JOHN LEE. The rise of China’s tech sector: the making of an internet empire.

Jan 10, 2018

Part one of this two-part series looks at the rise of China’s digital economy, the champion firms that dominate it, and their relationship with the Chinese state. 

The Chinese government’s online censorship and alleged cyber espionage activities have long been a focus for international media. But while Beijing’s heavy hand on the internet deserves attention, it is China’s agile private sector that is generating advances truly felt beyond the country’s borders. Backed by state industrial policy under the rubrics of Internet PlusMade in China 2025 and the National IT Development Strategy, China’s internet/tech sector is leveraging the country’s fast-growing markets to build market power and drive innovations with global reach.

The centrepiece of this story is an online ecosystem that has evolved separately from the platforms engineered in Silicon Valley. How much this owes to state controls on China’s internet and protectionist support, versus Chinese firms’ home market knowledge and entrepreneurial drive, is open to debate. In any case, China’s online platforms are now distinct from their US-designed counterparts and in some respects more advanced, specifically in applications for mobile devices,‘online to offline’ services and financial technology (fintech). China now accounts for half the world’s digital payments and three quarters of the global online lending market, and those in China’s expanding middle class conduct much of their personal and professional lives through integrated web platforms. This holistic, mobile-oriented digital universe has grown symbiotically with the adoption of smartphones, a product in which China’s home-grown manufacturers are now catching up with global leaders.

The ferment of China’s internet economy, with 700 million users and climbing, has given rise to the world’s most dynamic start-up scene. In the last three years it has produced 34 ‘unicorns’ (private companies valued at more than US$1 billion), fuelled by a tsunami of private venture capital investment, a monstrous state-backed funding complex and a proliferation of state-supported incubators. Overshadowing this frenetic growth are a handful of corporate tech champions that nowrival their US counterparts in size – the e-commerce behemoth Alibaba and the social media giant Tencent each have market capitalisations over US$250 billion. Alongside the search engine leader Baidu, these ‘three kingdoms’ of China’s online services sector are funding and buying out start-ups even more aggressively than the titans of Silicon Valley.

This dominance of a few huge firms reflects a global trend towards concentration of capital and market power, particularly in the knowledge economy. In the US, the top five companies by market capitalisation are now all tech firms, which are expanding into other sectors and putting pressure on incumbents. In the car industry, for example, technological trends are forcing established players to partner with young internet giants in order to stay competitive.

Likewise, China’s tech titans are now the main force in domestic mergers and acquisitions. They too are expanding into sectors such as healthcarerobotics, and most notably self-driving cars. The growing role of network connectivity in car usage, and the need for huge amounts of data to develop artificial intelligence, has made China’s leading internet firms key players in this signature industry of the pre-digital economy. And they are squeezing out foreign competition in the process, with home-grown ridesharing app Didi’s buyout of Uber’s China business widely viewed as the nail in the coffin for US tech firms’ hopes of conquering the China market. Foreign automakers, battery makers andnavigation system providers may be next, as China seeks to leverage its unique online ecosystem into a physical ‘Internet of Vehicles’ based on Chinese technologies and firms.

The outsized role of the state in funding this digital business boom does risk creating the overcapacity, inefficiency and outright fraud that Beijing’s industrial policies have produced elsewhere. China’s cash-flushed venture capital sector not only breeds some expensive failures, but also fuels successful firms’ single-minded focus on speed and scale, to the neglect of profitability. Like the ‘post-nineties’ generation (China’s equivalent of the millennials) from which their workforce is drawn, most Chinese internet businesses have known only a quarter-century of economic growth in which the global financial crisis was a speedbump – they have yet to face a chastening experience like the US dotcom bust of 2000-2002.

A reckoning seems to have begun in 2016, with private investors going cold on internet start-ups and changing priorities from picking live unicorns to avoiding dead ones. This again mirrors the situation in the US tech sector, where concerns about overvaluation and unsustainable business models have dampened investor enthusiasm. But in China, the imperative to stimulate a slowing economy by promoting services and technological innovation means the state will likely keep pumping money into internet firms, raising the spectre of another asset bubble joining the nation’s inflated stock and real estate markets.

Nonetheless, China’s tech sector should maintain momentum through its sheer entrepreneurial drive and ruthlessness. Firms operate in what Baidu’s chief scientist described as a ‘permanent state of war‘ – Silicon Valley is now being judged as too well-fed and complacent by comparison, with one observer noting that the start-up depicted in the eponymous HBO comedy would never survive in China. The general spirit is captured by a leaked Alibaba memo on responding to an invasion of penguins(referring to Tencent’s moves into e-commerce) by taking the fight to their natural habitat and killing them there. This dog-eat-dog attitude is mirrored in the competition between Chinese provinces for start-up talent and capital, marking the digital economy as the next phase in reform-era China’sDarwinian process of development.

