Saturday, July 01, 2006

Intellectual Property, Business Entry and Exit Strategies and Structural Change in China - A Case History in the Textile Industry

By sheer coincidence, seconds after posting my blog on intellectual property, I was delighted to recieve a copy of a paper by my friend Brian Porter, on a related subject.

This provides unusual insight into the historical, cycle and competitive dynamics of a global industry, specifically in view of Chinese business practices.

He has kindly given me permission to publish this here but do note that the copyright in the text below belongs to him:

The Implications of Structural Change in China - A Case History in the Textile Industry
(c) Brian K. Porter of Walchwil, Switzerland

This paper details the experience of a foreign equipment supplier during a fundamental shift in China’s domestic market structure. A short summary of the broader implications and lessons which could be learned from the experience is also provided.

As Sales/Product Manager for China, I was responsible for selling the equipment in our company’s product line which dealt with the crystallization and drying of polyester pellets. This thermal process is an integral part of the decentralized manufacture of synthetic fibers from polyester. As with most Asian countries, development of light industry in China has been the precursor to greater economic expansion into other manufacturing sectors. Textiles are a major economic component of the light industry sector.

The Chinese market was unique to others in the Asian region in that the Chinese government, through the Textile Ministry, originally pushed for a decentralization of the synthetic fiber industry in order to maximize local employment and create an indigenous and well-distributed, light industrial base. This created a significant market opportunity for our company, which produced equipment specifically for small to medium sized industrial applications.

As an aside, most other large producers of polyester fibers in the world spin the fiber directly, and in great quantity, after an upstream polycondensation. Our process required that the polyester be first pelletized as amorphous chips. This pelletization would facilitate shipping from a central polycondensation plant to remote locations. The amorphous chips would then require an additional crystallization and drying step before being re-melted and extruded into fiber; a process unnecessary during the direct spinning of fiber.

When I began working for this company in 1989, we had a majority share of the Chinese import market of PET crystallization and drying equipment. By the time I left in 1995, we had no market share. Of course, I don’t want to take the entire blame for this occurrence. I would like to think I maintained and extended the profit stream from this product line as long as possible. In my defense, no other foreign manufacturer has any market share at this point either.

Our success in the market started with the long-suffering efforts of one individual who, at the expense of his marriage, spent the greater portion of his time over a three-year period developing contacts in the market through frequent business trips to China from his German-based headquarters. Eventually, after spending an inordinate period of time banqueting and drinking Mao Tai, he gained the trust and understanding of important individuals in the relevant State Owned Enterprises (SOEs) and Textile Ministry.

This sales manager combined these contacts and relationships to create a “boom” in the company’s equipment sales to China. From the time he began to the time I finished, we had sold more than 180 crystallization and drying lines. Previous to taking the sales position, I was the project manager responsible for implementing projects for our customers in China. This previous project experience provides a somewhat greater overview on the cost positioning of the product during the rise and demise of the product line. I became a sales manager after the former sales manager believed his efforts were not being adequately rewarded and had quit the company.

Profit margins sustained our business throughout the entire duration of sales. There were only two cases where losses were incurred, and these were due to both an excessive shaving of design criteria and stringent demands from the customer for compensation. Before I took over the product line, the company was able to increase prices by 2 - 3% per year due to “inflation”. Unfortunately, this windfall stopped during my tenure.

When I took over Chinese sales efforts, we were negotiating the sale of five-to-seven year old technology. At the time we felt that the Chinese government had been inviting our competitors to openly compete in the domestic market in order to stem the flow of foreign exchange out of the country. This competition would lower the cost of imported equipment to China while we foreigners fought it out amongst ourselves.

We were exporting 100% of the scope of supply of our process from Europe, providing all engineering and design work, holding preliminary design meetings in China with our project engineers, supervising construction activities with a construction manager, providing start-up assistance, with both mechanical and control engineers, and providing all project documentation. We can, for the purpose of illustration, set a market price at this point in time as a datum at 1.0.

The competition between foreign suppliers initially put significant pressure on our own sub-suppliers as we project managers requested that they significantly reduce their prices (higher discounts). This effort was basically an internal exercise, working closely with the purchasing department during occasional visits from our sub-suppliers as we compelled them to lower their prices. Initially, this worked to everyone’s benefit because our suppliers (those that could meet our price/quality level) had a steady income from our expanding orders. Economies of scale could also be generated in their equipment/component production. This small change allowed us to undercut our competitors’ best evaluated bid (we were still more expensive but our technology sold at a premium due to our quality reputation). This development resulted in a savings of around 7%; thus, the new price level was 0.93.

