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IJOEM 6,3

VIEWPOINT

Chinas emerging software industry


John McManus
Lincoln Business School, University of Lincoln, Lincoln, UK
Abstract
Purpose The purpose of this paper is to offer a point of view on the challenges China faces competing in a twenty-rst century software industry. Design/methodology/approach The approach taken was desk research and conversations with other academics and industry experts. Findings The paper suggests that China needs to overcome weaknesses in managerial and technical skills and focus on international markets where it is positive strengths. Practical implications India provides some important and practical lessons for Chinas emerging software industry including those Chinese rms looking to increase their export revenues and presence around the globe. Originality/value This paper provides insight into the issues and challenges faced by the Chinese software industry looking to expand within a global economy. The paper may also prove useful to those researchers interested in emerging economies. Keywords China, India, Software industry, IT services, Markets, Competition, Piracy Paper type Viewpoint

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Introduction Chinas software industry has been domestically focused since its beginnings in the 1970s. Only recently has China started to seriously look into their competitors success in software exports. Arguably the Chinese government has been much more enforcing in shaping the trajectory of its software industry compared with other emerging BRIC economies (Brazil, India and Russia). In contrast to these emerging economies the characteristics associated with exporting and government support have signicant implications on all aspects related to future opportunities and threats for the Chinese software industry. Chinas emerging software industry Science and technology are the chief productive forces these words by Deng Xiaoping seem to reect the signicance of technology to Chinas vision of a modern, powerful economy (Wang, 1997). Evidence would suggest that China sees software as a critical pillar essential to Chinas economic progress and national security, therefore deserving government promotion, along with more established industries such as computer manufacturing, telecommunications, lasers and aerospace (McManus et al., 2009).
At the time of writing this paper Dr John McManus was Senior Research Fellow at the University of Lincoln. Dr McManus subsequently moved and is now Professor and Chair in Leadership and Development at York St John University, York, UK.

International Journal of Emerging Markets Vol. 6 No. 3, 2011 pp. 276-283 q Emerald Group Publishing Limited 1746-8809 DOI 10.1108/17468801111144021

The current government is determined to develop China into an innovative society. In launching the National Medium- and Long-Term Programs for Scientic and Technological Development (2006-20), the central government has vowed to spend more on science and technology, and to insist on business reforms. The goal is to move China beyond its dependence on natural resources and cheap labour, and stake its place among the economies that depend on education and information technology. The plan calls for an increase in research and development spending from its current 1.23 per cent of GDP to 2.5 per cent by 2020, putting China in the same range as OECD countries current scores (Einhorn, 2007). Over the past 20 years, China has cultivated a successful domestic hardware industry through state-funded research and development of new technologies, as well as tax incentives (Ashish, 2005). In addition, hardware producers have traditionally bundled software into the hardware as part of the total package to be sold on the market. As a result, the software industry in China lags signicantly behind world market leaders. Chinas top leaders have recognized this disparity and have shifted industrial policies in favour of the development of the software industry. China has issued a number of policies ranging from export incentives to value-added tax rebates and nancial assistance to small businesses, as well as laws addressing intellectual property rights protection (McManus et al., 2007). Despite Chinas WTO membership the creation of policies that encourage investment in the software sector, government authorities have created situations that favour state-owned enterprises (SOEs) in some cases (ADB, 2002). As part of a government contract, a government agency could require companies to obtain a Certication of Capability and Quality that is issued by Ministry of Information Industry (MII) at the national, provincial, and municipal levels. Whether MII will grant this certicate depends on a rms total net assets, registered capital, and annual revenues, rather than the ability of the company to complete the work requested. By most accounts, it is very difcult for a private sector company to receive such a certicate based on these standards. According to McManus et al. (2007), Chinese software output has grown an average annual rate of 30 per cent since 1995 and is predicted to continue this rapid growth. There are about 20 million small to medium-sized enterprises in China, which provides a substantial business user base. This base is expected to increase the domestic software market from 10 billion to 100 billion in the next ve-eight years. Furthermore, the proportion of the population with personal computers is ever increasing as is the proportion of mobile telephone users (Mingzhu and Zhang, 2005). Evidence would suggest that all of these factors will spur the demand for software services (McManus et al., 2009). The industry has great potential to grow it is located in the worlds fastest growing market alongside a dynamic IT manufacturing sector. Some aspects of the Chinese economy are expected to have positive inuence on the industrys growth, such as the strong manufacturing sector, which uses software in many products even beyond computer equipment, for example, telecommunications equipment (some of which is now 50 per cent software), consumer electronics products and automobile machinery (Harwit, 2004). Although Chinas software industry has achieved some degree of success and shown a huge potential in the long run, there are still some major problems, which are becoming obstacles in the path of Chinas software industry development. One issue is that software piracy is not under control.

