China - Electronics sector report

Report No. 7962-CHA China Electronics Sector Repcrt June 21, 1990 Industry and Energy Operations Division China Department Asia Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Name - Renminbi Currency Unit - Yuan (Y) US$C.c3 = Y 4.72 Y 1.00 = US$0.21 (as of April 1990) /a FISCAL YEAR January 1 - December 31 GLOSSARY OF ABBREVIATIONS ASICs - Application Specific Integrated Circuits c.i.f. - cost, insurance and freight CAD - Computer Aided Design CAE - Computer Aided Engineering CIM - Computer Integrated Manufacturing CMRS - Contract Management Reponsibility System CEEI - China Electronics Export and Import Corporation CTV - Color Television DRC - Domestic Resource Cost EEC - European Economic Community ERP - Effective Rate of Protection IC - Integrated Circuit JIT - Just-in-Time Manufacturing MEI - Ministry of Electronic Industries MMEI - Ministry of Machinery and Electronics Industries NIEs - Newly Industrialized Economies PCB - Printed Circuit Board TPM - Total Preventive Maintenance TQC - Total Quality Control /a The exchange rate for the Renminbi vis-a-vis the US dollar was changed in December 1989 to US$1.00 = Y 4.72. However, the currency translations in the report are for periods prior to December 1989, and hence use the previous exchange rate of US$1.00 = Y 3.72.  - i - FOR OFFICIAL USE ONLY CHINA ELECTRONICS SECTOR REPORT Table of Contents Page No. EXECUTIVE SUMMARY ............................................. i-vi I. THE GLOBAL ELECTRONICS INDUSTRY ............................... 1 A. Introduction .............................................. 1 B. Major Industry-wide Trends in the Global Electronics Industry . .. 1 C. Emergence of the NIEs . . . 4 D. Implications for China . . . 9 II. RECENT TRENDS, POLICIES AND PERFORMANCE IN CHINA'S ELECTRONICS INDUSTRY ...................................... 18 A. Introduction .............................................. 18 B. Historical Development of China's Electronics Industry and Recent Trends ....................................... 18 C. Broad Government Strategies and Polici3s in Electronics... 20 D. Impact of the Policy Regime on Industrial Performance and Behavior ............................................ 24 E. Comparison of China's Industry with the NIEs .............. 27 III. THE COLOR TELEVISION INDUSTRY IN CHINA ................. ....... 40 A. Introduction .. .. . ............................ .. 40 B. The Global Color Television Industry . . 40 C. The Development of China's CTV Industry . . 41 D. International Competitiveness of China's CTV Industry ..... 42 E. Obstacles to International Competitiveness . . 52 F. Options for Improving Competitiveness . . 54 IV. ELECTRONIC COMPONENTS . . . 78 A. Introduction . . ........78 ................................... 78 B. Active Components .. 78 The Global Industry .... . 78 Development of China's Active Components Industry ....... 80 Competitiveness of China's Industry ..................... 81 Options for Improving Competitiveness ................... 82 C. Passive Component3 .................................... ... 83 The Global Industry .. 83 Development of the Passive Component Industry in China.. 84 Competitiveness of China's Passive Component Industry ... 84 Options for Improving Competitiveness ................... 85 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Page No. V. COMPUTERS..... ..... ....... ...... 95 A. The Global Computer Industry ..................... .......... 95 B. The Development of China's Computer Industry .............. 97 C. Current Strategy, Obstacles and Outlook for China's Computer Industry ....................................... 98 D. Policy Issues Affecting China's Computer Industry ......... 101 VI. OEERALL ISSUES AND OPTIONS FOR THE FUTURE ..................... 114 A. Introduction ......................... 114 B. Industry-wide Issues ..... ............................ . 115 C. Industry-Specific Policies and Programs ............... 118 This report was prepared by D. Mans (principal author), D. Bateman, A. Mody (PPR), A. Miller, M. Ripper, W. Schweikert (Consultants) and S. Krishnan (AS3IF). Research assistance was provided by Yue-Qin Li. The report is buised on the findings of a March 1988 Bank mission to China, and on a 1988/89 study of China's color televisiun industry by a joint working group from China's Ministry of Machinery and Electronics Industries (MMEI) and the Bank.  - iii - LIST OF TEXT TABLES AND FIGURES CHAPTER I Figure 1.1 - Comparative Employment by Industry, US. 1977-86 Figure 1.2 - Interdependenca of Electronics Subsectors Table 1.1 - Data Processing Revenues, US Computer Firms Table 1.2 - Global Electronics Production Table 1.3 - World Electronics Trade Balance: $ Billion Table 1.4 - Internaticnal Comparison of Annual Percentage Growth in Electronics Output Table 1.5 - Value of Exports (In millions of US dollars) and Share of Global Exports (in percentages) for Major Trading Economies in 1982 Table 1.6 - Recent St ategic Alliances of Korean Firms CHAPTER II Table 2.1 - Historical Growth Rates in Electronics Table 2.2 - Product Structure of Electronics Table 2.3 - Total Electronics Output Value in top 5 Regions Table 2.4 - Size Distribution of Consumer Electronics Firms Table 2.5 - International Comparison of Electronics Prices Table 2.6 - Effective Rates of Protection in Electronics Table 2.7 - Comparative Data on Production, Imports, Exports, and Markets for Selected Electronics Producing Countries CHAPTER III Table 3.1 - Projected Worldwide Television Demand, 1990 Table 3.2 - Major CTV Manufacturers Worldwide Table 3.3 - Consumer Durable Ownership in China Table 3.4 - Number of Television Sets in China Table 3.5 - Annual Television Demand in China: Projected at the Beginning of the Seventh Five-Year Plan Table 3.6 - Major TV Projects Planned in the Seventh Five-Year Plan Table 3.7 - CTV Production in 1986 Table 3.8 - Size of Sample and Benchmark International CTV Producers Table 3.9 - Recent Growth of Sample Firms Table 3.10 - Structure of Ex-Factory Costs for a 14-Inch Color Television in China and Internationally Table 3.11 - A Comparison of Per-Unit Material Input Costs for a 14-Inch Color TV Table 3.12 - A Comparison of Per-Unit Overhead Costs for a 14-Inch Color TV Table 3.13 - Summary of Components of Working Capital Cos-cs Table 3.14 - Hourly Wage Rates for Production Workers in Electronics, 1988 Table 3.15 - Summary of Wage Costs, Per-Unit Labor Costs and Labor Productivity for 14-Inch Color TV Production, 1985 Table 3.16 - Retail Prices, Taxes and Profits in the Domestic Market Table 3.17 - DRC Ratios for 14-Inch C.olor TV Production in China  - iv - CHAPTER IV Figure 4.1 - Rapid Rate of Technical Change in Integrated Circuits Table 4.1 - Worldwide Semiconductor Output, 1987 Figure 4.2 - Integrated Circuit Capacity Utilization Table 4.2 - Annual Production by Category of Active Components Table 4.3 - Technological State of the Art in Shanghai's Semiconductor Industry Table 4.4 - The Market for Active Components in 1985 Table 4.5 - The Market for Passive Components Figure 4.3 - Passive Component Competitors by Segment - 1987 CHAPTER V Table 5.1 - Computer Production and Markets Figure 5.1 - Worldwide Computer Usage Table 5.2 - Top 5 Computer Firms Worldwide by Product Segment Figure 5.2 - U.S. Shipments of Mainframes antd Microcomputers Table 5.3 - U.S. Spending on Research and Development (1986) Table 5.4 - Computer Usage in Selected Counteries (end-1987) Table 5.5 - Installed Base of Computers in China Table 5.6 - Market Forecast for Microcomputer Sales in China (1989-91) Table 5.7 - Production Volumes of Computers and Certain Peripherals in China Table 5.8 - Installed Computer Base in China by Uaer Group CHAPTER VI Figure 6.1 - Recommendations on Key Policy Issues in Electronics  EXECUTIVE SUMMARY i. This report is intended to provide GOC and the Bank with an analysis of the main issues and options facing China's electronics industry. Chapter I examines the major trends in the global electronics industry that are relevant for China. Chapter II looks at recent overall trends, policies and perfor- mance in China's electronics industry. It provides a broad overview of the critical issues facing China's industry. Chapters III to V look in detail at international competitiveness of three key subsectors of electronics: color televisions, components and computers. Chapter VI, the final chapter, pro- vides some concluding thoughts on the major strategic and policy issues facing China in electronics and briefly summarizes suggestions made throughout the report for the kinds of measures that are essential if China is to become a successful player in the global electronics industry. The Global Electronics Industry ii. In the last 20 years, world production of electronics has grown more rapidly than any other category of industrial production. The electronics industry is expected to continue to experience very high rates of growth worldwide because of the increased use of existing electronics products, par- ticularly in developing countries, the development of new electronics products and services and the spread of electronics technologies througbout the global economy. It also is characterized by rapidly changing technologies that have dramatically reduced product life cycles; in many areas of electronics research and development costs (R&D) are high and rising. Rapidly changing technology and increasing product differentiation in electronics have intensi- fied global competition in the industry. iii. Under such conditions, no single company, or even any single country, is capable of being entirely self-sufficient in electronics. For high tech- nology products, strategic alliances among firms increased in electronics as a means to acquire needed technologies, and to share R&D and manufacturing costs and expanded access to markets with other major players in electronics. For less sophisticated technologies, global sourcing of parts, components and sub- assemblies has become commonplace in electronics. Manv developing countries have become major suppliers of such items to the world market. iv. The postwar trend of offshore manufacturing in electronics opened up opportunities for many newly industrialized economies (NIEs), especially those in East Asia, to establish basic capabilities as manufacturers of less sophis- ticated, labor-intensive electronics products. Those countries established solid reputations for being able to meet the technical specifications, product quality and cost requirements of the international market. However, sourcing decisions today are not influenced by these factors alone. Increasingly, it has become important that global suppliers be able to provide services related to design, testing, component qualification and prototyping capabilities and access to markets. The more successful NIEs have achieved these capabilities and managed to build an electronics base that would support moving up the ladder of value added. This has opened up very attractive export opportuni- ties in low-end products to countries like China provided they are able to be  - ii - competitive with respect to delivery requirements, and product quality, price and performance. v. The NIEs have pursued very different strategies in electronics to achieve these capabilities. For China, it is instructive to look at these different strategies to see what lessons could be applied at home. Looking at the success cases among the NIEs, Taiwan, China and South Korea stand out. On the other hand, India and Brazil have followed strategies that have resulted in much less success judging by their manufacturing and technological capa- bility, and export performance. There are at least five key lessons to be learned from a comparison of the experiences of these NIEs in electronics. vi. First, rather than pursue across-the-board import substitution through electronics, a careful approach to product sequencing has been impor- tant in the more successful NIEs. This has allowed them to put in place all the basic building blocks for the industry before moving up the ladder of value added in electronics, i.e., before moving into more sophisticated elec- tronics products, they had succeeded in establishing a reliable supply of basic components and production equipment, rigorous quality standards, and the ability to successfully assimilate imported technology. Second, policies to encourage strong domestic competition and a viable industry structure have enabled firms to achieve the necessary economies of scale, specialization and diversification and provide incentives for efficiency and sustained productiv- ity growth. Third, while protection from imports has been common to all the NIEs, a strong export orientation has played a critical role in fostering a dynamic electronics industry. Fourth, in the successful cases, foreign involvement in the industry was well managed to provide continuous access to strategic technologies, a channel for exports and in some cases a force for greater competition in the induatry. Fifth, mechanisms to facilitate thn development of local technological capability have been absolutely essential. Local efforts to assimilate and improve upon foreign technology at the firm level and through R&D institutions with strong links to manufacturers have been common in the successful economies. China's Electronics Industr! vii. As is the trend worldwide, China's electronics industry has been growing at a rapid rate since the 19509, well above the growth rate for indus- trial value added as a whole. While the electronics industry has its origins in military applications, its recent rapid growth hap been mainly fueled by a boom in civilian applications, especially consumer electronics. This growth has accompanied a major devolution of control over electronics enterprises by the Ministry of Machinery and Electronics Industries (MMEI) to local govern- ments. The geographical distribution of production also has broadened. The coastal regions of China account for the majority of China's total electronics output, with Jiangsu and Guangdong provinces growing much faster than the tra- ditional centers of the industry in areas such as bhanghai Municipality and Sichuan province. viii. Government strategy in electronics has been largely subsector focused with the low- and medium-end of consumer electronics being designated as the major engine of growth for the entire industry. There also are pragmatic plans for promoting other subsectors of electronics, particularly integrated  - iii - circuits because they are essentia. building blocks for all of electronics. These strategies have been supported by a set of policies geared primarily toward