Wen's main message was that China is entering a new era in its development — one that demands sustainable and equitable growth. Wen and other top officials talked at length about the need to halt environmental degradation and to bring more balance to the distribution of wealth, between the haves in the rich coastal cities and the have-nots in the poor, agrarian interior.

At the center of the new five-year plan, which lasts until late 2010, is a target for GDP growth to average 7.5 percent a year, starting with 8 percent this year. This is down from an average of 9 percent or more per year that China has recorded for the last five years, and it translates into foregone economic output of about $45 billion annually. China's GDP growth last year was 9.9 percent, which equates to total output of $2.3 trillion, according to government figures.

In addition to targets for slower economic growth, the Chinese government is mandating a 10 percent reduction in the discharge of major pollutants by the end of the decade. And to elevate the standard of living in rural areas, the gov-ernment plans investments that include telecommunications and infrastructure spending. Unlike the GDP targets, which are just recommendations, the pollution caps and rural investment plans are mandated.

New focus for high tech
So what is the impact for the technology sector? For starters, over the next five years the Chinese government will focus on upgrading business processes and improving competitiveness at the expense of growth.

Indeed, growth for growth's sake will take a backseat. The government wants to nurture a few world-class brands like Lenovo, which acquired IBM's PC business for $1.75 billion at the end of 2004. It also wants to see the industry become more innovative by investing in R&D and design, and by moving away from its comfort zone of low-cost, low-margin manufacturing.

At a recent conference in Shanghai, Xudong Wang, minister of the Ministry of Information Industry (MII), reinforced the message of quality over quantity. He urged Chinese electronics companies to work on a number of areas, including homegrown technological innovation, international technology partnerships, intellectual-property protection, environmental safeguards, and world-class manufacturing and supply chain capabilities.

Growth in electronics is already coming down out of the stratosphere. Revenue for the sector grew 24.8 percent in 2005, compared with 41 percent in 2004. And MII is forecasting the industry will grow 21 percent in 2006, to $500 billion.

On the manufacturing front, a shift to more-complex, higher-margin content is under way as well. China's electronics GDP grew at an 18 percent clip in 2005 and is projected to grow 22.5 percent this year, to $109 billion. This higher growth rate comes in part from higher value-add, including both higher design content and the manufacture of more-complex products.

Of course, Chinese electronics companies have a long way to go before they will be on an equal footing with their foreign counterparts. Foreign companies in China account for 80 percent of the sector's revenue and 81 percent of its profits, according to the MII. They represent more than 93 percent of total profits in the computer sector and down to a low of 63 percent in audio/video, where Chinese companies have a strong position, according to the MII. Although all the top-tier international EMS providers and ODM companies have manufacturing operations in China, midsize and small Taiwanese and Hong Kong-based manufacturers — mainly PC and laptop makers — account for the majority of foreign-owned production.

High-volume, low-mix pro-ducts still dominate China's electronics-manufacturing sectors, but there are signs of change. What are known as midmix, midvolume products — medical devices and high-precision instruments, for instance — have seen growth in the past 12 months. Market research firm iSuppli Corp. forecasts that medical electronics will become the fourth-largest sector in China by 2010, after the three C's: computers, communications and consumer electronics.

That plays well into the Chinese government's strategy of becoming a technical value-add center for both local and international OEMs to outsource the design and manufacture of these products. (See "China's medical Rx" in the March issue of ESM at www.my-esm.com.)

One requirement for playing in the midmix market is high quality and adherence to international manufacturing standards. That means Chinese manufacturers must invest in business process improvement and qualify for certification to international standards and regulation, while at the same time increasing their capabilities in design and supply chain management, said Emily Chan, an executive with Philips IPO in Shanghai.

That includes obtaining ISO 9000 and 14000 certification, complying with the European Union's RoHS and WEEE directives, and, in the case of medical-equipment manufacturing, applying for CE marking and U.S. Food and Drug Administration certification.

Chan said she is seeing some modest gains in that regard. Philips outsources the production of some modules for its medical devices to local Chinese manufacturers, then brings final assembly back in-house. "We were challenged by achieving our business goal because of the scarcity of qualified vendors," said Chan.

A marketing researcher with Vishay Shanghai, who requested anonymity sees opportunity in this gap. "Because of high reliability and quality requirement, we have an advantage in serving [medical equipment OEMs]," the researcher said. "However, we can't compete with local Chinese suppliers because they can provide cheaper components."