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The Business Software Alliance estimates that pirated software account for 92 per cent of the Chinese software market the second highest piracy rate among the 86 countries it tracks. McManus et al. (2007), estimate the value of lost revenue due to piracy in China at $2.4 billion. While the amount of the loss may be over-estimated considering most piracy copy buyers would not have spent much more to own an authentic program, it denitely hurts incentives for software rms, both foreign rms and domestic rms, to innovate and market their software products in China. Barriers to market development According to International Intellectual Property Alliance (Legard, 2004), more than a quarter of Chinese software rms believe software piracy is the most important barrier to their development, and about one fth of the companies complain that software piracy has seriously constrained further R&D investments into software products. Recognizing the negative impact of piracy on the software market, the Chinese government has taken actions to ght against producing and selling pirated software (Legard, 2004). Many academics agree that China has many obstacles to overcome. For example, piracy software is so prevalent that it has become a habit, even for consumers who can afford legitimate copies, to purchase bootleg copies. However, how to effectively control software piracy is still a major challenge to China. The second problem is that majority Chinese software rms lack competence in the software market. This problem can be identied from two aspects: (1) Aspect one. Chinas domestic software industry is still at an embryonic stage of development, and few Chinese software companies, if any, are capable of developing upper level software, such as operating systems. As we move towards the end of this decade 85 per cent of Chinas software products and services are in the categories of maintenance and application, and the market share of system software is negligible. Application software represents 64.5 per cent of the total revenue, implying the revenue from system software still contributes less to the overall revenue. In fact, the most valued market segments such as operating systems and major packaged software are dominated by foreign software superpowers. (2) Aspect two. Chinas software industry is an extremely fragmented industry that consists of thousands of small, undercapitalized rms with few competitive advantages relative to the foreign corporations that dominate the market. The size of software rms matters in the market because a rms economic scale predetermines its ability to compete and to survive. According to the MII and National Bureau of Statistics of China, by 2002 China had 4,700 software companies, about doubled that of a year ago. However, the sizes of Chinas software companies are still relatively small. Two-thirds of Chinese software entrepreneurial companies have employees not exceeding 50 people (Dickson, 2003). Furthermore, Chinese software companies lack senior professionals in core technology competence. The low competency of Chinese software companies has become a barrier to Chinas software industry development. According to one report (Blum, 2002) it is hard for Chinese companies to compete effectively in the international outsourcing market, in which Indian software companies have won majority of the contracts. The revenue of Chinas software industry

(US$13.3 billion) was about the same level of that of India (US$ 12 billion). However, Chinas revenue from software export in 2002, at US$1.5 billion, was far below that of India, at $9.5 billion. Domestic market pressures In the domestic software market, Chinese software companies have been facing more pressures from powerful foreign competitors. Foreign software companies in Chinas market are normally more competitive and more experienced, particularly when they have monopoly power in the software market. The competition between Kingsoft and Microsoft Chinese word-processing software is a classic case. Kingsofts Chinese processing system had a market share of about 90 per cent in 1994. But it hit rock bottom due to competition from the Microsoft Word system. With its advantages in operating system, Microsoft launched its Windows XP that undermined Kingsofts effort in its word processing system (WPS). Kingsoft released WPS Ofce 2002, the latest version of its WPS, to contend with its powerful US archrival Microsofts Ofce XP. Still, Microsoft is now believed to have about 90 per cent of the Chinese market for word-processing software. Ironically the overzealous support from the government may become a weakness to the healthy development of Chinas software industry. As noted by Saxenian (2004), The shift to market-coordination thus coexists with the aggressive promotion and preferential treatment-either explicit or implicit of domestic producers or national champions:
Moreover, the identication and promotion of select producers, by providing government contracts, preferential access to capital, and regulatory priority, leaves open a multiplicity of opportunities for bureaucratic discretion and corruption (Saxenian, 2004).