increasing the degree of import substitution because of the inability of most of the industry to meet iomestic requirements. ix. The policy regime in electronics, together with strong domestic demand, has facilitated rapid output growth, broadening of the product struc- ture and major changes in the location of production. However, these policies also have led to a high degree of industrial fragmentation, high product prices, low economic efficiency in many parts of the industry and rapid growth in the electronics trade deficit. This is unfortunate because of China's potential competitive advantages in electronics, including lower factor costs compared with the NIEs, China's much larger electronics market and a large pool of technical manpower. For several reasons, China has not been able to use these advantages to achieve the static and dynamic efficiencies that ar3 so important in electronics. First, there is a high degree of industrial fragmentation in electronics. Moreover, the product structure in electrontrs is much less developed in China, which has limited the economy-wide impact of the benefits of electronics technologies. In addition, technology development has been slow in China. The report notes that these deficiencies reflect problems with the choices China has made with respect to product sequencing, competition policy, foreign investment and technology development and infra- structure for electronics. Chapters III to V look at these issues of govern- ment strategies, policies and competitiveness in the three key subsectors of color televisions, components and computers. Together, these three subsectors account for over 80S of total electronics output in China. The Color Television Industry in China --. Despite the rapid development abroad of technology in the CTV indus- try at the high end, there are good opportunities for China to become a major exporter of CTVs. Moreover, China's internal market for CTVs is enormous; it is the second largest CTV market in the world. Unfortunatelv, China has yet to fully exploit the advantage of its large internal market as the basis for achieving a degree of competitiveness that would enable it to be a significant exporter. xi. China's CTV industry is very inefficient. The major reasons are: a shortage of, and high prices for, key parts and components, low capacity uti- lization, very high inventories of raw materials, low plant efficiency, poor product quality and limited product technology. The major issues to be addressed if China is to become competitive in this industry are the: need for price reform; availability, pricing and allocation of key raw materials; need for consolidation within the industry, including the exit and amalgama- tion of unviable manufacturers; distortions imposed by the foreign exchange control system; and absence of product standardization in the industry. While plant-level actions should be taken by the leading CTV manufacturers, these would be fully effective only if the systemic industry-wide issues are addressed.  - iv - Electronic Components in China xii. The subsector producing active and passive electronic components is vital to all of the electronics industry. Among the active components, the integrated circuit (IC) industry is the most rapidly expanding segment because ICs are the basic building blocks of nearly all electronic e'quipment. Their increasing sophistication allows greater scope for integrating more of system design into ICs, giving firms a competitive advantage in final equipment. Increasingly, world leadership in many areas of electronics depends on innova- tions in IC technology. It also is the most R&D intensive segment of elec- tronics --d is characterized by high and rising R&D costs. xiii. I IC industry has bee.a given priority in China and is growing rapidly. tuch effort is going into acquiring advanced technology through joint ventures and licensing. However, ICs in China tend to: embody technol- ogies that are out of date and be expensive compared to international prices. This reflects two major problems. First. like other areas of electronics in China, there are too many srall producers who are unable to realize scale economies. Second, too much effort has gone into the manufacture of commodity ICs, areas where China really has little chance of becoming internationally competitive in the medium term.. To overcome these problems, China needs to: (a) restructure its IC industry, including a consolidation of existing manu- facturers and a restructuring of relationships between systems designers and component makers, including mergers between the two; and (b) move into the are.-. of application specific irtegrated circuits, restructure much of the existing industry around this approach and be content to continue to rely on imports of commodity ICs. xiv. The segment of electronics pro :,g passive components includes a broad ran,ge of components that are widei, .sed in electronics. Many of them are fairly labor in.tensive and are produced at competitive prices in China. Moreover, world demand for these products is large and growing at 5-10Z p.a. However, China's exports are insignificant in the brisk world trade for these components which is dominated by other developing countries. Even though China is price competitive in many passive components, low and variable prod- uct quality and poor service levels are the reasons most common'.y cited by overseas buyers for lack of interest in components made in China. These prob- lems would have to be addressed if China is to become a major exporter of pas- sive components. Encouragingly, there is evidence that increasing domestic and import competition and the demands placed on local component manufacturers by end users are driving China"s producers to improve product quality and com- petitiveness. However, this needs to be supported by improving product stan- dards, and upgrading process and test equipment and the supply of critical raw materials used in this subsector. Computers xv. Global competition in the computer industry is primarily based either on innovation and product differentiation, as among larger computers, or on commodity pricing, as with microcomputers. China's computer industry could attain competitiveness in the near term in the lower end of the market, with effective sourcing and efficient production being necessary preconditions for success. There also are significant opportunities in the areas of system  - v - Integration and specialized software, particularly in the domestic market but also to some extent in the international market, provided China can establish the required business and communications links with foreign fi-ms. The domes- tic computer industry currently is plagued by a high cost structure due to expensive components, inefficient scales of production and poor factory pro- cesses. Market development efforts also need to be enhanced, and telecommuni- cations and other supporting infrastructure further developed. The efficient development of the industry will largely depend on the policy regime within which it operates, with the primary issues being pricing, competition, indus- try restructuring, copyright protection, and the foreign exchange system. Overall Issued and Options xvi. The experiences of other countries demonstrate that success in elec- tronics requires a framework that