The tech sector will also benefit from the government’s plans for the wider economy. Beijing is seeking to network and digitise not just China’s vehicle fleet, but the nation’s entire manufacturing sector, to keep it competitive in the face of rising wages, aging demographics and foreign technological advance. If this occurs for even a fraction of Chinese manufacturers, it will open new horizons for firms that provide data management and connectivity services. The rapid prototyping model already extant in the electronics hub of Shenzhen shows what can be achieved by marrying digital knowhow with Chinese manufacturing’s agility and scale.

Furthermore, the tech sector is increasingly entwined with the state-owned enterprises that retain a privileged place in China’s political economy. Most of the US$10 billion of capital raisings for Chinese fintech firms during 2016 (more than double the figure for North America) came from state-owned investors. For these institutions, integration with internet services firms holds the promise of boosting profits and upgrading technological systems to internationally competitive levels. For the tech firms, the arrangement provides stable funding and political influence, although they are now wielding this in their own right – the influence of Tencent’s chairman in spurring the central government’s ‘Internet Plus’ industrial policy marks the tech sector’s arrival as a national lobby group.

For their part, China’s leaders have expressly enlisted tech entrepreneurs to the national agenda, which to date has mainly meant ‘purifying’ the internet through cooperation with censorship directives. But leading tech firms are now exploiting their vast troves of user data to trial credit rating systems, which if successfully integrated by the Chinese state will give it an unprecedented capacity for individual monitoring and hence social control. In a country where the government asserts near-unrestricted access to personal data and requires internet firms to facilitate its control of information, the tech sector has no choice but to help the build the tools of a digital totalitarian state. And China’s political economy rewards those who actively promote state policy directives.

The Chinese tech sector’s ability to work with the state and its demands (somewhat in contrast to US tech firms) is embodied by Alibaba’s chairman Jack Ma. Mr Ma, whose stated policy on dealing with the government is ‘to be in love with but not marry them’, advocated using big data for crime pre-emption, in tune with the extant state-led project to develop Minority Report-style software for predicting malfeasance, and branded Alibaba’s new e-commerce hub in Malaysia as part of a new Silk Road , echoing President Xi Jinping’s centrepiece ‘One Belt, One Road’ foreign policy concept.

The tech sector is also helping China’s lumbering state-owned enterprises and strategic research projects exploit the benefits of digitisation – though the state sector and academia are also suffering from the internet firms’ voracious demand for scarce talent. Alibaba, for instance, is partnering with Sinopec and China Mobile to develop cloud computing services and big data analytics, and with defence giant Norinco to drive commercialisation of China’s Beidou satellite navigation system (at the expense of the US-controlled GPS).

But the key field in which private sector internet firms are aiding China’s race to the technological frontier is artificial intelligence. As ‘the greatest business opportunity of our time’, AI development is a natural investment for China’s cashed up and data-rich internet giants. The frontrunner is Baidu, which has been commissioned to lead China’s new national deep learning laboratory, fulfilling CEO Robin Li’s call for a state-backed ‘Apollo programme’-style drive to make the nation an AI world leader. Artificial intelligence is now an identified priority across China’s science, technology and defence planning architecture – given US progress towards employing AI for military use, it will probably not be long before the People’s Liberation Army follows the Pentagon’s attempt to enlist the tech sector for defence innovation.

To quote Baidu’s former chief scientist Andrew Ng, ‘whoever wins artificial intelligence will win the internet in China and around the world’. Yet as represented by Ng himself (a Stanford professor andformer leader of the Google Brain project, who ran Baidu’s research lab in Silicon Valley until last month) the rise of China’s tech sector did not occur in isolation, but through exchanges with the outside world. How this happened, and what impact China’s tech sector will have internationally in future, will be addressed in my next article.

Part two of this two-part series looks at how the outside world shaped China’s internet firms, and how they are now shaping the international economy. For part one, click here.

The rise of China’s internet firms was not a result of autarkic industrial policy from Beijing. It was achieved through entrepreneurial initiative to leverage what the outside world could provide in order to tap China’s growing markets. Like all private firms in reform-era China, tech companies had to survive in an environment of ‘structured uncertainty‘, in which government institutions did not provide the protection and predictable support needed to foster novel product innovation that could compete with foreign technologies. Instead, Chinese private firms became competitive by adopting and adapting foreign technologies, supported by local authorities happy to ignore Beijing’s ‘indigenous innovation’ directives in the interest of economic growth. The tech sector’s ruling triumvirate of Baidu, Alibaba and Tencent (BAT) built their success on technologies developed overseas, including the internet itself.