As our competitors followed our lead in the market, we were forced to find our own economies from increased production runs. This effort reduced our in-house production costs. We were effectively cutting our factory’s production profit in order to load production. This resulted in a redundancy of employees in our German factory as cost cutting measures were implemented and lower margins on production were seen. We were then able to take another 5% from project costs, moving the factor to around 0.88.

By this time, the Chinese textile industry had done its market research and had found a supplier in England that could effectively produce and supply a similar process at around 20% less than our minimum price level with only slightly lower product quality. More and more orders were given to them. Negotiations were getting very hectic. Many times our Chinese customers had two or three of us suppliers in as many rooms in a hotel—going from room to room driving our prices to an absolute minimum.

In order to meet these challenging market developments, we started more frequent cooperation with one regional design institute within the Textile Ministry with some help from two other design institutes. These relationships leveraged a few more projects at fair profit margins. The margins also went up because the design institutes started to perform initial design drawings rather than having this done in our own engineering group. They performed these services at a very small premium. Unfortunately, this outsourcing created redundancies in our engineering department.

Immediately before moving into sales, I had helped develop and engineer a new process somewhat similar to that of our competitor. Fortunately for me, being new to the sales group, I did not appear hypocritical in presenting the technology to our customers. I could always claim ignorance of my predecessor’s arguments against the technology. An additional benefit was that I had been the primary force in pushing through, and taking part in, this new products’ development. This new process would have allowed us to initially reduce our sales price by an additional 30%.

Being a good sales manager, I reduced the price level by 10%. We were able to do this and still get projects because we still had the best name in the market and the Chinese had no idea what our production costs for the new process were (this would prove to be short lived). I had also over-designed the production capacity of the process by around 30% in order to insure that absolutely no performance guarantees would be compromised. This move also left an engineering margin to play with as the inevitable forces of competition came into play. This initial 10% reduction moved the factored reference price down to 0.79

My sales efforts became much easier since negotiations, at ever diminishing prices, took place behind the scenes with our local representative, the design institutes and our customers. My negotiations became a pricing formality. Negotiations, which used to take up to a week as we negotiated each individual component’s price in our system, now took around one day on a system pricing basis.

As time passed the Textile Ministry was disbanded in a government restructuring and its former employees were forced to seek outside positions. They went primarily to the regional design institutes which, with these former ministerial level connections, became even more powerful. The design institutes also began designing and producing downstream equipment, and we heard that their personnel were undertaking operation of this equipment in our previously supplied plants.

More and more rumors were being heard that new domestic suppliers were springing up with copies of foreign supplied equipment. We knew of five or six, and we would often get direct spare-part requests for our newest process from obscure parts of China rather than obtaining them from delivered plants through the normal channel of our country organization. We could easily trace the origin of the equipment specifications to recently supplied plants in completely different geographical locations. These were obviously being forwarded to our domestic competitors through some form of broker or agent. I then found personnel from our design institute/alliance partner operating a plant we had recently delivered. They had a domestic version of a German extruder in operation. They assured me that they were not interested in producing our equipment which was actually much simpler to produce than the more complicated extruder.

I once saw a copy of our old process sitting next to one of our new lines. The quality was not up to our standard, and the customer said he was compelled to buy it in order to minimize expenditures.

Over the next year, due to price competition, the remaining 20% margin of our new process was reduced from the price bringing the factor to 0.63. The design margin was then brought down to an acceptable minimum bringing about a further 10% reduction in price to a factor of 0.56.

About this time, we increased our cooperation with the design institutes having them produce all design drawings. We also stopped our on-site preliminary design meetings (which proved unpopular with our project managers). We additionally changed our control system from relay (the Chinese preference) to PLC and trained our mechanical start-up engineer to perform the control system start-up. This saved an additional 15% bringing the factor down to 0.48.

We then went to our factory and asked if they could find methods of reducing the production costs of our main equipment. They claimed the price level was already at an absolute minimum and nothing more could be done.

In a further effort to reduce price, in order to maintain sales volume and satisfy the diminishing market price, I traveled to Malaysia and located an equipment supplier who could manufacture our stainless steel process vessels and other components for 30% of our European price in one-third the delivery time (this reduced price included inspections and quality control). A slight allowance had to be made for the materials used but the quality was comparable to that of equipment made in Europe; and contrary to our factory, they managed to meet scheduled deliveries. As an aside, the additional logistical effort of obtaining the equipment in Malaysia did not negatively affect our total project price because the contracts were F.O.B. and the additional point of origin was negotiated into our supply contract.