encourages competition, especially at home and in export markets, the requisite economies of scale and scope, as well as mobility of goods, people and capital in order to achieve efficiency and the kind of flexibility and innovativeness that is so critical in electronics. To take advantage of the opportunities that exist in the global market, the industrial policy framework should ensure that electronics firms are focused on market-oriented R&D, have the capability to do long-term product planning and respond to shifting market needs, and are committed to the cost, quality, delivery and service requirements of the demanding international market. This also has to be supported by effective supplier networks that permit competi- tive sourcing of parts and components. xvii. In many respects, China lacks this broad framework, although much has been done recently to improve it. For example, emphasis has been placed on the creation of large group companies to spearhead China's drive toward inter- national competitiveness and on expansion of production capacity in certain areas, especially parts and components, where China cannot produce enough to meet demand. However, many of the group companies that have been formed are mere administrative arrangements. Such groups are incapable of carrying out the kind of enterprise and plant restructuring needed to operate in a competi- tive environment. Other models of industrial organization and restructuring need to be considered and there are some useful examples within electronics in China as well as in other countries. The planned major expansions of capacity should be guided by the need to be internationally competitive with respect to price and performance, as China's export competitors in final equipment mar- kets are able to competitively source their components un a global basis. Without policy reforms, however, there are real limits on the degree of compe- titiveness t..at can be achieved through industrial restructuring, enterprise reform, and the establisbment of new capacity. xviii. Most importantly, there is a need to directly tackle the missing elements of the broad industrial policy framework de 'ribed above. Competi- tion policies merit priority consideration. China must address those impedi- ments to strong domestic competition including price controls; administrative controls over the allocation of materials; and obstacles to sorely needed industrial mergers, exit and entry in electronics. Equally important is the need to promote external competition, including rationalization of the struc- ture of tariffs, overhaul of the system of quantitative restrictions, address- ing the distortions imposed by the foreign exchange control system and the  Vi - limitations on exports imposed by the jystem of foreign trade and the inade- quacy of export financing mechanisms. While these are Issues t.at are rele- vant throughout the industrial sector, they are particularly critical in elec- tronics because of the inherent dynamism of the industry and the need to strive for international competitivenese from the very start in electronics. By not addressing these issues, there is a real danger of 1x"posing high costs throughout the economy, given the increasingly pervasive role electronics plays in economy-wide productivity grcwth. Iu addition, improvements ate needed in the approaches that have been taken to technology development, par- ticularly the management of foreign investment, given the need for continuous access to foreign electronics technologies and the importance of internation- alizing the electronics industry. Finally, there is an lrgent need to improve interindustry linkages in electronics and to give greater attention to provid- ing the infrastructure support needed in electronics, including standards, standardization where needed to get scale economies. product certification, worker training programs, and provision of basic electronic materials. xix. Until now, China's electronics industry has registered rapid growth rates almost entirely based on its large domestic market. However, the indus- try faces the challenges of providing a wider scope of technologies that would increase the use of electronics throughout the economy and exploiting the export opportunities available to Chkia. At the same time, greater attention needs to be placed on facilitating tne use of electronics throughout the econ- omy without insisting that China be self-sufficient in all areas of electron- ics. Implementation of measures along the lines suggested in this report would allow China to capitalize on its strengths in electronics and meet these challenges, and thereby enter the ranks of those NIEs that have been so suc- cessful in the global electronics industry.  - 1 - I. THE GLOBAL ELECTRONICS INDUSTRY A. Introduction 1.1 This chapter provides an overview of major trends in the global elec- tronics industry as background for understanding the issues and options facing China's electronics industry. Section B describes recent worldwide trends in electronics related to growth, technical change, competition and sourcing. Section C discusses the emergence of the newly industrialized economies (NIEs) as important players in the global electronics industry. Section D notes the implications of these major trends in electronics for other emerging electron- ics producers like China. B. Major Industry-wide Trends in the Global Electronics Industry 1.2 Growth of Electronics. Worldwide output of electronics, which includes electronic components, consumer electronics, and industrial electron- ics, is estimated at about US$500 billion in 1986, or about 5S of global gross domestic product. Worldwide, electronics is the fastest growing subsector of industry. Since 1965 the output of the electronics industry has grown at an average rate of 13S a year--higher than any other segment of industrial pro- duction. In the post-war period electronics has been the fastest growing subsector of industry in the industrialized countries and in many developing countries as well. It also has been one of the fastest growing categories of industrial exports and employment in the w- ld. In the US, for example, elec- tronics has registered the highest growth rate of employment among all catego- ries of industry during 1977-86 (see Figure 1.1). The electronics industry is expected to grow at least twice as fast as global GDP in the 19909 because of increased market penetration by existing electronics products, the development of new products, and the spread of electronic technologies to other indus- tries. Because of its importance to competitive advantage in so many sec- tors, electronics is expected to become the largest segment of global industry by the year 2000. 