial and educational products), and to optimise operations (crowd-sourced logistics). Chinese companies will also have opportunities to use their skills in customer-focused innovation to take a lead in selling to other emerging markets.
2. Efficiency-driven innovation: The ecosystem advantage
In manufacturing, China’s extensive ecosystem has provided an unmatched environment for efficiency-driven innovation. The country has the world’s largest and most highly concentrated supplier base, a massive manufacturing workforce, and a modern logistics infrastructure. These advantages give Chinese manufacturers a lead in some important knowledge-based manufacturing categories, such as electrical equipment, construction equipment, and solar panels.
Today, Chinese companies improve their efficiency with a variety of cutting-edge approaches, including agile manufacturing, modular design, and flexible automation. The apparel manufacturer Everstar, for example, uses automated equipment and online design and e-commerce systems that help consumers to customize designs for clothing and receive finished goods within 72 hours. China is also pioneering the use of open manufacturing platforms.
The challenges are mounting, however. As wages rise, the country becomes less competitive for the most labor-intensive work. At the same time, a worldwide transition is under way toward a new kind of manufacturing, sometimes called Industry 4.0: a much more intense digital linkage of manufacturing components, processes, and logistics. As a result, Chinese companies will face pressure to improve their performance in utilizing assets, matching supply with demand, and controlling quality. Success will depend on how well China can exploit the scale of today’s manufacturing ecosystems and clusters to extend their benefits beyond individual factories through digitally linked networks.
Some efforts are under way to mobilize rapid, flexible manufacturing. In Guangdong province, for example, manufacturers have set up joint platforms to share the benefits of R&D and operations among companies in the same clusters. Elsewhere, companies are looking at ways to mass-customize products by combining flexible manufacturing with the aggregation of a huge Internet consumer base. New manufacturing gains may also emerge from the aggressive use of robots, which could make China’s huge pool of semiskilled factory workers more effective.
Entrepreneurs are poised to play a bigger role. In Shenzhen, a rich ecosystem of component suppliers, design services, business incubators, and outsourced assembly capacity has helped start-ups prototype products and scale up global manufacturing businesses quickly.
3. Engineering-based innovation in “learning industries”
China has had mixed success with engineering-based innovation. The best performers are found in Chinese markets where motivated domestic industries are nurtured by national and local governments that create local demand, push for innovation, and facilitate the transfer of knowledge from foreign players. China has used this formula successfully in high-speed rail (Chinese companies have a 41 percent share of the global railroad-equipment revenues, according to McKinsey estimates), wind power, and telecommunications equipment.
In 2008, the Ministry of Railways launched a major program to develop a new generation of high-speed trains—a top-down, nation- wide effort that has been China’s equivalent of the Apollo space program in scale and complexity. We estimate that the country has accounted for 86 percent of global growth in this market since then. Using technology transfers from overseas partners as a knowledge base, Chinese companies tailor their offerings to local requirements, such as terrain and temperature conditions, through incremental innovation.
Learning and innovation have been slower to come in automotive manufacturing. To date, most domestic Chinese carmakers have relied on platforms from their global partners or on designs from outside firms to bring products to market quickly. Thanks to exploding domestic demand and strong profit streams from joint ventures, they have felt little pressure to innovate.
Deregulation, a rapid increase in China’s base of engineering talent, and continued high levels of government investment promise to make engineering-based companies more motivated and effective innovators in the future. In some sectors, such as nuclear power, explicit state support will continue to be critical. China has an ambitious government plan to build nuclear plants resulting in a total installed capacity of 58 gigawatts by 2020, which can support its goal of obtaining 20 % of its energy from non–fossil fuel sources by 2030.
In other industries, such as medical equipment, the private sector will drive innovation. Mindray, United Imaging Healthcare, and other smaller new Chinese players will continue to make inroads in market categories (for instance, CT scanners and MRI machines) that foreign suppliers now dominate. Government programmes to subsidise purchases of Chinese-made equipment by the country’s hospitals are providing a boost even as a new generation of medical entrepreneurs draws from global knowledge and partnerships.
4. Science-based innovation: Novel Chinese approaches
A massive government push to raise R&D spending, train more scientists, and file more patents has yet to give China a lead in science-based innovation. The slow progress has a number of explanations—not least that this type of work takes a long time to pay off and requires an effective regulator to protect intellectual property. Huge investments by government, and the private sector to shepherd projects from the lab to commercial deployment are needed as well. What’s more, despite the large number of Chinese students trained in scientific and technical fields, companies struggle to find capable talent.
The government is addressing some of these obstacles. For example, recently launched reforms to the drug-review process could reduce the time to get a new drug to patients by two or more years. Efforts such as the Thousand Talents program bring overseas Chinese to the country to launch their own companies, and work in scientific organisations and universities.