Like firms across China’s wider information and communications technology (ICT) sector, the success of internet companies was greatly aided by returning Chinese expatriates who had gained knowledge through study and work abroad. Taking Baidu as an example, the firm’s co-founders, chief operating officer and former Big Data Lab director all received their postgraduate education and foundational work experience in the US. From 2000-2006, Beijing’s Zhongguancun technology park (the heart of China’s ICT sector) registered an average of two firms established each working day by such returnees.

Many Chinese tech firms also relied in their early phases on funding by foreign investors, a blatant breach of Chinese law connived at by regulators so as to grow private sector champions in the face of inadequate domestic capital markets. Foreign entities are still the largest interest holders in Alibabaand Tencent, now China’s two biggest companies by market capitalisation. Alibaba’s 2014 float on the NYSE remains the largest IPO in history, despite the company’s legal structure giving foreign interest holders minimal control over business operations, which remains in the hands of the Chinese founders.

The question for China’s tech sector today is how this interdependence with the outside world may change due to a renewed drive for technological independence. Beijing’s increasingly expansive and intrusive regulatory regime for ICT, and its reported goal of purging foreign ICT entirely from government agencies and state-owned enterprises, drew claims from the US Chamber of Commerce that these measures would cost China’s economy $US3 trillion by 2025 and an open letter from 40 foreign business associations pleading that China’s ICT market be kept open.

But China’s tech firms are already stepping into the breach. Backed by more robust government policy than in the past, and having accumulated the capabilities to compete technically with foreign industry leaders, China’s internet firms are taking advantage quickly. Alibaba’s proprietary operating systems are starting to replace foreign software in state use, while its cloud computing and data analytics services are being adopted by SOEs and provincial governments.

The internet giants are among a handful of Chinese firms starting to achieve what has long eluded the nation’s private sector: technical innovation. Their ability to combine this with effective business models led MIT’s Technology Review to pick five Chinese ICT firms (the BAT triumvirate, Didi and Huawei) for its 2016 global ’50 Smartest Companies’ list. As competition in China’s domestic markets intensifies, tech titans and startups alike are increasingly turning their eyes to overseas expansion. In 2016, Chinese tech firms’ mergers and acquisitions included US$17.6 billion of foreign investment, and their proportion of China’s total outbound investment will rise as Beijing closes the spigot on less profitable sectors.

This outbound investment includes a determined push by the BAT firms into US markets, and substantial investment in US start-ups – Alibaba is again in the lead, with its chairman Jack Ma meeting then-US President-elect Donald Trump to promise a million new American jobs if his company is allowed to pursue expansion in the US. But just as US tech firms’ attempts to crack the China market have been stymied, it is unlikely that China’s tech leaders will out-compete US internet giants on their home turf. The decisive battles will be in third party markets, where the intensifying contest for the internet economy raises the prospect of US and Chinese tech titans carving the world into digital spheres of influence.

Certainly, the distinctiveness of China’s online ecosystem has hindered apps and business models that evolved within it from capturing market share abroad. But thanks to adaptability and deep pockets, China’s internet champions are starting to gain traction. As the dominant Chinese firm in online messaging and gaming, Tencent is making inroads into Latin America and even into advanced economies such as South Korea and Japan. Chinese ICT firms have built a major presence in India through both direct operations and investment, and Chinese money is pouring into European tech start-ups – Tencent’s acquisition of Finland’s Supercell has cemented its lock on the global online gaming industry.

But the key battleground will be Southeast Asia’s fast growing internet economy, projected to be worth US$200 billion by 2025. The region’s largest online retailer and payments platform are now controlled by Alibaba, its content access and instant messaging markets are seeing inroads by Tencent, and its lead ridesharing platform has partnered with Didi to compete with Uber. The online services sector is by nature a winner-takes-all game, and Chinese firms could well be planning to sweep the board in Southeast Asia just as they conquered their own nation’s digital economy. Alibaba’s creation of an e-commerce hub in Malaysia (the first step in Jack Ma’s brainchild ‘World Trading Platform’ concept endorsed at last year’s G20) and Ma’s new role as e-commerce adviser to the Indonesian government shows how pressure to outflank domestic rivals is driving China’s tech titans abroad to dominate emerging markets.