1.3 The rapid growth and dynamism of the electronics sector is the result of at least three major trends. First, the pace of technical change has accelerated. The technological frontier in electronics has shifted outward, reducing product life cycles from five years to less than three years. The development of software in particular has grown in importance because it is providing a larger proportion of the value of electronics products as improve- ments in manufacturing reduce the costs of hardware. It is also broadening the application of electronics,throughout the economy. Second, rapid develcp- ment of technology and increasing product differentiation have intensified competition and upset leadership rankings in the industry. It has also opened up opportunities for new entrants to become global sources of more labor- intensive, less sophisticated parts, components and even complete sets of equipment. Third, while the trend of offshore manufacturing has helped some developing countries become important electronics producers, procurement deci- sions are no longer based on minimizing labor costs but on providing greater customization in design and reducing the time it takes to get new products to market. This also has contributed to the dynamism of the industry.  1.4 Technical Change. The reduction in product life cycles in electron- ics is due to the rapid development of new products and processes. Moreover, there is growing interdependence among key subsectors of electronics. Manu- facturing techniques, tools and products from one segment of electronics are rapidly spilling over to other electronic subsectors, leading to the rapid development of new electronic products and sources. Product and manufacturing capabilities across all subsectors of electronics are being enhanced by advances in semiconductors, computer-aided design and engineering, communica- tions networking, optical storage, production automation and softwarelintelli- gent control (see Figure 1.2). Increasingly, manufacturing processes are becoming automated. The focus of many efforts at innovating the manufacturing process is shifting from islands of automation towards the systematic integra- tion of production, design and control and computer integrated manufacturing (CIM). Moreover, R&D costs in many areas of electronics are high and rising, which often leads to large and rising economies of scale as firms seek to amortize their R&D costs over larger volumes of output. 1.5 These developments make it impossible for any one company, or even any single country, to be self-sufficient in developing technology. Conse- quently, in advanced electronics and microelectronics especially, many of the major players are establishing strategic alliances with other firms, including those of other nations, to acquire needed technologies and to share R&D and manufacturing costs and expanded access to markets. Now there are major stra- tegic alliances based on technological exchanges, joint ventures, and joint R&D, production, marketing and distribution between various firms. 1.6 The development of software has been a particularly important techno- logical trend in electronics. Software is providing a greater share of the value of wide range of electronics products because improvements in manufac- turing and semiconductor technology are reducing the costs of the hardware base while system design, engineering and integrtLAon capabilities have become critical to the ability to develop new products and services and achieve greater customization. Software development and systems engineering are areas that are crucial to increasing the use of electronics in the economy. They also are still relatively labor intensive areas and provide developing coun- tries that possess relatively low cost engineering talent with important opportunities in export as well as domestic markets. 1.7 Competition. Rapid technology development and product differentia- tion has been central to the way in which competition has evolved in electron- ics, particularly through its influence on economies of scale and scope. Firms have attempted to recover fixed R&D costs through higher production volumes and by developing a wide array of products using technology developed in R&D. Consequently, the rapid development of technology has stimulated competition and changes in industry leadership over the last decade. In semi- conductors, for example, Japanese firms have riean to dominant positions in key markets, and considerable changes have taken place in industry rankings in the US, where two of the five largest manufacturers did not even exist fifteen years ago. As another example, in computers IBM continues to dominate the industry, but industry rankings have changed dramatically with the merger of Burroughs and Sperry, the emergence of firms like Hewlett-Packard and Wang, and the rapid growth of DEC (see Table 1.1). Much of this realignment also stems from the emergence of new firms to capture major market share in new  products (e.g., Apple, Sun and Apollo in computers) and the retreat or acqui- sition of established firms whose market shares have been challenged by new entrants. 1.8 Although technology development is a central feature of competition in electronics, technological leadership is not a precondition of success in the industry. In computers, for example, some units are sold on the basis of their ability to be integrated with other systems rather than on their state- of-the-art hardware. In mature consumer electronics products, a solid know- ledge of basic technologies and consumer preferences are required to develop products which offer enough value to the consumer to generate replacement purchases. The keys to success in this segment are total commitment to prod- uct quality, high brand awareness and control of manufacturing costs. In most areas of electronics manufacture, the ability to reduce time-to-market, inven- tories, throughput time, and production, distribution and marketing costs are even more critical to competitiveness than technological leadership. In fact, rapid development of technology has opened up significant export opporttui- ties, particularly for less technologically sophisticated products, to those developing countries that have these capabilities. Apart from rapid technical change, organizational innovations such as Just-in-Time (JIT) inventories, Total Quality Control (TQC) and Total Preventive Maintenance (TPM) are becom- ing essential to international competitiveness in electronics. 1.9 Sourcing. While rapid technology development has provided some developing countries with opportunities to export low-end products, the pro- curement or sourcing of parts, components and subassemblies in electronlcs is no longer determined primarily by labor costs as it was in the 1960s and 19709. At that time, the need to reduce labor costs led many US and European electronic companies to implement major off-shore manufacturing programs in the Republic of Korea, the Philippines, Mexico, and Malaysia. This phenomenon was critical in establishing an electronics capability in these countries. Now, because of automation, the decreasing labor content of electronic prod- ucts, and their increasing technology content, success for suppliers depends more on increasing technology and service capabilities. Procurement decisions are increasingly based rot just on the cost competitiveness and ability of suppliers to meet technical, delivery and quality standards, but also on their ability to provide design, testing, component qualification, failure analysis and prototyping capabilities as well as access to local markets including enhanced distribution networks. Therefore, electronics suppliers now tend to become involved much earlier in the development of the customers' end-product technology, and the absolute number of suppliers 's expected to decline as well. 1.10 In many areas of electronics, materials account for a large share of production