The Rise of China's Innovation Engine

As if the US and Europe did not have enough to worry about competing against China in manufacturing, new data suggest that the Chinese are making good on their objective of transitioning from a 'brawn' to a 'brain' economy.

In telecom, mobile and online services, Chinese companies like Tencent, Huawei, Baidu and Alibaba are demonstrating the capacity not just to compete, but even, in a growing number of cases, to lead.

Just as technology adoption cycles can take 40 years, so the inculcation of cultural, intellectual and philosophical changes to enable technology mindset take time. The Chinese have observed, have learned - not infrequently the hard way, by experience - and have adapted as well as adopted.

That Lenovo just announced the purchase of IBM's faltering server business is now considered less an example of a Chinese business picking up someone else's leftovers, but of a global competitor with a robust home market understanding how to increase penetration that it can build on - and protect.

Just as more and more once 'safe' technological jobs are being lost to technology, so western economies must recognize that the innovation, design and marketing tasks believed to be a western sinecure are now open to competition as well. JL

Juro Ozawa and Paul Mozur reports in the Wall Street Journal:

Keeping better-known global competitors at bay in their massive home market, Chinese firms are hiring Silicon Valley executives and expanding overseas with aggressive marketing campaigns featuring international sports stars and celebrities.

China has long been the factory floor that churns out popular gadgets for companies world-wide, but the country's own technology products were rarely viewed as leading edge.

Now, that is beginning to change. China's own technology companies are challenging market leaders and setting trends in telecommunications, mobile devices and online services.

Chinese companies still face a perception problem among consumers in many parts of the world that their products aren't as high-quality or reliable as others. Some foreign competitors have alleged that Beijing gives unfair advantages through subsidies, cheap financing and control over the currency market.

But, many executives at Chinese and Western companies contend, China's technology sector is reaching a critical mass of expertise, talent and financial firepower that could realign the power structure of the technology industry in the years ahead.

"Traditionally Chinese companies were fast followers, but we are starting to see true innovation," said Colin Light, partner at PricewaterhouseCoopers.

The rise of China's tech industry is fueled in part by its growing investment in research and development. According to a study released in December by U.S.-based Battelle Memorial Institute, R&D spending in China will likely reach $284 billion this year, up 22% from 2012. That compares with just 4% growth forecast in the U.S. to $465 billion for the same period. It forecasts China will surpass the U.S. by 2022.

At Shenzhen-based Huawei Technologies Co., the second-largest telecom-equipment supplier by revenue after Sweden's Ericsson, ERIC-B.SK in Your Value Your Change Short position annual R&D expenditures rose fourteenfold in a decade to $5.46 billion in 2013 from $389 million in 2003.

When Peter Zhou joined Huawei straight out of graduate school in 2000, the company's Shanghai research center had a few hundred workers in a shared office. Every Wednesday night after work, Mr. Zhou and other young Chinese engineers gathered for study sessions, sometimes using university textbooks from the U.S.

"At that time, Huawei was not at the same level as Western companies," Mr. Zhou, now an executive at Huawei's wireless-equipment business, recalls.

"We were like students."

But in the past decade, Huawei overtook Western rivals such as Nokia Corp.  NOK1V.HE in Your Value Your Change Short position and Alcatel-Lucent SA  ALU.FR in Your Value Your Change Short position in the telecom-gear market. Part of its success stemmed from Huawei engineers' creative ways to upgrade wireless networks using software instead of a costly method of replacing all hardware components, according to Mr. Zhou.

Huawei now has an R&D center in Shanghai that employs more than 10,000 engineers, many of whom have computer-science degrees. As the mobile industry deploys faster fourth-generation networks, Huawei is already working on the technology for fifth-generation networks, which could be ready around 2020.

Huawei's global expansion has met some skepticism. Last year, some European Union officials alleged that unfair subsidies from the Chinese government allowed Huawei to sell its gear at lower prices in Europe. Huawei denied those allegations.

