When China joined the World Trade Organization (WTO) in 2001, the country got more than it bargained for, says Eric Thun of Oxford University's Said Business School. While China's legions of small, private-sector industrial companies knew market liberalization would lead to much stiffer competition from foreign multinational heavyweights, what they — and others — didn't expect was that it would also bring a great deal of cooperation.

Nearly 10 years later, new field research by Thun, a lecturer in Chinese business studies, and Loren Brandt, an economics professor at University of Toronto, has found a much higher amount of both competition and cooperation between foreign and indigenous firms than previously assumed. Such "co-opetition" is now having a deep impact on the business models of foreign and local players alike.

Thun says it's one of the "unanticipated outcomes" of China's recent domestic growth, which has opened a vast mid-tier market of goods that's up for grabs. "There’s this big middle segment, which both foreign multinational firms and Chinese firms for different reasons are struggling to capture," he says. "Both are trying to get to this middle segment of the market."

Analyzing their findings in a paper (to be published soon in the academic journal World Development)titled,"The Fight for the Middle: Upgrading, Competition, and Industrial Development in China," Thun and Brandt take a 360-degree view of what this means for firms, consumers as well as policy makers. In this interview with China Knowledge at Wharton, Thun discusses the top-level findings of this four-year project and what it could mean for the globalization of industrial value chains far beyond China.

An edited transcript of the conversation follows.

China Knowledge at Wharton: What were you looking to discover from this research?

Eric Thun: The heart of the issue is really trying to understand whether Chinese firms are successful in increasing their capabilities, and moving from low value-added activities to higher value-added activities. In many respects, this is the most critical question facing China right now because, as you read in all the papers these days, they have the perfect storm of rising costs — the exchange rate of the currency is changing, labor costs are rising and raw material costs are increasing. The Chinese economic model has to shift from one dependent on low-cost labor to one based much more on higher value-added activities. We wanted to understand whether that’s happening and why it’s happening. That’s one set of issues.

The other set of issues has to do with the role of foreign direct investment (FDI) in this process. The rate of FDI in China has been somewhat controversial. It’s very different from other developing countries in the sense that the country has been enormously dependent on it and some people have argued that this has been a bad thing, because it’s not pushing the development of indigenous Chinese firms. From the research we have done in the past, both Lauren and I sensed that this wasn’t really the case, but rather that Chinese firms were gaining a lot of benefits from foreign investment. We wanted to look at this in more depth.

China Knowledge at Wharton: You used the country’s entry into the WTO as the starting point. Why?

Thun: When China joined the WTO and tariff barriers were lowered, most foreign firms were expected to do very well in the country — that they would prevail over smaller Chinese firms that weren’t as sophisticated with respect to technology or brands. For this reason, joining the WTO was controversial in Beijing. Some policy makers thought the then premier [Zhu Rongji] had sold out Chinese industry to the West. But what’s surprising is that there’s been very little analysis that tries to understand systematically what the outcome of that has been across all of Chinese industry. So the first step of the research was to look at the full universe of Chinese firms with trade data to understand who’s prevailing in different markets. As you might expect, foreign firms dominate a lot of capital and R&D-intensive markets and Chinese firms dominate labor-intensive ones.

But a lot of stories were much more mixed, and we try to explain why. We also saw that, as you would expect, foreign firms' overall share of the Chinese market increased after China's WTO membership at first, but it wasn’t that great of an increase, and then began to tail off, particularly in the last couple of years. Now we’re beginning to see Chinese firms rebounding and capturing market share.

China Knowledge at Wharton: How did you go about analyzing the sectors you did to understand what was happening?

Thun: The sectors we chose were ones that you would expect to see foreign firms doing better from the aggregate data. We wanted to show that even in these "easy" cases, Chinese firms are making gains. We looked at the automotive sector, construction equipment — like wheel loaders and excavators — and machine tools.

For the intensive field research, we had to visit these companies and spend a lot of time talking to managers, and their key suppliers and distributors. It meant going to all the different elements of the value chain. You can imagine that a Chinese firm, which on paper looks like it’s doing very well, could be importing all its components from foreign companies, so it really doesn’t have any technical capabilities of its own….

