The Dragon Machine

Exploring the state of manufacturing and innovation in China.

By Paul Altaffer &
Grant Washington-Smith

In the last of this year’s series on China and India, this column turns back to China to investigate its record as a manufacturer and supplier of nutraceuticals. Five hundred years ago China led the world in innovation with important inventions and products. China now has the opportunity to establish itself as an innovator once again. The question is whether China has what it takes to establish itself as a global leader in innovation and whether this innovation applies to the nutraceuticals industry in particular.

This column previously reported (March 2007) on China’s growth and its emerging consumer markets. For the past 30 years, China has grown at a yearly average of nearly 10%, making it the strongest growth cycle in modern history. No one would have believed this kind of growth was sustainable. China, however, continues to defy the skeptics.

Many also feel that China’s economy is overly dependant on ex-ports and that a downturn in the American economy could trigger a major recession. This is unlikely to be the case, as China’s growth is mostly driven by internal consumption. China may be at risk of a downturn at some point in the future, but this will probably result due to several factors—i.e., overheating markets, rising inflation or an immature economic/financial infrastructure. In other words, China’s risks are their own and not entirely dependant on issues affecting the U.S. or Europe.

The Least Cost, Most Efficient Producer

A significant reason for China’s big boom is its incredible manufacturing capacity. China has transitioned rather quickly from a poor, undereducated, rural (agricultural) society to the fastest (sustained) growing of the developing ec-onomies, with technical and skilled labor and strong incentives for producers.

China has established itself among the least cost and most efficient producers in nearly every manufacturing sector in the world. Why? There are a lot of reasons: (1) access to an abundant (skilled and unskilled) and relatively inexpensive labor force; (2) significant incentives; and (3) perhaps most important, a spirit of entrepreneurialism and competitiveness that is difficult to match. The Chinese are formidable competitors in any manufacturing business they enter. They can produce cheaper and better than their competitors. Chinese companies are also good at adopting technologies quickly and efficiently, and improving them along the way.

The nutraceuticals, botanicals, OTC pharmaceuticals and chemical intermediaries industries are all well aware of the efficiencies offered in China. China is said to produce one-third of the world’s vitamins and supply nearly 50% of the raw materials in the U.S. nutraceuticals industry. In a report compiled by Bridgehead International Ltd. (“Business Opportunities in China: The impact of the WTO”—2006), China’s share of the global vitamin supply market was estimated at over one-third, and together with India its share of the global herbal and botanical supplements supply channel is also some 30%. Industrial output of chemicals for use in the pharmaceutical industry rose from 40.7 thousand tons in 1978 to 1,267 tons in 2005, a 30-fold increase in 27 years. A significant amount of growth has come about in the last five years since China joined the WTO (World Trade Organization) and adopted global standards for trade.

According to the China Statistical Yearbook (China Statistical Yearbook—Years 2002, 2004, 2006), China’s industrial output for related industries (Pharmaceutical Chemicals and Traditional Chinese Medicine) has grown by almost 250% over the past five years (see Figure 1). The combined output for these two categories approached 2.5 million tons of products in 2004 and 2005. These numbers are staggering and yet many feel that China has merely scratched the surface of its manufacturing capabilities.

China is a dominant competitor in the global trade of nutraceuticals. The numbers speak for themselves—China has nearly doubled its volumes of exports over a five-year period to over 600 thousand tons of pharmaceutical and nutraceutical exports. At this point, only the U.S. can match China’s capacity for output and exports. Some day India may catch up, but not in the near future.

Since the year 2000, the dollar value of China’s exports of pharmaceutical products (including chemicals) and natural medicines has more than doubled from less than $2 billion to over $4 billion in 2005 (see Figure 2). The U.S. is a major importer of Chinese nutraceutical ingredients, but China has been able to increase its trade activity with Europe, South America, Africa and other Asian countries as well. One thing is for certain: Chinese companies have demonstrated tremendous skill in developing new markets and competing in existing markets.

Quality: The First Step Toward Innovation

The great myth about China is that it’s a low cost and efficient producer, but of cheap and inferior products. This attitude was exacerbated this year in the U.S. with the scandal over adulteration of animal feed with a nitrogen-based fertilizer, melamine. What happened in the days and months that followed raised important issues regarding food safety. While many Chinese manufacturers do fit the mold of being low cost and inferior, the truth is China has also proven itself, across many industries (from hi-tech to biotech), to be a highly sophisticated and technologically advanced manufacturing powerhouse.