In October, when Danish telecom carrier TDC  TDC.KO in Your Value Your Change Short position A/S announced a $700-million deal to replace its existing Ericsson equipment with Huawei's gear, TDC Chief Executive Carsten Dilling said he chose Huawei for its technical expertise, not its prices—adding that Huawei was "actually quite expensive."

Glory Global Solutions Ltd., a U.K.-based global supplier of cash-handling machines used at banks, opened a research center in Shanghai in 2011. The center's Chinese engineers are developing advanced sensor technology to identify various security features embedded in bank notes to detect counterfeit bills, combing software programming, hardware engineering and scientific methods like spectrometry.

Working on cutting-edge technology with Chinese engineers involves a risk of them leaving to set up local competitors, said CEO Paul Adams. Still, local engineers are bringing new ideas to Glory Global, he said.

China is also moving up the technological curve in sophisticated areas like mobile processor chips, where it used to be absent. U.S. competitors like Qualcomm Inc.  QCOM in Your Value Your Change Short position and Nvidia Corp.  NVDA in Your Value Your Change Short position are still far ahead, but China's Fuzhou Rockchip Electronics Co. and Allwinner Technology Co. are increasing their presence in chips used in low-end smartphones and tablets. Last month, the Chinese government announced plans to spend almost $5 billion to create a fund to make investments in the country's microchip industry.

In consumer products, few Chinese brands have succeeded in becoming household names globally. But personal-computer maker Lenovo Group Ltd. 0992.HK in Your Value Your Change Short position , which last year overtook Hewlett-Packard Co. as the world's largest PC maker by units sold, is setting a new precedent with its aggressive expansion in phones. In the third quarter of last year, Lenovo ranked third in smartphone sales globally after Samsung Electronics Co.  005930.SE in Your Value Your Change Short position and Apple Inc.,  AAPL in Your Value Your Change Short position according to research firm Gartner.

Lenovo, which bought International Business Machines Corp.'s  IBM in Your Value Your Change Short position PC business in 2005, released its first smartphone in China in 2010. At that time, its executives knew the company lacked many of the resources necessary to compete globally in smartphones. Lenovo recruited many people from telecom and Internet industries to inject "new blood," according to Chief Strategy Officer Zhou Qingtong.

In mid-2013, it launched Qiezi, an app for both Apple's iOS and Google Inc.  GOOG in Your Value Your Change Short position 's Android operating systems that enables two phones to instantly share photos and videos without an Internet connection. In four months after its debut, Qiezi gained more than 30 million users.

In 2012, Lenovo signed a three-year sponsorship deal with the National Football League that allowed it to use NFL trademarks in its marketing. Lenovo also hired National Basketball Association star Kobe Bryant for its smartphone ads in Asia and enlisted actor Ashton Kutcher in its latest U.S. marketing.

In late December, Lenovo opened its new hub for research, development and production of smartphones and tablets in the central Chinese city of Wuhan, after it spent $800 million to build the facility.

"We definitely want to be number one in smartphones, but it will be a long journey," said Lenovo Chief Executive Yang Yuanqing in an interview.

While Chinese companies have made big gains in hardware, many of them face a challenge that has plagued other Asian companies: developing software and user interfaces that appeal to a global audience.

Tencent Holdings Ltd.  TCEHY in Your Value Your Change Short position , which owns the WeChat smartphone application, is bucking that trend. Launched in late 2010, WeChat dominates China's mobile messaging market and the majority of the app's 272 million monthly active users are in China. But last year, it spent $200 million on overseas ad campaigns to push WeChat into markets including India, South Africa, Spain and Italy. Tencent says the app has more than 100 million downloads abroad.

WeChat was ahead of competitors in offering an easy-to-use feature for sending recorded voice messages and it is challenging the dominance of Silicon Valley's WhatsApp, which has more than 300 million monthly active users globally.

"In handsets or laptops, Chinese tech companies' global expansion has been much more of a hardware story so far, and I think what's fascinating about Tencent is that it's becoming a software and services story," said Michael Reynal, a portfolio manager at San Francisco-based RS Investments.