The world turned upside down

IN 1980 American car executives were so shaken to find that Japan had replaced the United States as the world's leading carmaker that they began to visit Japan to find out what was going on. How could the Japanese beat the Americans on both price and reliability? And how did they manage to produce new models so quickly? The visitors discovered that the answer was not industrial policy or state subsidies, as they had expected, but business innovation. The Japanese had invented a new system of making things that was quickly dubbed “lean manufacturing”.

This special report will argue that something comparable is now happening in the emerging world. Developing countries are becoming hotbeds of business innovation in much the same way as Japan did from the 1950s onwards. They are coming up with new products and services that are dramatically cheaper than their Western equivalents: $3,000 cars, $300 computers and $30 mobile phones that provide nationwide service for just 2 cents a minute. They are reinventing systems of production and distribution, and they are experimenting with entirely new business models. All the elements of modern business, from supply-chain management to recruitment and retention, are being rejigged or reinvented in one emerging market or another.

Why are countries that were until recently associated with cheap hands now becoming leaders in innovation? The most obvious reason is that the local companies are dreaming bigger dreams. Driven by a mixture of ambition and fear—ambition to bestride the world stage and fear of even cheaper competitors in, say, Vietnam or Cambodia—they are relentlessly climbing up the value chain. Emerging-market champions have not only proved highly competitive in their own backyards, they are also going global themselves.

The United Nations World Investment Report calculates that there are now around 21,500 multinationals based in the emerging world. The best of these, such as India's Bharat Forge in forging, China's BYD in batteries and Brazil's Embraer in jet aircraft, are as good as anybody in the world. The number of companies from Brazil, India, China or Russia on the Financial Times 500 list more than quadrupled in 2006-08, from 15 to 62. Brazilian top 20 multinationals more than doubled their foreign assets in a single year, 2006.

At the same time Western multinationals are investing ever bigger hopes in emerging markets. They regard them as sources of economic growth and high-quality brainpower, both of which they desperately need. Multinationals expect about 70% of the world's growth over the next few years to come from emerging markets, with 40% coming from just two countries, China and India. They have also noted that China and to a lesser extent India have been pouring resources into education over the past couple of decades. China produces 75,000 people with higher degrees in engineering or computer science and India 60,000 every year.

The world's biggest multinationals are becoming increasingly happy to do their research and development in emerging markets. Companies in the Fortune 500 list have 98 R&D facilities in China and 63 in India. Some have more than one. General Electric's health-care arm has spent more than $50m in the past few years to build a vast R&D centre in India's Bangalore, its biggest anywhere in the world. Cisco is splashing out more than $1 billion on a second global headquarters—Cisco East—in Bangalore, now nearing completion. Microsoft's R&D centre in Beijing is its largest outside its American headquarters in Redmond. Knowledge-intensive companies such as IT specialists and consultancies have hugely stepped up the number of people they employ in developing countries. For example, a quarter of Accenture's workforce is in India.

Both Western and emerging-country companies have also realised that they need to try harder if they are to prosper in these booming markets. It is not enough to concentrate on the Gucci and Mercedes crowd; they have to learn how to appeal to the billions of people who live outside Shanghai and Bangalore, from the rising middle classes in second-tier cities to the farmers in isolated villages. That means rethinking everything from products to distribution systems.

Anil Gupta, of the University of Maryland at College Park, points out that these markets are among the toughest in the world. Distribution systems can be hopeless. Income streams can be unpredictable. Pollution can be lung-searing. Governments can be infuriating, sometimes meddling and sometimes failing to provide basic services. Pirating can squeeze profit margins. And poverty is ubiquitous. The islands of success are surrounded by a sea of problems, which have defeated some doughty companies. Yahoo! and eBay retreated from China, and Google too has recently backed out from there and moved to Hong Kong. Black & Decker, America's biggest toolmaker, is almost invisible in India and China, the world's two biggest construction sites.

But the opportunities are equally extraordinary. The potential market is huge: populations are already much bigger than in the developed world and growing much faster (see chart 1), and in both China and India hundreds of millions of people will enter the middle class in the coming decades. The economies are set to grow faster too (see chart 2). Few companies suffer from the costly “legacy systems” that are common in the West. Brainpower is relatively cheap and abundant: in China over 5m people graduate every year and in India about 3m, respectively four times and three times the numbers a decade ago.

This combination of challenges and opportunities is producing a fizzing cocktail of creativity. Because so many consumers are poor, companies have to go for volume. But because piracy is so commonplace, they also have to keep upgrading their products. Again the similarities with Japan in the 1980s are striking. Toyota and Honda took to “just-in-time” inventories and quality management because land and raw materials were expensive. In the same way emerging-market companies are turning problems into advantages.

Until now it had been widely assumed that globalisation was driven by the West and imposed on the rest. Bosses in New York, London and Paris would control the process from their glass towers, and Western consumers would reap most of the benefits. This is changing fast. Muscular emerging-market champions such as India's ArcelorMittal in steel and Mexico's Cemex in cement are gobbling up Western companies. Brainy ones such as Infosys and Wipro are taking over office work. And consumers in developing countries are getting richer faster than their equivalents in the West. In some cases the traditional global supply chain is even being reversed: Embraer buys many of its component parts from the West and does the assembly work in Brazil.

Old assumptions about innovation are also being challenged. People in the West like to believe that their companies cook up new ideas in their laboratories at home and then export them to the developing world, which makes it easier to accept job losses in manufacturing. But this is proving less true by the day. Western companies are embracing “polycentric innovation” as they spread their R&D centres around the world. And non-Western companies are becoming powerhouses of innovation in everything from telecoms to computers.

Rethinking innovation

The very nature of innovation is having to be rethought. Most people in the West equate it with technological breakthroughs, embodied in revolutionary new products that are taken up by the elites and eventually trickle down to the masses. But many of the most important innovations consist of incremental improvements to products and processes aimed at the middle or the bottom of the income pyramid: look at Wal-Mart's exemplary supply system or Dell's application of just-in-time production to personal computers.

The emerging world will undoubtedly make a growing contribution to breakthrough innovations. It has already leapfrogged ahead of the West in areas such as mobile money (using mobile phones to make payments) and online games. Microsoft's research laboratory in Beijing has produced clever programs that allow computers to recognise handwriting or turn photographs into cartoons. Huawei, a Chinese telecoms giant, has become the world's fourth-largest patent applicant. But the most exciting innovations—and the ones this report will concentrate on—are of the Wal-Mart and Dell variety: smarter ways of designing products and organising processes to reach the billions of consumers who are just entering the global market.

No visitor to the emerging world can fail to be struck by its prevailing optimism, particularly if his starting point is the recession-racked West. The 2009 Pew Global Attitudes Project confirms this impression. Some 94% of Indians, 87% of Brazilians and 85% of Chinese say that they are satisfied with their lives. Large majorities of people in China and India say their country's current economic situation is good (see chart 3), expect conditions to improve further and think their children will be better off than they are. This is a region that, to echo Churchill's phrase, sees opportunities in every difficulty rather than difficulties in every opportunity.

This special report will conclude by asking what all this means for the rich world and for the balance of economic power. In the past, emerging economic leviathans have tended to embrace new management systems as they tried to consolidate their progress. America adopted Henry Ford's production line and Alfred Sloan's multidivisional firm and swept all before it until the 1960s. Japan invented lean production and almost destroyed the American car and electronics industries. Now the emerging markets are developing their own distinctive management ideas, and Western companies will increasingly find themselves learning from their rivals. People who used to think of the emerging world as a source of cheap labour must now recognise that it can be a source of disruptive innovation as well.