German Knowledge Intensive Business Services (KIBS) in China

Table of contents

List of tables

List of figures

List of abbreviations

1. Introduction
1.1 Background and research question
1.2 Structure of the thesis

2. Conceptual context: Theoretical background of Knowledge-Intensive Business Services (KIBS)
2.1 Evolvement of KIBS research
2.2 Definition and characteristics of KIBS .
2.3 Explanations and drivers of KIBS dynamics
2.4 KIBS - Spatial features and the role of proximity
2.4.1 Dimensions of proximity ..
2.4.2 Spatial distribution - Concentration of KIBS in urban areas.
2.4.3 Network connections of KIBS
2.5 KIBS - Functions in the knowledge-based economy
2.5.1 KIBS as innovators - The process of knowledge generation inside KIBS
2.5.2 KIBS as intermediaries and innovation carriers
2.6 Dimensions of the KIBS knowledge base
2.6.1 Knowledge categories
2.6.2 Knowledge value chain
2.6.3 Knowledge domains

3. Conceptual context: Legal and economic framework conditions for foreign service companies in China
3.1 Chinese government policies on the service sector
3.1.1 The reform and opening period
3.1.2 Trade and investment policies
3.1.3 The 12th Five Year Plan - Implications regarding the service sector
3.2 Legal conditions of foreign operations in China
3.2.1 Legal forms of foreign direct investment
3.2.2 Implications of China's WTO membership and existing restrictions on the service sector
3.2.3 Intellectual property rights
3.3 Current problems of foreign invested service companies
3.3.1 Intellectual property rights violation
3.3.2 Intransparency of administrative measures and discrimination
3.3.3 Lack of highly qualified personnel
3.3.4 Cultural issues
3.3.5 Perspectives
3.4 Research questions for the empirical analysis

4. Empirical macro analysis - German KIBS in China with focus on Beijing
4.1 Methods
4.1.1 The tertiary sector in China - Approach
4.1.2 The tertiary sector in China – Data quality and availability
4.2.1 German KIBS in China – Approach
4.2.2 German KIBS in China – Data quality
4.2 National level: the tertiary sector and German KIBS in China
4.2.1 Development and structural transformation of the tertiary sector
4.2.2 German KIBS in China - Structural analysis
4.3 Beijing: tertiary sector and German KIBS
4.3.1 Structure of the tertiary sector in Beijing
4.3.2 German KIBS in Beijing - Structural analysis
4.4 Empirical macro analysis – Summary and discussion of results

5. Empirical micro analysis – The contribution of German KIBS as knowledge intermediaries in Beijing ( interviews with chosen German KIBS in Beijing)
5.1 Methods
5.1.1 Empirical questions and interview sample
5.1.2 Qualitative interview and scriptualization
5.1.3 Text extraction and preparation
5.1.4. Implementation of the comparative analysis
5.2 Comparative Analysis
5.2.1 Background of interviewed companies and market entry
5.2.2 China specific regulations and challenges
5.2.3 Quality of external network relationships
5.2.4 Network relationships in the context of one project
5.2.5 Discussion of results with respect to conceptual context

6. Conclusion and prospects
6.1 Hypothesis for interaction patterns of German KIBS in China-specific projects
6.2 Conclusion and prospects for further research

7. References

8. Appendix
8.1 Appendix
8.1.1 Macro analysis primary data table – German KIBS in China
8.2 Appendix
8.2.1 Interview Guideline
8.2.2 List of interview partners
8.2.3 Interview data extraction tables...

List of tables

Table 1: KIBS branches and aggregations according to the NACE Rev. 2 classification…

Table 2: Definitions of KIBS Sectors by different authors

Table 3: KIBS linkages to vertical and horizontal knowledge domains

Table 4: Development of total FDI and FDI in services over time

Table 5: Percentage of KIBS-relevant service sector aggregations on total FDI in services

Table 6: Multi-sectoral frequencies of specified business activities of German KIBS operations in China

Table 7: Frequency of specified business activities by city

Table 8: Frequency of KIBS-business activities of German KIBS in Beijing

Table 9: Frequencies of non-KIBS business activities of German KIBS in Beijing by KIBS branch aggregation

Table 10: Interviewed KIBS: background information

Table 11: Interviewed KIBS: Clients and cooperation partners

Appendix Tables:

Table I: Macro analysis primary data table – German KIBS in China

Table II: List of interview partners

Table III: Interviewed KIBS - Background information

Table IV: Project implementation in China - Framework conditions

Table V: Architectural companies - Clients, cooperation partners, regional networks

Table VI: Business consulting companies - Clients, cooperation partners, regional networks

Table VII: [Architect 1] - Network relationships in the context of a project

Table VIII: [Architect 2] - Network relationships in the context of a project

Table IX: [Architect 3] - Network relationships in the context of a project

Table X: [Architect 4] - Network relationships in the context of a project

Table XI: Architectural companies - General division of functions

Table XII: [Consultant 1] - Network relationships in the context of a project

Table XIII: [Consultant 2] - Network relationships in the context of a project.