costs. For example, the cost structure for products such as com- pact discs, color televisions, personal computers and word processors typi- cally consists of 70Z material, 5? direct labor, and 25? other costs such as indirect labor, buildings and interest. Changes in product design, simplifi- cation of manufacturing processes, and automation have greatly reduced product costs and reshaped the product cost structure itself by increasing the cost of materials relative to conversion costs (i.e., the cost of transforming input materials into an end product). For example, in 1969, it took 12.5 hours to  - 4 - assemble a color television. Today the process takes approximately 60 min- utes. In general, the cost of conversion has been reduced by factors of ten over the last decade for many electronics products. These time savings have been achieved mainly by automation, reducing the number of parts to be assem- bled, and an increase in the complexity of components and subassemblies. In effect, the distribution of value added has shifted toward the component stage, further raising the share of materials in total costs. The cost of components has become the major element in the cost structure of modern elec- tronic products. 1.11 While some vertical integration exists within the major electronics manufacturers, complete integration is not possible. A central strategic problem for the manufacturer, therefore, is to find the right balance between encouraging technology development among suppliers and investing in vertical integration. As an alternative, many firms are building as much as possible from standard parts while developing a proprietary advantage in certain criti- cal parts such as chips or circuit boards. These critical parts that are made in-house or by suppliers who are encouraged to develop technology for them. This practice has reduced the number of suppliers used by final product manu- facturers and is encouraging manufacturers to become involved earlier on, and develop stronger relationships, with suppliers. These trends related to glo- bal sourcing underscore the importance of technology development, flexibility and customer responsiveness on the part of global supplie_s including the NIEs. C. Emergence of the NIEs 1.12 As shown in Table 1.2, the United States, Japan, and Western Europe together account for about 90? of global electronics production. The United States contributes about 48X, Western Europe 212, and Japan 19X. Although it accounts for only 192 of global electronics production, Japan is a dominant force in the industry. Japan's strength in electronics is demonstrated by the strong trade surpluses it runs with all the major regions of the world (see Table 1.3). However, even though the United States, Western Europe and Japan dominate global electronics production, growth in electronics output has been highest for the developing country market economies, particularly NIEs of East Asia (see Table 1.4). 1.13 In consumer electronics, for example, they supply over 70? of the world market for radios, over 50? of the world market for audio tape recorders and monochrome televisions, and more than 10? of color television exports. The NIEs also are major world suppliers of electronic parts and components, where they account for over 20? of US imports, and with the addition of Malaysia, over 502 of US imports of solid state devices. In 1982, for exam- ple, the East Asian NIEs accounted for over 601 of the developing world's share of these electronic exports and about 10? of global electronics exports (see Table 1.5) and these shares have since risen. As can be seen in Table 1.2, electronics production in South Korea, Taiwan, China, Hong Kong and Singapore together accounted for about 7? of global electronics output in 1986, in part reflecting a high degree of offshore manufacturing by US and Japanese producers that have turned to the NIEs for low-cost manufacturing.  1.14 The NIEs are expected to achieve the highest growth rates in elec- tronics because of increasing demand for electronics at home as well as for export and because they are moving up the ladder of value added as their tech- nological capabilities increase. Electronics markets in those countries, particularly the markets for consumer electronics and communications, have grown rapidly because of increased domestic demand. Moreover, production of electronic components has shifted between US and Japan on the one hand and the NIEs on the other as technology and exchange rates have altered. 1.15 While the Japanese model of value-added migration has been adopted in varying degrees by many of the NIEs, the electronics strategies followed by the NIEs have varied substantially. For example, South Korea, Taiwan, China, India and Brazil, the newly industrialized countries that are the most advanced in developing their electronics industries, pursued very different approaches with respect to trade orientation, product sequencing, industry structure and competition policy, the role of foreign involvement and technol- ogy development. 1.16 Trade Orientation. From the beginning, Brazil and India have pursued strategies for electronics that have focused primarily on manufacturing a wide range of electronics products for the internal market. Exports have not played a prominent role the electronics strategies of those countries because of the inward-looking nature of policies to support the industry, based on a desire to achieve technological self-reliance and the false perception that the domestic market was large enough to sustain the industry. Consequently, both countries pursued a strategy of across-the-board import substitution in electronics. Taiwan, China and South Korea, on the other hand, chose early on to base their strategies on penetration of global markets as the main engine of growth for electronics since their domestic markets were correctly per- ceived as being too small to structure an industry around. On the other hand, all four of these countries have followed very restrictive policies related to imports. In the case of Taiwan, China and South Korea, such policies have been effectively used to provide firms with an opportunity to move down the learning curve and export. In Brazil and India import protection has only encouraged inward-looking behavior of firms, reinforced excessive industrial fragmentation and removed incentives for the kind of intra-industry speciali- zation that has been so important in South Korea and in Taiwan, China. 1.17 Product Sequencing. Product specialization and sequencing have been important aspects of electronics development in South Korea and Taiwan, China. Initial efforts to develop electronics in those countries focused on produc- tion of basic components. In the late 1960s and 1970s, both South Korea and Taiwan, China embarked on labor-intensive production of basic electronic com- ponents where they were able to achieve economies of scale in the production of a wide variety of products. In addition, both countries subsequently developed a number of supporting industries (e.g., production equipment for basic components and injection moulding capability) that provided the founda- tion for developing an end~ products industry, i.e., consumer electronics tar- geted at penetrating foreign markets for mass products like televisions (and more recently microwave ovens and video tape recorders). Now firms in South Korea and China are quickly moving into the high technology areas of semicon- ductors and computers. By contrast, India and Brazil never had a clear strat- egy of product sequencing, having chosen to develop simultaneously a number of  segments of electronics with the result that much of the basic infrastructure for electronics and intra-industry linkages remain weak. For example, the component base and industry for capital goods used in electronics, and links between components and final equipment and between various key segments of final equipment (e.g., telecommunications and computers) are very weak in Brazil and India. 