Even as these reforms play out, Chinese innovators are adopting novel approaches—for instance, using the country’s massive market size and huge pool of low-cost researchers to industrialize and speed up experimentation and data collection. One such innovator, BeiGene, gained ground in the biotech industry by developing drugs to treat cancers and other diseases. The company has accelerated the drug-discovery process by deploying a large-scale drug-testing team, testing compounds on human tissue (such as cancerous tumour samples) during the preclinical phase to get early indications of issues that might arise in human testing, and capitalizing on access to China’s large pool of patients. In genomics research, another company, BGI, is deploying massive scale (2,000 PhDs and more than 200 gene-sequencing machines) to power its way through bio-tech problems.
The extent and speed of China’s advances in innovation will have significant implications for the country’s growth and competitive- ness and for the types of jobs, products, and services available to the Chinese people. They will also have powerful consequences for multinationals (competing at home and abroad with Chinese companies), some of which are now using China as an R&D base for global innovation. Fortunately, that is not a zero-sum game: a more innovative China ought to be good for a global economy that seeks new sources of growth.
The authors wish to thank McKinsey’s Jason Lee for his contributions to this article.
Important data from Strategy & pwec from the report “Winning in China’s changing economy
Important data from a December 16, 2015 study by Strategy & pwc on “Winning in China’s changing economy: A strategy for managing complexity” by John Jullens, Krishnan Narayanan, Keat Lai, Tong Zhang we present here in the form of graphs.
The full study by Strategy&pwc can be accessed here
How China country heads are coping
Wouter Baan and Christopher Thomas are the McKinsey authors with this complementary feature offered by TextileFuture
As multinational companies face stronger headwinds, how are local leaders dealing with the situation, and what would help them move faster?
Signs of weaker growth in China during 2015, including its stock market’s tumble, have commanded widespread attention from economic policy makers, businesspeople, and investors. Not surprisingly, the leaders of local operations of multinational companies are feeling the pressure.
Earlier this year, we surveyed more than 70 such country heads, who, for simplicity’s sake, we call China CEOs. The companies they lead cover a wide range of B2B and B2C businesses, generate more than USD 200 billion in China-based revenue, and in many cases are among the top five global players in their industries. Fifty-five percent tell us that their companies are growing faster than the corresponding market segments in China. Nearly 40 % of the China CEOs were Chinese nationals; a similar proportion came from Europe or North America, the rest primarily from other countries in Asia. Roughly 90 % work for companies based in the United States or Europe. Nearly half had more than ten years of experience in China before taking on their current roles, but roughly 30 % had less than two years’ experience there or were new to the region.
Regardless of background, these China CEOs are under severe time constraints. 40 % said they do not have time to respond quickly enough to the rapid changes in the China market, and another 40 % admit that they are hard pressed to do so. Two challenges that China CEOs say demand large amounts of their time are hitting the numbers while they cope with the downturn in demand, as well as building their local teams. Another major issue is managing headquarters, including explaining the unique Chinese context to senior management there. That’s particularly true for the subset of the sample that can be characterized as headquarters focused, who spend nearly 40 % of their time at or dealing with headquarters. Even locally focused China CEOs spend about 20 % of their time at or speaking with the global HQ Head Quarter.
Most China CEOs have direct line control over go-to-market and support functions, such as branding and corporate affairs, but limited direct line reporting in upstream areas like product development, operations, and supply-chain management. Less than 50 % can make decisions about pricing and product strategy independently of headquarters (Exhibit 1). Among those with integrated control over country operations and commercial results, most must still involve HQ in overall China strategy, long-term multiyear plans, and annual budgeting.
Regional-reporting relationships complicated things for some. Roughly two-fifths of China CEOs report to an Asia head, 20 % to a global CEO (Exhibit 2). Many say it is challenging, even uncomfortable, for them to report to the Asia head, when their China businesses account for a huge proportion of Asian results. Problems include the risk that they will duplicate approaches to targeting and reaching customers made at a regional level, along with lengthy planning and decision cycles.
Time pressures and decision-making complexity are hampering China CEOs as they seek to adapt to a changing country, to customise their business models and product offerings to Chinese requirements, to compete with local competitors, and to respond nimbly to opportunities and threats.
Despite these issues, the vast majority of respondents said that China remains a top-priority growth engine for their companies—and that experience as the China head is a “rocket” to advance their own careers. However, overall, most do not see the business environment in China getting any easier. Most also fear that the policy environment for multinationals in the country will get more challenging. Efforts to increase their agility by simplifying interactions with headquarters or by delayering and accelerating decision- making processes may therefore be a boon for many China CEOs and the organizations they oversee.
Companies address these challenges in different ways. Some have removed the regional structure and elevated China to a position equal to that of the rest of Asia. Others have consolidated all activities there under a China CEO with direct access to the global CEO. Several companies have built up their organic capabilities by moving full business units and global senior executives to the country. One created a China advisory board of senior global executives who coordinate and accelerate the local agenda.
Still others have taken people-based rather than structural approaches—promoting the China head to a global executive position, so that China expertise enters the boardroom. Some CEOs are addressing the slower-growth environment in today’s China by making personal commitments to remove barriers, in the cause of creating an organization that is sufficiently nimble and responsive to the market. Efforts to attain that objective would seem to be a sensible use of time not only for executives at headquarters but also for those struggling on the front line.
The authors wish to thank McKinsey’s Yatu Ji and Rachel Jin for their contributions to this article.