Can Taiwan leap forward? As technology and jobs flow to China, Taiwan faces a critical economic challenge.

The entrance to Taiwan's high-tech corridor known as Hsinchu Science Park is deceptively green. Subtropical shade trees line a traffic-islanded parkway dotted with shrubs and flowers. But when the promenade gives way, it reveals the monolithic headquarters of the park's tenants, companies with celebrity-status names in the tech industry but with little name recognition among American consumers who use their products. This, it turns out, is the high-tech heart of Asian manufacturing.

Your iPod, Apple or Dell computer and Sony PlayStation likely have been made by one of these companies whether in Taiwan or at one of their many factories in China. And take a look at your cell phone, your PDA, your laptop, or the dashboard of your car (if it has a GPS system). Booming demand for the small color screens in modern devices has put Taiwan in a race for world leadership with South Korea and Japan. In liquid crystal display (LCD) monitors for televisions and computers, Taiwan is already tops, ranking No. 1 with a 68 percent share of a $21 billion market. It's also leading in the markets for PDAs, semiconductor packaging, notebook computers, cable modems, CD-Roms, DVDs and computer networking equipment. Taiwan officials like to tout a stunning array of figures to prove their manufacturing prowess, such as that Taiwan produces one motherboard every 0.374 seconds, 24 hours a day.

But that pride of place has been starting to falter, and even its most ardent proponents are worried. "In terms of information technology products, Taiwan is the leading nation," boasts Taiwan's Vice President Annette Lu. "However, we feel we have to upgrade the IT industry. Now we are encouraging R & D in order to innovate and to create our own brands."

That's a key point, and how Taiwan handles this transition is critical. Unless it transforms itself from a manufacturing center into an island that innovates, designs and markets its own products, Taiwan faces an uncertain future. For 30 years, Taiwan's economic growth has hinged on making components and products for others, using a combination of shrewd government policy, incentives for local companies to grow, and an autocratic government that could channel resources into manufacturing. One example of that strategy was the government's decision to create Taiwan's version of "Silicon Valley"--the Hsinchu Science Park--clustering Taiwan's leading companies, researchers and engineers in an area outside of Taipei.

But now, Hsinchu is overflowing with mature--and not all rapidly growing--companies. Margins are falling. And like the United States and Europe before it, Taiwan faces the harsh "Rust Belt" reality of its manufacturing jobs moving to the mainland. In that sense, perhaps, the economic "threat" posed by China is of greater worry to Taiwan than the military one. Under pressure to keep product prices ever lower as manufacturing costs rise at home, the Taiwanese have no choice. To make up for job losses and re-employ the local work force, they must try to develop service-related industries. And they must invent their own technologies and try to build brand names out of their homegrown successes.

Can they do it? Does Taiwan have the capability to invent, create and sell brand-name products and services for which it can charge a premium? Or will the continuing transfer of manufacturing to the mainland leave Taiwan a hollowed-out shell of an island?

Next Step

Those are big questions, and Taiwan's leading thinkers are trying to come up with answers. For a business leader such as Stan Shih, the retired founder of computer manufacturer Acer and its two off-shoots, Asustek Computer and BenQ, the solution is clear: "So what is the next step for Taiwan? What is the next economic miracle? I cannot think of anything except branding."

Shih, in fact, has been the only Taiwanese entrepreneur to develop a leading consumer brand, and he recently started a venture capital company that aims to help other companies do it as well. (BenQ, where Shih still serves as a director, recently acquired Siemens Mobile in a move toward building a larger consumer brand market.) Shih's vision is to transform Taiwan into more of an R & D center than a manufacturing base, with land devoted to laboratories making new innovations that are then manufactured on the mainland. He and other business leaders believe that the only manufacturing that should remain in Taiwan is pilot lines for testing R & D ideas.

Companies in Taiwan say a freer flow of labor is another part of the solution--bringing in software engineers from places such as India--as well as a move toward more IT training in services industries for Taiwan's work force. "The trend will be that we're going to see people wake up to the fact that jobs lost in manufacturing can be sopped up by services--not by making dumplings, but by areas such as health care and elder care," says Richard R. Vuylsteke, executive director of the American Chamber of Commerce in Taipei. Vuylsteke cites a futuristic plumber who must show up with a laptop, show the customer which options of faucets he or she can buy online, order them over the Internet and return later to install them. "Every profession is now high tech," he asserts.

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As Taiwan develops these skills at home, it can then export the expertise to the rest of the region--just as in previous decades when Taiwan's factory managers garnered reputations as being among the best in the world. It's true that Taiwan's dependence on services is growing at the same time that manufacturing is declining. From being about 50 percent of the economy in 1991, services have risen to 68 percent today. Manufacturing, which was 35 percent of the economy then, is only 30 percent today.