Table XIV: [Consultant 3] - Network relationships in the context of a project

Table XV: Business consulting firms - general division of functions

List of figures

Figure 1: Fields of tension for KIBS-related horizontal and vertical knowledge domains

Figure 2: KIBS focal points in knowledge categories and phases

Figure 3: The Chinese service sector: Total value added in bil. RMB

Figure 4: The Chinese service sector: Number of employees in mil

Figure 5: The Chinese service sector: Share of employees and turnover in %

Figure 6: Share of value added and employees of the tertiary sector by province in the year 2009

Figure 7: Company number development of different KIBS sectors in China from 2000 to 2004

Figure 8: Turnover development of different KIBS sectors in China from 2000 to 2004

Figure 9: Workforce development of different KIBS sectors in China from 2000 to 2004

Figure 10: Employee numbers of KIBS-relevant service sectors in urban units by province in the year 2009

Figure 11: German owned KIBS in China by City

Figure 12: German KIBS operations in China: Year of establishment

Figure 13: Legal form of German KIBS in China

Figure 14: Number of operations in China per KIBS-firm

Figure 15: Employee number range of German KIBS locations in China

Figure 16: Legal form of German owned KIBS in Beijing

Figure 17: German KIBS locations in Beijing: Year of establishment

Figure 18: Project interaction patterns [Architect 1]

Figure 19: Project interaction patterns [Architect 2]

Figure 20: Project interaction patterns [Architect 3]

Figure 21: Project interaction patterns [Architect 4]

Figure 22: Project interaction patterns [Consultant 1]

Figure 23: Project interaction patterns [Consultant 2]

Figure 24: Project interaction patterns [Consultant 3]

List of abbreviations

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1. Introduction

1.1 Background and research question

This thesis aims to research the situation of German owned Knowledge-Intensive Business Services (KIBS) in China with respect to business activity, structure and function. A particular focus is laid on German KIBS in Beijing.

The development of the Chinese economy since the beginning of the reform and opening period in 1978 is nothing short of spectacular. After a gradual process of privatization and opening towards foreign trade and investment, the country featured economic growth rates that are without example in recent history. In 2008, China became the biggest exporting nation. The country’s gross domestic product surpassed that of Japan in 2010 to become the second largest worldwide after the United States (cf. World Bank 2012, p. 3). To a large part, economic growth was initialized by the development of an export oriented industry, benefiting from the advantage of low labor costs and the increasingly open access to world markets. In this context, foreign direct investment played a vital role for China’s development, as foreign manufacturing companies established production bases for the export to markets in Europe, North America and Japan (cf. Liefner 2006, p. 16f). German companies participated in this development as well. By 2009, 1274 German companies were active in China, creating a turnover of 75.3 bil. Euro (cf. Deutsche Bundesbank 2011, p. 22). The majority of German invested firms were manufacturing firms in the fields of automotive and machinery, which entered the Chinese market either for cost-efficient, export oriented production or for selling their products in the growing Chinese market (cf. GIC et al. 2007, p. 15f).

In recent years, the start of a far reaching structural change inside the Chinese economy became visible. A number of policy initiatives aim to promote domestic innovation, the production of higher technology goods and the extension of the service sector. This impacts the domestic economic development and foreign investment patterns. Since China joined the WTO in 2001, trade and investment restrictions of previously tightly regulated service sectors were gradually removed (cf. WTO 2010, p. 69). The development goals outlined in the 12th Five-Year Plan (2011-2015) point out a transition towards a more innovative and sustainable model of development in which the service sector, domestic innovation and high technology manufacturing are prioritized (cf. Roach 2011, p. 1f).