After overcoming internal opposition (“we haven’t done that before” and “we will make enemies in the factory”) we gained management approval, and the required assistance from the purchasing department, to acquire the equipment in Malaysia. We had some problems translating the drawings into English (from German) and adapting to more international standards, but this did not radically affect production schedules. This reduced the total system price by another 15% to a factor of 0.41.

We then considered forming a joint venture with the design institute. We talked with a reputable consultant and developed a business plan. The calculated sales volume was unreasonable in its magnitude and the competitive market price of our system could not be met with the relatively high business development and expatriate expenses we would incur. And because of these overheads, the calculated price of the equipment we would produce in China would be higher than the price we were already paying for Malaysian equipment. As a result neither we, nor our partner, were sufficiently interested. Additionally, we were only producing 40% of the total scope of supply of our process internally. And with our external European-supplied component sourcing so high, we clearly could not support the JV concept by shipping low value-added, out-sourced components to China.

About this time (1993) we were hearing that increasing price pressure was coming from domestic suppliers. To us, this made sense because of Zhu Rongi’s clamp-down on domestic investment and expenditures by SOE’s. On one of our projects, on which a down payment had been made, the customer could not honor the Letter of Credit and our equipment sat at the dock with no purchaser. We were effectively powerless to force the issue with our customer due to other Chinese business interests within the company. Fortunately, we found another buyer for the system at-cost in another country.

We were then informed that local competitors were taking over the market and that something drastic was required to maintain market share. I then increased our cooperation with the design institutes turning over all initial design (except design review), construction supervision and start-up, thus, saving an additional 10% bringing the factor to 0.37.

Our China sales started to plummet. We were eventually informed that domestic suppliers had taken over the market and that the price level had dropped to around 0.24. Needless to say the import market had collapsed. We also heard rumors that our alliance partners had started delivering the entire scope of supply for this process.

When this became apparent, I shifted my focus to developing sales of another chemical process of ours to customers in other Asian markets.

It must be pointed out that, even though the profit margins as a percentage of sales remained relatively constant over this time period, the total profit generated from the previously mentioned sales and product development activities continued to fall throughout because the actual sales volume never increased enough to compensate for the less expensive process.

I have spoken with many other sales managers in the China market. And the business cycle I have just described appears to be quite common. This is the strategic “principle of importing, digesting and absorbing” utilized in China to develop a domestic technological base.

As a consequence of this learning experience, it is apparent that the profit to be made from exporting to, and producing equipment in, any rapidly developing country, such as China, comes during the interim period between a technology’s introduction and its eventual domestic diffusion and absorption. Controlling the lead time in the introduction of a technology and controlling the lag time involved with domestic development generates the ability to gain a reasonable profit. Providing the highest technology in the shortest time frame prevents a company from generating long-term income from this market and concurrently creates technological diffusion and absorption difficulties for domestic industry. A foreign company must incrementally introduce its technology into developing markets by flexibly phasing out the import content of its highest technology over time as domestic alliance partners develop the qualified ability to produce it themselves.

If a foreign company can manage to develop profitable domestic production, with supplementary export opportunities, as its technology is optimally introduced, it can consider this as a significant accomplishment. Domestic technology transfer to, and production in, China will be problematic and difficult to control in the short run, therefore, foreign companies should not raise false expectations by developing business plans, production scenarios and sales projections which are overly ambitious. Companies must also not forget that no matter how large a share of the business it owns, the Chinese industries we deal with will, either directly or indirectly, influence the factors of production and leverage them to their liking.

Over time, as China integrates into a more open economic framework, these complexities should diminish, but until this transformation takes place companies should proceed with caution.

As a foreign supplier of specialized equipment into a niche market specific to China or, for that matter, specific to any other relatively isolated market, one has no other choice than to follow the commonly stated concept of “low-price, high-volume”. One should also clearly understand that any niche market which is progressively exposed to international market forces will close out regardless of what one does with stop-gap measures aimed specifically at cost reductions. This is competitive global market dynamism. A pure cost reduction policy is clearly a last ditch effort to milk the last profits from a declining industry while alternatives are developed within a dynamically evolving market.

With sufficient perspective it is easy to see that both our company and the Chinese textile industry were dealing with the same problems. We were only observing the same phenomena from different perspectives. Our combined and integrated efforts define the reality of what was occurring in both the domestic and global markets.