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Funding and human capital issues Although China has a huge surplus of capital funds paradoxically shortage of funding is a major obstacle to Chinas future software industry development. There is a strong bias among banks in China against lending to private enterprises because it is far more risky than investing in SOEs. This problem is particularly acute in software because the banks have virtually no credit analysis capabilities, and in any case prefer to invest in businesses with physical (as opposed to intangible, intellectual) assets. Venture capital (VC) has been an important mechanism for nancing new technology ventures in a mature market economy, but it is not an option to most Chinese software rms at this stage since the VC industry is still in its infancy. As a result, the great majority of software enterprises in China are self-nanced. This is one of the reasons why many large software rms in China are afliates of large IT manufacturing or telecom rms. With the deepening of multinational corporations presence in China, the industry has witnessed increasing capital investment of these corporations in the Chinese software rms which will help alleviate the funding problem. For example, Intel announced in July 2009 that it would fund four more IT companies, upping its $200 million China Technology Fund that was launched in 2005 (Deffree, 2009). Investments BY Intel include semiconductor-design, software development, and knowledge management. Since investing in China in 1998, Intel has invested in nearly 60 companies based in or focused on China. The shortage of highly skilled software professionals is a concern for many software companies in China and poses a long-term threat to the industry development.

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In 2003, there were about 4 billion IT personnel working in the IT industry, including 590,000 in the software sector. According to the estimation of the MII, the shortage in the software industry is about 150,000. Approximately, 37,000 students graduate annually from Chinese universities and colleges with computer science degree; 50 per cent have a software certicate and only about 5 per cent have advanced (masters or doctors) degree. Many industry insiders believe that the high-end talent is the most urgent need for the Chinese software industry. One reason is that the high-end software program managers prefer to work for the multinationals which can afford to pay higher wages and provide better training and career development path. The brain drain problem is also a major threat to Chinas software industry development. It is estimated that 30 per cent of the computer science degree earners from Chinas most elite universities went abroad to pursue higher degrees in the 1990s, and the return rate was very small. There is some evidence that the number of returning Chinese students who have studied and worked abroad is increasing rapidly. In the long-term, these returnees will be important for the Chinese software industry to close the gap with India and more advanced countries (McManus et al., 2009). Future opportunities Four key factors are opening signicant opportunities for IT hardware and software suppliers to take advantage of Chinas vast consumer market. These are: (1) the governments informatisation drive, as stated in its Tenth Five-Year Plan, to spread the use of information technologies among communities, government agencies, and Chinas traditional industries; (2) the Go West campaign to narrow the digital divide between Eastern and Western China and other similar projects to reduce regional imbalance in economic development; (3) Chinas accession to the WTO; and (4) the 2008 Beijing Olympic Games and its particular focus on high-tech applications. According to IDC, Chinas increase in e-government spending of nearly 40 percent annually provides IT rms with the opportunity to introduce solutions that will help the national, provincial, and municipal governments offer online services to their citizens. These solutions include networking hardware and software, Chinese language database software, Chinese language content management tools, portal software and network security solutions. Thanks to the market opening resulting from Chinas membership in the WTO, foreign IT suppliers will have new business prospects in traditional industries, such as manufacturing and banking that need to upgrade their systems to become competitive internationally. These industries will require solutions (e.g. enterprise resource planning, customer relationship management and supply chain management packages) that will help them become more efcient in delivering products to customers and receiving inputs from their suppliers (Botten and McManus, 1999). Information Technology companies could take advantage of Chinas rapidly growing market for IT services by not only targeting the traditional industries, but also by assisting SOEs to increase their competitiveness through selecting the right combination of equipment and software. ICT suppliers should benet from