China is actively working to create a more-sophisticated business environment that will encourage the growth of qualified local vendors. "We encourage technology innovation," said the MII's Wang.

One way is through good old-fashioned market economics. In February, as part of the 11th five-year plan, China's State Council introduced national guidelines for the medium- and long-term development of science and technology by creating formal markets for investment capital. In addition, it's promoting the development of a secondary stock market and is encouraging Chinese companies to get listed on both domestic and overseas stock markets as a way to raise funds.

Based on the new guidelines, the government will liberalize banking policies for promoting innovation and for creating formal mechanisms for high-tech startups to go public. The guidelines also encourage financial institutions to grant preferential credit loans to support state projects for industrialization of technology. Starting this year, the country will conduct experimental trading in stocks of unlisted high-tech companies within national high-tech development zones. China will also set up markets for the exchange of property rights and will adopt formal measures to improve the flow of capital into venture investment funds.

Meanwhile, the Chinese government plans tax incentives to encourage the development of software and semiconductor products — two high-value-added product areas. More details on the tax policies to support the growth of China's semiconductor and software sectors are expected to be released this year.

And to regulate the market and promote cooperation between local and international companies, the Chinese government focuses on the formulation of technical standards with the involvement of both international and domestic electronics companies. The formation of TD-SCDMA, China's homegrown wireless standard, is a good example that involves both local Chinese companies, such as Datang and Huawei, and international players like Siemens and Motorola.

On the environmental front, China has just released its own version of the European Union's Restriction of Hazardous Substances directive, known as "The Administrative on the Control of Pollution Caused by Electronic Information Products." The Chinese measure, like the EU's RoHS, aims to curb the use of hazardous substances in electronics products (see story, page 11). China expects to draft an environmental labeling standard for review in the second quarter and pass the regulation into law in July. However, it will not take full effect until mid-2007, a year behind Europe.

Phones, set-top boxes for the masses
One element of the plan to address a more-equitable distribution of wealth is the Chinese government's Village Phone Program. Launched in 2003, the project aims by 2020 to connect all of China's rural population of 700 million, representing more than half the country's populace of 1.3 billion.

Targeting the rural market was essential, since growth in new telephone subscribers has declined since 2003 in the saturated urban market. By the end of last year, China had 393 million mobile-phone subscribers and 361 million fixed-line telephone subscribers, for a total of 754 million phone subscribers. Annual growth of new subscribers was 14.6 percent last year, down from 24.5 percent in 2004.

The first step in the Village Phone Program was to connect 95 percent of all "administration villages" by 2005. Telecom operators exceeded that target by connecting 670,000 such villages, or 97 percent of the total. (Administration villages have government representatives and are under the leadership of town-hall governments.) An administration village usually has 1,000 to 2,000 residents or 200 to 400 households, and manages a number of remote villages.

Between 2003 and 2005, some 52,800 administration villages were connected by phone using a combination of wireless and wireline technologies. And the government plans to sign up 50 million new telephone subscribers in rural areas in the next two years, likewise using a combination of wireless and wireline technologies.

The Village Phone Program provides opportunities for telecom equipment and terminal-device OEMs, as well as component suppliers. It also allows the government to propagate TD-SCDMA, which China hopes will become a low-cost wireless standard.

Another way to catalyze technology development is to mandate upgrades. That's the strategy behind China's June 30 deadline for cable TV operators to begin transitioning from analog to digital service. Operators that fail to start the migration to digital broadcasting and digital set-top boxes may lose their digital-cable operating licenses.

Most important, a digital-cable license gives an operator the right to access government funding to help in the transition. However, the digital migration has not run as well as anticipated, in part because of limited content and the terms of the incentives. At the end of 2005, there were only 1.4 million digital-cable subscribers in China. With the regulation deadline looming, however, nearly 4.2 million households had subscribed to digital service by the end of February.

How did operators add 2.6 million subscribers in just two months? Free set-top boxes. Topway, the government-owned cable TV operator in Shenzhen, converted its entire subscriber base of 530,000 to digital cable in five months. With government funding, Topway provided a total of 810,000 set-top boxes; about half of the subscribers are installing two set-tops in one house.

Like other sectors of the electronics industry, Chinese set-top-box manufacturers are responding to two things. One is China's domestic market demand for new services such as video-on-demand and other paid services. The other is government incentives, which are part of the 11th five-year plan.

Amy Wang can be reached at amywang@china-outlook.com.amywang@china-outlook.com.

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