We probably started this particular paper four years ago. We make two to three research trips to China a year, each one for two or three weeks. All told, probably several hundred interviews have gone into this…. Looking at raw data doesn’t always tell you a whole lot.

China Knowledge at Wharton: What were your top-line findings?

Thun: The reason why Chinese firms didn't have trouble after WTO membership was that competition was a good thing in these sectors, despite what the Chinese government or WTO critics thought. First, it increased the size of the domestic market so competition naturally led to lower prices and more people being able to afford particular goods. The market has been growing rapidly, especially if you combine this with overall economic growth and rising incomes in China.

Think of cars. After WTO membership, private consumption in China grew rapidly. At the end of the 1990s, mainly state-owned enterprises and government bureaus were buying cars. Now, the country is the largest automotive market in the world. That leads to a couple of fundamental changes. First, there’s a very large low end to this market, the relatively inexpensive cars. Chinese companies have captured this low end because multinational companies were not focused on it and have trouble competing in this part of the market because their cost structure is too high.

If you think about General Motors, Volkswagen or Toyota, they’re designing cars for Europe, North America and Japan, right? Because that's where their dominant markets are, so the design of the car, the suppliers used for the car, the R&D, all of these costs are tremendously higher than what a Chinese firm would [afford to invest in].

You have natural barriers to entry at the low end of the market. Multinational firms couldn’t go into the low-end markets [because of the costs] and that created an opportunity for Chinese companies. They could use the low end of these markets to gain scale, learning by doing and ramping up their capabilities. These markets did not exist to the same scale back in the 1990s.

The second impact of the growing markets is that multinational firms had to react. A multinational could say, “We’re just going to stay in the premium segments where we have a natural advantage due to our technology, scale and brands.” But the most rapidly growing markets are lower down. To access these markets, they have to blow up their business model. They have to re-think designs, supply chains and organizational structures to compete in a market that has very different demands from their usual global markets.

To continue with the example of an automotive firm, it can’t just transfer its designs from Europe or the United States to China. It has to begin to design a lower cost car for the Chinese consumer and that means that it has to move R&D activities to China and use Chinese suppliers because these suppliers will have a lower cost base. To use these suppliers, it has to train them, so it has to send its engineers down into the supply chain. All of this is localizing activities.

When you talk about multinational firms localizing these activities, you begin to see an interaction between these dynamics because multinational firms, in order to compete in the lower end, are doing a lot more in China than they would otherwise do in terms of R&D, component sourcing and capability building. Combine that with local firms trying to build up their capabilities and think about how suppliers in China can work with foreign firms and get lots of training from them, and they can work with domestic firms and broaden their capabilities.

You see a real depth of capabilities in the supply base and this is what a lot of people miss when they say that no innovation happens in China. A lot is not the sort of innovation we commonly think about it in the West in terms of technological, Silicon Valley type of innovation. Some scholars call this cost innovation, by producing a good product at a much more basic price.

The irony is that multinational firms are now doing exactly what China's government used to struggle to get them to do in the 1980s and 1990s using regulatory means. Then, auto companies [were required] to localize a certain percentage of component sourcing. Now, it just happens because of natural market forces. If you want to compete in China, you have to localize.

China Knowledge at Wharton: What does your research tell you about the globalization of production?

Thun: In some ways, the dynamics I’m talking about in China, particularly with respect to multinational firms, are foreshadowing a general trend in the global economy. In the past, when you looked at global value chains, the end point was usually in an advanced capitalist economy. Manufacturing was in the developing world, using low-cost bases, and they would export to the U.S. or Europe because these economies dominated the global economy. This shaped the dynamics of competition between multinational firms and firms from the developing world because multinational firms had a better understanding of the design, technology and brands required in these final markets. But emerging markets are going to be much more important because that’s where the growth of the global economy is and increasingly, leading multinational firms are finding that their largest markets are in these emerging markets. China, for instance, is the largest market for an endless array of products now: Mobile phones, automobiles, construction equipment, machine tools, airplanes, and the list goes on and on.