the $24 million investment that Chinas Ministry of Science and Technology is making to bridge the countrys digital divide through the wide variety of programs that are a part of the Go West Initiative. IT solutions companies will be needed to educate communities, local governments, and businesses in Western China in various uses of information technologies and to train citizens on how to use computers and the internet. Because of the large rural economy in this region, US software rms will nd substantial demand for Chinese-language software targeted at the agricultural sector and packages that would help farmers distribute their products more efciently throughout China. In addition, US internet content providers will have an opportunity to develop Chinese-language content to increase the use of the internet, especially for educational purposes in schools and hospitals in Western China. Foreign suppliers interested in pursuing opportunities in Chinas ICT markets should recognize the differences in business and cultural styles between their home countries and China and develop an appropriate market entry strategy. Some form of local presence is essential. Options include using agents and distributors; partnering with large IT rms, systems integrators, or consultants; partnering with like-minded Chinese small and medium-sized enterprises (SMEs) with complimentary skills or products; or setting up a local ofce staffed by local employees to do marketing and training and to provide ongoing support. Even though China is a very large market of 1.3 billion people, it is essential that businesses understand consumer behaviour in the provinces/regions they are targeting. For example, spending patterns and needs of ICT end-users in the Pearl River Delta Region are very different from those of end-users in the Yangtze River Delta Region and from those in Western China. Future threats Amid the dominance of the multinationals in Chinas packaged software products, the development of Chinas software products market segment seems to be a daunting task. As for the nascent software service industry which is mainly targeting the Japan market, it is also facing challenges from India which has had much sophisticated experience and successful track records (Bajpai, 2006). Transforming these threatening foes into cooperative partners will be the right approach for the Chinese software industry to enhance its capability and move up the value chain. When compared to India, the Chinese software industry suffers from the fact that it is highly fragmented, with many thousand small players. Indian software companies have signicantly higher size both in terms of their annual revenues and manpower base. For example, the top ve Indian rms each have revenues in excess of US $1 billion and employ more than 40,000 people each. There is no single Chinese company that is anywhere close to these Indian rms in terms of size. Many Indian rms are also listed in overseas stock exchanges like NASDAQ (Christie et al., 1994), NYSE and LSE, enjoy a high market capitalisation. The lower cost structures that have so far been responsible for fuelling industry growth continue to be attractive when compared to North America and Central Europe (Hope and Hu, 2006). Currently, the average cost per software professional in India is lower roughly by 15 per cent when compared to an equivalent professional in China, and almost 13 per cent of an equivalent professional in North America and Central Europe. Software rms in India have adopted and evolved best practices in human resource management and invested considerably in employee attraction, development and retention, besides instituting attractive ESOP programmes. Chinese software rms

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seem to be way behind on this front. It is however, not all bad news: the Chinese software industry has had, and continues to have, a strong domestic market, and so is the case with the North American and European software industries. China also has access to a large manufacturing base, which provides additional revenue opportunities for the local software industry. The software industries in North America and Europe benet from a strong industry-academia interaction, and increasingly this is the case with the Chinese software industry as well. The pressure on operating margins applies to the North American and European software industries as well, but currently they are somewhat advantageously positioned because of their ability to do large, integrated, total outsourcing deals, which allows them to maintain an overall protable margin. The Chinese software industry has a low operating margin currently because of its structure. This low operating margin in Chinese companies is due to sub-optimal scale which is a result of a highly fragmented industry, with several thousand small rms having less than 50 employees which put many Chinese companies at a disadvantage in terms of scalability (Wilson and Purushothaman, 2003). For example, consulting and services companies are rapidly expanding their base in India and competing with the Indian software rms from their own ground and playing by their rules to pursue global opportunities. As a result, the large IT consulting and services rms like IBM, Accenture, CSC, EDS and Cap Gemini are able to position their offerings in as cost competitive a manner as some of the leading Indian rms, and to inuence large deals by leveraging their brand and boardroom relationships they received as legacy. This cost-based positioning is likely to impact the operating margins of the Indian companies unless they are quick to discover new sources of differentiation and offer a compelling proposition to their clients through value migration. In the short to medium term this is also likely to impact the ow of outsourcing business into China (McManus et al., 2007). Conclusion Emergence of other software nations on the global software industry landscape has certainly meant growing competition to the software and IT services industry in India. A vast, high-quality, English speaking and young talent pool, superior operational capability, and a strong reservoir of structural, social and relationship capital lend strength to Indias software industry. While the Indian software industry is not yet connected to software products market opportunities, it certainly has a strong upper edge when compared to the Chinese software industry, which suffers from high fragmentation and weak institutional frameworks besides the lack of credibility. The rst mover advantage the Indian software industry has will allow it to continue to stay ahead of the pack, especially in the realm of software and IT services. After almost two decades of development, Chinas software industry has shown its strength in high market growth and the governments strong support. How to overcome the weaknesses in managerial and technical skills and gain a signicant market share in the ever enlarging world software market remains a daunting task.
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