Restricting Manufacturing

For the government, its preferred solution has been to try to block the manufacturing move to China. Fearing an unemployment surge, Taipei outlawed the manufacturing of high-end semiconductors by Taiwan companies on the mainland as of 2001, saying it would review applications on a case-by-case basis. So far, only a few companies, such as Taiwan Semiconductor Manufacturing (TSMC), have received exemptions, and only for previous-generation and not next-generation production. Taipei officials fined the chairman of chip foundry UMC, Robert Tsao, $96,000 this spring for allegedly sneaking around government laws to set up a factory in China. (UMC denies any wrongdoing.)

But investing via companies set up in the British Virgin Islands is a key way that Taiwan companies get around the laws. Partly as a result, the BVI is ranked as the fourth-largest foreign direct investor in China. About 90 percent of that money can be traced back to Taiwan, according to Tung Chen-yuan, professor at National Chengchi University and head of the China Economic Analysis project of the Cross-Strait Interflow Prospect Foundation. "You can control money, but you cannot control people," he says. He expects the continuing restrictions on manufacturing's move to China to go the way of the dodo before long--once Taipei realizes that it is killing the competitiveness of its own companies and Cross-Strait trade continues to rise. From $32 billion in 2000, it nearly doubled to $62 billion in 2004.

Back in 2001, nearly half of Taiwan's $42 billion IT output was manufactured on the island. But by the end of 2003, the proportion had fallen to roughly one-third--a reaction to huge customer side cost pressure at the end of the tech boom: "The only escape was to very rapidly shift over to mainland China. Literally, there was a giant sucking sound that started in 2001 and ended in 2003," explains Martin Hirt, the Taipei-based head of McKinsey & Company's technology practice for Greater China.

Now, Taiwan companies account for about two-thirds of hardware output from mainland China. Around one million Taiwanese, including investors, factory managers and their families, have relocated to China. But without direct air links, currently prohibited by Cross-Strait tension, they must take long and costly detours to China via a third location, such as Hong Kong.

The government's continued insistence on blocking the manufacturing shift in its entirety "is already an impediment to their competitiveness," says Hirt. "If they don't eat a piece of the China cake, somebody else will."

That's starting already. Share prices of TSMC, despite an expected boom in chip sales, have been trading at levels of two years ago. Traders are discounting TSMC because of the continuing challenge from its Chinese rival Semiconductor Manufacturing International (SMIC) and fears that Taipei's policies will continue to affect TSMC's competitiveness in the long term.

The squeeze is on nearly everywhere. From 1998 to 2003, the average profit margin of Taiwan's IT companies, excluding semiconductors, fell by nearly half, to 4.8 percent, according to government figures. Margins on manufacturing notebook computers fell to between 4 percent and 8 percent from 15 percent a few years before--one reason that Acer's Shih had the foresight to get out of manufacturing altogether and instead contract out the assembly while focusing on design and innovation.

The reason semiconductor companies have fared better is innovation. Taiwan's big chip companies moved from being two generations behind to being highly innovation-driven world leaders, with net margins of 20-30 percent. Assemblers of licensed products continued to squeeze out 5 percent margins. Taiwan likes to brag that it is now No. 4 in the world in the issuing of U.S. patents: It earned 5,298 in 2003. That beat out South Korea's 3,944, but the U.S. was still leading at 87,901.

So President Chen Shui-bian has made R & D--and keeping it in Taiwan--a continuing government priority. He has increased the number of "Science Parks" such as Hsinchu to 10, although most appear to be little more than real estate plays so far. The few that have attracted big name companies include Taichung Science Park on the west central coast, and Tainan Science Park on the southwest part of the island. The desire is to turn the entire west coast of Taiwan, the side of the island that faces China, into a big high-tech corridor, and the whole place into a "Green Silicon Island." Chen also has called for an increase in R & D spending from 2.45 percent of GDP to 3 percent, particularly in the areas of biomedical research and energy and environmental technology.

One part of the solution is the government-supported Industrial Technology Research Institute (ITRI), located in Hsinchu just adjacent to the Science Park. Looking back, it was the government's creation of ITRI in 1973 that gave the island its leap into the high-tech realm. With government funding, the research institute has lent hundreds of technicians, engineers and researchers to the private sector. The creation of the Hsinchu Science Park next door in 1980 put Taiwan's leading companies in proximity, so that they could share the innovations from ITRI and benefit from close ties to both suppliers and competitors within the cluster, as well as proximity to Taiwan's two leading universities nearby.

"Taiwan is a great example of successful government policy," says Hirt. "Without that policy, I guarantee there would not be a Hsinchu and the kind of success that Taiwan has enjoyed." The result was that Taiwan started producing integrated circuit (IC) technology, including microprocessors and memory chips, and thus became the hub of the digital revolution. By the 1990s, Taiwan had moved into LCD panels, motherboards, networking equipment, and optical storage devices (floppy disks, CDs, DVDs).