Yet despite the increasingly adverse climate for foreign ICT firms in China, and the global competition presented by the rise of Chinese companies, China’s tech sector will likely keep growing in symbiosis with foreign counterparts. For all its obstacles, the Chinese market’s allure has kept US ICT giants knocking at its door. Mark Zuckerberg is still courting Beijing to allow Facebook’s re-launch behind the Great Firewall, and Microsoft has developed (in partnership with a Chinese state-owned firm) a modified Windows 10 version for Chinese government use, with Intel and Qualcomm reportedly having reached similar deals. Apple has poured a billion dollars into Didi, Nvidia has partnered with Baidu to build a computing platform for self-driving cars, and Tesla, which is racing Baidu to put autonomous vehicles on the roads, has received a big investment from Tencent. Google and Facebook are partnering with a Chinese investor to finance a new high capacity trans-Pacific internet link.

All this raises questions about how far the US ICT sector will be willing to assist the US government in its emerging digital arms race with Being, let alone support the technological embargo of China advocated by some in Washington. As highlighted by Jack Ma’s meeting with Trump, blocking Chinese access to the US economy would entail large opportunity costs in export markets for US products and in foregone investment. Chinese FDI into Silicon Valley alone topped US$6 billion (excluding real estate) by mid-2016, and Chinese venture funding and skilled labour has become deeply embedded in the local tech sector. Non-US citizens make up half the core workforce in the Valley, where Mandarin is now the most spoken foreign language after Spanish.

Even if Washington could strong-arm US firms into cutting off China for strategic reasons, their advanced-economy competitors are unlikely to follow. German industry is pushing ahead in China, despite growing European concerns about the lack of a level playing field for foreign businesses. China’s role as both indispensable market and technological collaborator is especially salient for German automakers and their push towards driverless cars – Audi has signed agreements with all three BAT firms to develop digital connectivity, while last year Daimler held its first hackathon in Beijing.

Foreign firms can be expected to increasingly seek access to Chinese technologies and skilled labour, given the nation’s growing research spending and pipeline of qualified personnel, particularly in artificial intelligence. Rising state and private funding in China for AI has created a virtuous cycle of talent recruitment and technical advance, which is starting to manifest in academic researchindustry recognition and marketable applications. Conversely, Chinese tech firms still need to go abroad for cutting-edge technologies and scarce talent. They are aggressively hiring in Silicon Valley and atleading US universities, while Baidu, Didi and now Tencent all run AI research labs in the US.

At home, China’s tech sector is also developing an increasingly international character. There is a growing presence of foreign start-ups, which is actively promoted by local government and is now spreading beyond the expatriate hubs of Beijing and Shanghai to smaller cities. Conversely, the parlous state of US immigration policy, now aggravated by antipathy towards foreign tech workers and students that goes to the top of the Trump Administration, raises questions about whether the US can keep attracting the foreign talent on which its tech sector depends. Hefty sign-on bonuses offered by internet firms for relocation to China, and encouragement of skilled immigration by Chinese industry leaders, may further erode the US advantage in catching the ‘new argonauts’ of the transnational digital economy.

For smaller advanced countries, the speed and scale of China’s tech expansion has still greater implications, given their own increasing dependence on ICT-oriented sectors that demand foreign capital, labour and markets. For example, a quarter of Australia’s GDP growth in the last financial year came from three districts in inner Sydney with a concentration of knowledge-intensive industries. Located in this area is the first cross-border fintech incubator connecting Australia and Asia, intended to be a bridgehead for Australian startups into the Chinese market.

China’s own transition towards an internet-enabled, service-oriented economy still has far to run. One study estimates that from 2004-2009, the internet contributed over 20% of GDP growth for the US, but only 3% for China. Internet penetration across China’s population is still barely 50%, and while the tech-savvy urban consumer market is approaching saturation, other huge segments (the rural population, older people and enterprises) are still largely untapped; the nation’s online retail market is projected to double in size to US$1.7 trillion by 2020. And despite Beijing’s plans for technological autarky, the Chinese economy in general remains at a lower level of sophistication than the advanced countries. All this holds much promise for foreign tech firms that can navigate an increasingly complex and demanding Chinese market, and work effectively with the home-grown champions that now dominate it.

John Lee was previously a visiting fellow at the Mercator Institute for China Studies in Berlin, where he worked on economy and technology, foreign policy and security issues.  He is a graduate of the University of Melbourne and the Australian National University with majors in economics, history, political science and international law. Previously he worked and published at the Australian Strategic Policy Institute, Canberra

This article first appeared on the Lowy Institute, The Interpreter, on 4 May 2017


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