1.18 Industry Structure and Competition Policy. Industry structure in electronics varies considerably among the four countries. In South Korea, the electronics industry has been dominated by a few well-financed firms that are highly diversified across the electronics industry. The financial backing and high degrees of vertical and horizontal integration of those conglomerates have allowed them to: do long-term strategic planning across the related activities of the company and commit substantial resources to those plans; establish scale economies in production, marketing and R&D and quickly move technology developed in-house to production; integrate backward into sophisti- cated components using internal requirements as stable sources of demand, thereby giving the firms greater value added, control over input materials and greater freedom in formulating product strategies. By contrast, in Taiwan, China, the industry is made up of a large number of firms of limited size. Ulowever, most of these firms belong to large group companies which has helped to promote some of these linkages. But while Taiwanese firms have been able to achieve economies of scale in a narrow production sense, they tend to be at a disadvantage vis-a-vis South Korean firms in being able to attain the neces- sary organizational, R&D, pecuniary scale economies. In both countries, but especially in South Korea, inter-firm rivalry in domestic as well as export markets has been a powerful competitive stimulus for improving production costs, quality, variety, delivery and time-to-market. 1.19 In India, industry structure in electronics is highly fragmented. Licensing and other regulatory policies were used to reserve some sectors for particular types of firms. For example, up to the early 1970s the consumer electronics industry was dominated by small-scale industry supplied by an indigenous small-scale components industry; large scale public sector firms were permitted to dominate and in some cases monopolize key areas in indus- trial electronics. In India, firms typically operate at much lower levels of capacity and with a much broader spectrum of products than their international counterparts because of limited external and internal competition. However, the government has recently begun to address these problems of scale and lack of interindustry linkages and specialization by starting to delicense produc- tion. However, India's electronics industry continues to receive a large measure of protection from competing imports through the use of high tariffs. In Brazil, the computer and component subsectors also are characterized by excessive fragmentation, with a large number of firms operating at suboptimal scales of production also because of limited competition. The consumer elec- tronics industry (see para. 1.23 below) is dominated by a small number of foreign-dominated firms as is the case in communications, although there are now some important locally owned firms in the market for smaller telephone digital exchange equipment. Both communications and consumer electronics markets tend to be characterized by significant domestic competition and limited competition from imports or in export markets because of the high  degree of trade protection and the high cost nature of the domestic indus- tries. 1.20 A critical aspect of a successful industrial strategy in electronics is the importance of competition policy. While even the successful cases in electronics, e.g., Japan and the East Asian NIEs, have provided protection from imports as well as direct measures to nurture the electronics industry during its initial phase of development, competition policy has been used to provide the# industry with the incentives needed to constantly improve its performance. This has been done primarily by forcing firms to compete in export markets and by encouraging strong domestic competition. The experi- ences of India and Brazil demonstrate the disadvantages of providing a high degree of import protection without encouraging rigorous domestic competition and good export performance. 1.21 Foreign Involvement. Approaches to foreign involvement in the elec- tronics industries of the four NIEs have varied tremendously. Taiwan, China has been the most permissive in its policies regarding foreign investment. As an example, today 80? of computer production in Taiwan, China is linked to transnational corporations either through joint ventures or 100X foreign owned companies of which there are over lCO. By comparison, in South Korea, trans- nationals account for a very small share of total output. However, joint ventures played a critical role in the early development of the industry. For example, both Samsung and Goldstar began their electronics operations as joint ventures with Japan so as to acquire the technology for critical parts and components needed to become major producers of consumer electronics products. Subsequently, direct foreign investment declined in importance as technology licensing and in-house R&D became the preferred and major modes of acquiring technology. Since 1976, several of the major South Korean firms have entered into key strategic alliances with foreign firms in high technology areas of electronics (e.g., micro processors and custom chips) as a mechanism for get- ting access to technology, markets or to share development costs (Table 1.6). 1.22 India, and to a lesser extent Brazil, has followed very restrictive policies regarding foreign investment. In India, foreign collaborations involving majority foreign ownership are quite limited in electronics even though in principle they are permitted. Nearly all foreign ownership shares in electronics joint ventures are limited to 40X. Less than 10? of the value of electronics output in India is accounted for by these joint ventures. There also are restrictions on the duration and royalty rates for licensing agreements--5 years and a maximum of 82, respectively--which have inhibited access to foreign technology. Moreover, joint ventures are required to make commitments to export a large share of their production, e.g., 60? of total production for joint ventures with foreign majority ownership.l/ 1.23 Foreign investment policy in Brazil's electronics industry has per- haps been a little less restrictive in some segments of electronics than in I/ For a description of foreign investment rules in India's electronics industry, see the recent World Bank report entitled, "India: Development of the Electronics Industry", Report No. 6781-IN, June 1987.  - 8 - India. For example, Brazil's consumer electronics industry has developed almost entirely through foreign investment which was attracted to the Manaus export zone. However, the national content of new consumer electronics prod- ucts is very low, and most designs and many of the critical parts are of for- eign origin because of low, import duties firms in Manaus pay. One of the unintended consequences of this approach has been that many of the promising Brazilian companies in the southeast of Brazil, the major hub of the elec- tronics industry, that began to develop consumer electronics earlier have disappeared because they were unable to compete with firms in Manaus. Conse- quently, Brazil has not been able to use its large internal market for con- sumer electronics as an engine of growth for the creation of an electronics complex with significant local value-added. 1.24 In other areas of electronics, more attention has been placed on developing Brazilian equity participation and technological capability. For example, in Brazil's computer industry foreign firms were restricted to seg- ments of the market not reserved for national firms. Those areas reserved for national firms involved large and rapidly growing segments in which production using older generations of technology was possible, such as data processing equipment and microcomputers. This market reserve policy combined with restrictions on imports retarded the development of national firms. For larger, more technologically sophisticated machines requirin the newest gen- eration of technology, foreign firms were allowed to operate in joint ventures in an effort to develop national technological capability. In telecommunica- tions, even though multinational firms have historically dominated the indus- try, they had to accept Brazilian equity participation as a condition for continued market access. Today, sales of the new Brazilian designed digital switch, for which the PTT is reserving a large share of its market, are restricted to Brazilian companies only. 1.25 Technology DeveloDment. In Taiwan, China, foreign investment has been the most important vehicle for acquiring technology. In addition, a large public sector research organization--the Electronics Research and Ser- vice Organization--has played an important role in developing and diffusing technology since many Taivanese firms are too small to achieve economies of scale in R&D (para. 1.18). As noted earlier, in India foreign collaboration has historically played a minor role in electronics (para. 1.22). Much greater emphasis has been given to reverse engineering and indigenous develop- ment of technology, often in public R&D laboratories with limited focus on assimilating foreign technology. In Brazil, besides reverse engineering, the major mechanisms for technology acquisition have been licensing of foreign technology and limited use of foreign investment as a conduit for getting foreign technology. In addition there have been a number of important efforts to indigeno- sly develop technology, e.g., the Tropico digital telecomminica- tions switching system and fiber optic systems. 1.26 As mentioned earlier, joint ventures were an important mechanism for acquiring technology in South Korea during the early years of the electronics industry's development (para 1.21). The joint venture approach was adopted as a means of ensuring that the desired level of technology could be brought in from the start. However, a great deal of emphasis also was placed on efforts to absorb technology using joint venture arrangements and technical assistance agreements to improve in-house capability through training and technical assistance. South Korean firms mastered assembly techniques using CKD imports  of foreign products. Later firms progressively replaced some imported parts and components with local substitutes and modified the design of imported models through reverse engineering. With the commitment to compete in inter- national markets, firms laid great emphasis on developing their own R&D capa- bilities. These efforts were supported by government institutions which played a pioneering role in establishing R&D and pilot production facilities in areas such as semiconductors and telecommunications. In addition to spear- heading such work, these institutions produced experienced researchers and production workers who later played an important role in the private firms that moved into the manufacture of semiconductors. It is also important to note that after these public sector research institutions had proven South Korea's capabilities in semiconductors, large private firms invested heavily to assimilate foreign technologies, often taking advantage of the slump in the US industry to buy state-of-the art technology. In addition, some firms established listening posts in Silicon Valley by purchasing US firms and employing Korean-American design engineers who had worked for US semiconductor firms. D. Implications for China 1.27 These global trends have important implications for developing coun- tries like China that are seeking to become significant electronics producers. Rapid growth of the industry and world trade in electronics offers good oppor- tunities for newcomers seeking to enter the global industry as supply sources for many, particularly low end, parts and components. In this respect China should also benefit from its special relationship with Hong Kong. One can expect that more electronics factories in Hong Kong will move their less- sophisticated and more labor-intensive production processes to China because of the intensification of international competition, Hong Kong's labor short- ages, Hong Kong's need to move upmarket in electronics, its recent graduation from the US Generalized System of Preferences and its imminent unification with the People's Republic of China. 1.28 However, this chapter has also noted that there are some essential prerequisites to taking advantage of these opportunities, including the impor- tance of cost competitiveness and particularly the ability to meet delivery and quality standards and to provide service support as well, even at the low- end of the industry where the greatest opportunities in international markets lie for China. In this context it was noted that despite rapid development of technology in electronics, technological leadership is not a precondition to success in the industry. In most areas of electronics, the ability to: reduce time-to-market, inventories, control production, distribution and mar- keting costs and be attentive to customer requirements also are critical. 1.29 South Korea and Taiwan, China have been quite successful in electron- ics precisely for these reasons. After establishing a solid foundation on which to base their electronics industries, they are now successfully exploit- ing Japan's strategy of systematically moving up the ladder of value added in electronics. In comparing the experiences of some highly successful NIEs with others that have been less successful, some of the key elements noted are the importance of product choice and *equencing, industry structure and competi- tion policy and trade orientation. As discussed in the next chapters, these also are important themes in looking at the issues and options facing China's electronics industry.  - 10 - Sgum ct: CompatS tn nsit by Iimuc. U.1977 Each bH u fl anhdub 90 70 60 40S 80 XO'- * I I I I II I I I I I i 2 3 4 57 I. C4onum . Aln:e 6i_ Pt Z Corduulw EI6