Since its creation, ITRI has helped form 130 new spin-off companies from joint R & D projects, including the huge semiconductor success stories TSMC and UMC. In fact, some 62 CEOs in Taiwan have been ITRI alumni. "Everybody is looking for the same thing: innovation," says ITRI's president Johnsee Lee, whose background includes a stint at Argonne National Laboratory, the large Department of Energy research center outside Chicago. "Lots of small and medium companies don't have their own R & D, so we function as R & D for medium-sized companies." It has done this for about 27,000 of them; they then go on to grow in areas of niche manufacturing and share their financial success with ITRI. "When some [product] moves on to be made in China, we just have to move on to the next one," says Lee.

A recent ITRI success story involved helping a wheelchair company invent electronic technology to propel people to stand up without assistance. Another was in the services realm: 7-Eleven stores, which previously made deliveries using a refrigerated truck with a single temperature. Using the help of ITRI scientists, they developed a system to compartmentalize the truck with different temperatures--sectionalized but centrally controlled--for produce, ice cream and even drugs. Now, 7-Eleven stores around the region, as well as Starbucks coffee chains, want to adopt the technology, says Lee. "We are in a very interesting stage," he says. "Technology alone doesn't do it anymore. We have to link lifestyle to business."

The links between ITRI and Hsinchu companies created an economic "cluster" or "hot spot." Acer was one beneficiary. Its proximity to other component manufacturers allowed it to merge its panel display company with another to create a new entity in LCD panel manufacturing, AU Optronics, in 1996. AUO listed on the New York Stock Exchange in 2002 and has become the third largest manufacturer of LCD panels in the world, with 23,000 employees, mostly making screens for TVs, computer monitors, cell phones, digital cameras, and GPS displays. Its annual revenues grew from $166 million in 1999 to $5 billion in 2004.

For AUO, its proximity to ITRI led it to lure away a number of ITRI researchers and engineers. "The engineering pool and technology base of the universities and ITRI have been critical to the success of our early development," says Hui Hsiung, the company's executive vice president in charge of strategic planning who is a former DuPont scientist with a Ph.D. from the University of California at Berkeley.

Future Concerns

At AUO, the pressure of lower margins has been propelling the company to shift more and more manufacturing to China. While it still maintains its R & D in Taiwan as well as 20 percent of its manufacturing--with about 80 percent now in Suzhou, China--it easily could move all of it to the mainland, says Hui. "It's difficult to keep manufacturing and R & D far apart for a long time," he says. "It's just a matter of time before you have to move your design capability to where the manufacturing is. Basically, you cannot stop the flow of technology from Taiwan to China." Such desires by Hui and other major manufacturers pose the most serious challenge to Taiwan's plan to keep competitive as it moves up the IT chain.

And if R & D eventually starts leaving Taiwan and heading to the mainland as well, what's left for Taiwan? Capital-intensive industries will remain for the time being, but only as long as they can afford it. Infighting between opposition parties has brought the government virtually to a standstill and large infrastructure projects, such as a high-speed train that's intended to connect Taipei with the southern port of Kaohsiung, have been seriously delayed.

So even if Taiwan's government were a unified whole, capable of taking decisive actions such as the ones that created ITRI and Hsinchu in the past, it's unclear whether that would be enough. "Could you do it all again today, say in biotech?" wonders McKinsey's Hirt. "It's tough to say. Taiwan was at the right place at the right time, and it doesn't mean that if it did it again tomorrow, it's going to be successful again."

Still, Taiwan's resilient population of 23 million in a land mass half the size of Ireland has managed to create one of the most amazing economic transformations of the 20th century. How it will adapt to the globalized world of the 21st depends on how nimbly it can adjust to the giant on its doorstep.

Taiwan's Dynamic Industries*

                      No. of                                R & D
Sectors               Co.'s         Sales       Growth     Spending

Integrated circuits    164      $22.3 billion   33.0%    $935 million
PC peripherals          58       $4.1 billion    3.4%    $153 million
Telecom                 52       $1.8 billion    9.8%     $93 million
Optoelectronics         61       $3.9 billion   39.2%    $251 million
Precision machinery     21     $277 million     59.7%      $8 million
Biotechnology           28      $76 million     38.7%     $24 million
Totals                 384      $32.5 billion   30.6%      $1.5 billion
                                                (avg)

                        R & D as
Sectors                % of Sales

Integrated circuits      8.3%
PC peripherals           3.4%
Telecom                  3.9%
Optoelectronics          4.9%
Precision machinery      4.4%
Biotechnology           24.0%
Totals                   9%
                        (avg)

* In Hsinchu Science Park