It is clear that the domestic textile industry had to drastically force the price of this process to as low a level as possible. This was the only possibility of maintaining some sort of competitive positioning with regard to international markets. International markets were not burdened with China’s social concept of employment maximization and the cost burden of its decentralized production. Therefore, there was, and is, no global market basis for justifying the additional cost of the crystallization and drying process.

Synthetic fiber from foreign production using direct spinning technology is now, in a trend that must have been readily apparent to China’s former Textile Ministry economists, less expensive than China’s indigenous domestic production. Textiles are being smuggled into China. This development is destabilizing the economics of the initial decentralized production strategy of China’s planners and is undermining the very domestic producers that led the development of China’s light industry and helped create the basis of China’s economic growth since the late 1970’s and early 1980’s.

As an example of what a domestically-based foreign supplier can create when international market developments are considered in strategic planning, a Taiwanese company has now built an enormous direct spinning plant at a joint venture in the coastal region of South China. The economy of scale of this production process has significantly reduced the domestic production price of synthetic fiber (“low-price, high-volume”) and the potential for considerable profits will exist into the future, as domestic industries uncomfortably adapt to the economics of this new global production practice.

One can see many similar ongoing examples of the transition which took place in China’s textile industry. An analogous situation is the current structural change taking place in fertilizer production where outdated and inefficient coal-based urea production is being displaced by modern, large-scale and economically efficient natural gas-based production. Once farming methods can be modernized to accept direct field injection of ammonia fertilizers, urea production will also become a redundant step in a complex integrated agricultural process. And eventually more sustainable agricultural practices could displace ammonia. Such market-driven transitions require controlled structural change in order to maximize economic benefit and minimize social dislocation.

Thus, no country, or industrial sector, can indefinitely remain independent from the realities of the global economy if it wishes to play a part in that economy. Therefore, as (or if) markets continue to open, countries should increasingly integrate their global industries into the international economy using the most cost-effective technological processes available while strategically adapting domestic industries to rapidly growing internal market structures. Concurrently, and perhaps conversely, this has to be done with a “human face” in order to prevent social polarity and disparity.

In China’s case this global adaptation requires significant structural modifications to upgrade State-Owned Enterprises, originally developed purely for domestic production in a closed society, to tomorrow’s international standards. Domestic structural adaptations should be incrementally developed through enlightened central government policy. Globally oriented “strategic pillar industries” require rapid development and integration into an international market structure. This development has to be based on modern, efficient infrastructure. Due to China’s political, economic and social structure, a multi-level, macro-economic, infrastructure adaptation requires a high degree of coordinated central planning, policy making - and funding.

The primary difficulty in adapting to dynamic structural change would appear to be posed, not by the ability to acquire up-to-date technology, but by the difficulty of diffusing modern technology into greater Chinese society, which has up to now been insulated from a modern, market-based economic/technological paradigm. Modern technology and the economic principles associated with it can not be easily separated from the social and mental processes which created them.

As seen in the body of this paper, it is not the ability to just obtain the most modern technology, but the ability to obtain, diffuse and propagate the most cost effective, economically sustainable technology, suited for tomorrow’s global market applications, that determines global economic competitiveness. And can thereby provide the domestic ability to create wealth for social stability and economic welfare.

As foreign companies operating in China we are part and parcel of the same dynamic, interactive system of political economy. Therefore, it would appear that the “key to success” is in learning how to work cooperatively with our Chinese counterparts, at a higher level of business understanding, as we mutually experience productive adaptation to the changes occurring in this dynamic market environment.

Author’s note: It is now early on in the year 2005 and it is readily apparent that the Chinese strategy was not one of just “import, absorb and digest” but rather one of “import, absorb, digest and then export” – ultimately, back into those same countries, and against those companies, that provided the initial technology and management expertise to the Chinese market. Thus, not only has China been the demise of many a company, it has also hollowed out the manufacturing base of the former industrial powers. This has been accomplished by a system that condones and supports the theft of intellectual property on a truly grand scale.
With regard to synthetic fibers we can see that China has undertaken a massive industrialization scheme to achieve global economies of scale and market domination. The only significant drawback to Chinese development strategy is that primary infrastructure can not readily keep up with galloping industrial growth. However we must not forget what Lenin stated: “The West will give us the rope with which we will hang them”. China is still a communist country and will remain a paradox. If one does undertake to invest in China, it is best to have a cautious approach, a conservative implementation plan and an excellent exit strategy. The exit strategy should be capable of being initiated at any point along the implementation or operational path. The worst case scenario should be one based on the failure of finance capitalism and reversion to a more primitive mercantilist system.

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