It is not a coincidence that China may account for as much as 50% of the raw material supply to the nutraceuticals, natural products, and pharmaceutical industries in the U.S. The reason for this relates in great part to China’s systematic investment into the development of state-of-the-art manufacturing facilities, many of which have been created in partnership with large, multi-national companies. In response to the issues surrounding food safety, China has stepped up to the challenge and adopted more rigorous standards. Many, if not most, Chinese manufacturers meet and surpass international quality standards.

Quality and manufacturing sophistication may have quite a bit to do with innovation as well. As production and facilities improve, China is actually stepping closer toward innovation. It takes creativity to create quality and efficient manufacturing practices. China has become a master at adapting and improving technologies. A good case of such a capacity is the manufacture of co-enzyme Q10, or CoQ10. China has long produced some of the interim fermentation products for the production of CoQ10, but was not given the technology for preparing and stabilizing the finished product. A few Chinese companies were able to develop the process and have since reshaped the CoQ10 business. Another case is in the manufacture of vitamin C, where until recently, China was considered a low quality producer compared to the multi-national companies they compete with. Today, the quality differences are very difficult to ascertain, if at all.

Labor, Resources & Capital: Can China Sustain its Growth?

One of the reasons for China’s success in manufacturing is its wealth of labor, both skilled and unskilled. With a large population and a commitment to education, China is producing as many technically minded employees as anywhere else in the world. And while the availability of skilled labor is very positive for countries like China, there are already strong signs that China will face labor shortages in the future. Wages are already increasing at a rapid pace, causing employment inflation in some industries, but the real issue is that the highest skilled and most technical employees are difficult to retain as they receive offers from companies and institutions worldwide. China, as opposed to India, also has an aging population and may encounter some stress to maintain labor resources sufficient to sustain its growth ambitions.

This trend is also playing out for the country’s natural resources, the base ingredients China uses to manufacture goods. China’s consumption of commodities is insatiable, which is causing commodity price inflation around the world. Then there is the environmental question, and the rate at which China depletes and pollutes its environment. These are all important factors that may put China’s capacity for future growth at risk.

Innovation: Does it Make Sense for China?

In two recent special reports, The Economist magazine covered innovation around the world (“Something New Under the Sun”—October 13, 2007), as well as emerging technology in India and China (“High-Tech Hopefuls”—November 10, 2007). The two pieces shed a great deal of light on the emerging technological capabilities of both China and India.

China is a technology adopter, meaning it imports technology and know-how from other countries. However, China is also creative in what it does with technology and how it improves upon it. Use of intellectual and financial capital is best invested in areas of productivity and growth. Pure R&D is too expensive to conduct at this point for China, but it is still the place companies go to have their products manufactured. Just look at the pharmaceutical or high tech industry, where China is the choice producer for innovating companies and countries. The Economist describes it nicely: “Although China and India could devote their considerable intellectual resources to solving the problems faced by economies on the technological frontier, why cross that bridge until you reach it?”

The capacity to adopt and improve upon a technology has been dubbed as “architectural innovation” by Rebecca Henderson of MIT and Kim Clark of Harvard. This term was created to define the kind of innovation provided by (especially) Chinese and Indian companies.

Direction for the Future:
Innovation in Due Time

India has moved more quickly from the point of view of economic development to a “knowledge-based” economy. China on the other hand has very solid economic and manufacturing fundamentals, and is now considered among the top producers in just about every single import/export category.

Adopting intellectual property laws is causing many new patents to be filed, but it will likely be a while before the culture of intellectual property management catches up with the country and provides the kind of incentive for heavy investments into innovation. Again, from The Economist, “Technological pursuits have opportunity costs. Other, perhaps more lucrative, uses can always be found for the resources so expended. That is why no firm in China is betting billions on a risky search for the next blockbuster drug.”

At the end of the day, demand will drive true innovation. Although China (and India) has a large population that is growing in affluence, its (per capita) current consumption of foods and drugs is far below those of other developing countries. When China and India awaken to the demand of their consumers, there will be a drive to innovate and produce globally.NW