It will no longer be about who can have the most sophisticated, cutting-edge technology, and don’t worry about the price. It’s going to be: Who can give you a product whose cost-performance ratio meets the needs of a developing country consumer? Some people have talked about a "good enough" market — that [consumers] don’t want the best technology, they want good enough technology. Multinationals have a lot to learn from Chinese companies in this respect.

I visited a major multinational construction equipment firm in China whose entire ethos is about improving performance and R&D is done in the home country. If its R&D engineers think they can improve the performance of a piece of equipment but will need to add US$10 to the cost, it’s a no-brainer; they would do it. But its Chinese partners will probably say, “If you increase the price, you’re going to price yourself out of the market and we don’t necessarily need that extra performance for this particular market segment.” That type of calculation is going to become increasingly important. There are profound implications in terms of organizational structures for a lot of aspects of a business.

China Knowledge@Wharto n: In terms of organizational structure, what are you foreseeing in, say, 10 years?

Thun: At companies that are very centralized with product design decisions done in the home country, it’s very difficult to have flexibility. It’s this classic question in global strategy between the extent to which you want to decentralize an organizational structure that can respond very quickly and flexibly to a local market, or a more centralized organization that is going to make sure it carefully controls product quality and maximizes global economies of scale.

China Knowledge at Wharton: What do Chinese companies now need to be thinking about?

Thun: If they are very effective in markets where cost is important, that can translate well in other developing markets. They have an advantage over multinational firms there. But this is a window of opportunity that is not going to be open forever. With all the pressures on them that we’ve been discussing, multinational firms are reacting and are really focused on this issue right now. They are inevitably going to start responding to these pressures and develop the same products. Chinese firms have to take advantage of the opportunity that exists now.

Another implication to think about, however, is that there’s been a big push for the globalization of Chinese companies and often, from my perspective, this is premature. The largest markets in the world are at home and that’s where they have the advantage. Chinese companies that have the smartest approach to globalization are thinking carefully and in a hard-headed manner about what capabilities they can access abroad and how will that complement what they have at home.

A third challenge that Chinese firms face is organizational in terms of governance and trying to have the structures that match their growing scale.

China Knowledge at Wharton: What needs to change in terms of their governance in that case?

Thun: If you take the private-sector firms, many are family-dominated companies, as is quite common in East Asia. It’s making the transition to broadening family ownership in terms of how to have good corporate governance structures that give incentives to professional managers….

I should also clarify that in this paper, we’re talking about a particular category of industry in China and it’s mainly those that, in terms of consumption, are largely market-driven. So the state is not playing a very heavy role in terms of shaping these markets. That's why competition is really important in driving these sectors forward.

China Knowledge at Wharton: We talked about the multinational and the lessons they can learn and likewise the Chinese firms. What about policy makers, both from developed and developing countries? What lessons do you think they can take from your work?

Thun: The biggest lesson for the Chinese government — at least in the types of industries we were focused on where there’s a very large domestic market and are relatively mature — is that it can relax a little bit. It doesn’t have to be so worried about whether foreign firms are going to dominate the market or whether it should use government leverage to support domestic firms. China has a real luxury in the sense that its market is so big that for multinational firms to succeed, they have to build up capabilities within China. It’s a luxury other developing countries might not have.

From the perspective of foreign governments, there would be a couple of implications. The most basic is that a lot of political discourse about China and its relation to the global economy often takes an “us versus them” approach and that really doesn’t work. We’re all one and the same working together in a complex way. For a lot of foreign companies, their future is in China and markets like that, so they have to figure out how to compete in them so they can prosper. General Motors, for instance, now has its global headquarters outside of North America in Shanghai now because it wants all of its high-flying executives to have experience in that market.

The second implication, which might be slightly more troubling and also more of a challenge, is that in the past, [it's been assumed in developed countries that] it’s just blue-collar jobs being lost to China. That’s not necessarily the case. They’re building up a range of capabilities in all segments, including design, and so developed economies have to make sure they stay focused and support public policy programs to create jobs that are innovation-based and of higher value-added.