Already visible results of this ongoing transition are a growing share of the Chinese tertiary sector in terms of value added and employment, the increasing share of Chinese companies applying for invention patents, a shift in the export pattern from textiles, clothes and other low-end consumer goods to electronics and machinery as well as Chinese technology firms like Huawei offering their electronic appliances on the world market (cf. GTAI 2011, p. 2; SIPO 2011). Foreign investment patterns are visibly impacted by the ongoing structural shift, as the share of foreign investment in services generally increased during the last years. German investments were no exception: Between 2003 and 2007, the share of service firms among German owned companies new to the Chinese market grew from 25% to 43% (cf. GIC et al. 2007, p. 13).

These changes can be assumed to affect the development of the Knowledge-Intensive Business Services sector in China. The increasing technology intensity, international integration and liberalization of China’s economy create new markets for KIBS and simplify access to existing markets for foreign KIBS. In existing empirical studies, the KIBS sector in China was found to be still underrepresented but dynamically developing (cf. Wei 2007, p. xiii).

From a theoretical perspective, the assumption of an increasing importance of the KIBS sector in China can be derived as well: KIBS are seen as integral part of an emerging knowledge based economy as they act as innovators and knowledge- & contact intermediaries, which contribute to the creation and diffusion of knowledge. Through these mechanisms, the emerging KIBS sector contributes to the innovation capacity and competitiveness of an economy. As a strengthening of domestic innovation is a declared goal of Chinese economic policy (cf. OECD 2009, p. 3), the development of the KIBS sector may constitute one prerequisite element in order to achieve national development goals.

Based on these assumptions, the KIBS sector in China and the contribution of foreign KIBS-firms appears to be an important subject of research. The situation of German KIBS in China has rarely been focus of research before. The aim of this thesis is to make a contribution to filling this gap by providing an initial overview of German owned KIBS in China. This is done by a combination of quantitative and qualitative research to provide a broad picture on the overall situation of German KIBS in China on the one hand and detailed insights to the most frequently represented KIBS sectors on the other hand. Beijing, as an important location for foreign invested enterprises and KIBS, is the focus of the quantitative and qualitative analysis.

In this context, the thesis aims to empirically find out and discuss:

- Framework conditions, business activity, geographic distribution and structure of German KIBS in China with focus on Beijing
- The role of German KIBS in Beijing as knowledge intermediaries
German KIBS in Beijing as knowledge intermediaries are examined by reconstructing the mechanisms of knowledge acquisition, recombination and transfer in the context of specific China-related projects, illustrating interaction patterns and areas of functional focus.

The research question of this thesis is relatively broad and it is not the aim to provide a specific answer to a precise question. By combining a wide scope of analysis with an in-depth research, the author hopes to provide an overview from various perspectives and starting points for further research.

1.2 Structure of the thesis

This thesis consists of the conceptual context outlined in chapters 2 and 3, the empirical analysis of chapters 4 and 5 and the conclusion in chapter 6.

In chapter 2, a theoretical background on KIBS is outlined, briefly introducing the history of KIBS research and providing a definition of the research object. Theoretical perspectives in which findings of the empirical analysis were embedded are introduced as well. These include:

- KIBS functions in the knowledge based economy
- Spatial features and the role of proximity
- KIBS knowledge bases

Legal and economic framework conditions for foreign service companies in China are outlined in chapter 3, introducing Chinese government policies, regulations and current problems which affect the work of foreign companies in China.

The research questions outlined above are discussed in the empirical analysis. The macro analysis of chapter 4 focuses on the overall situation of German KIBS in China in the context of the development of the Chinese tertiary sector. Results are discussed by drawing references to other empirical studies and the theoretical background.

The empirical micro analysis aims to provide more detailed insights on chosen German KIBS operations. German KIBS of the two most frequently represented KIBS sectors are examined based on the research question. Commonalities and differences within and between the branches are researched and discussed with reference to the approaches outlined in the theoretical background of chapter 2.

Chapter 6 concludes the thesis by introducing hypothesis regarding interaction patterns of different KIBS sectors in the context of international projects, which were directly derived from the findings of the empirical analysis. Last but not least, as a scientific research raises more questions than it answers, open questions and possibilities of further research are outlined in the last chapter.

2. Conceptual Context: Theoretical background of Knowledge-Intensive Business Services (KIBS)

During the last decades, it became increasingly apparent that professional business oriented service companies were developing more dynamically than other sectors of OECD-economies (cf. Miles et al. 1995, p. 1).

For the general understanding of the research object of this thesis, a theoretical background on Knowledge-Intensive Business Services (henceforth referred to as KIBS) shall be provided in this chapter. First, the evolvement of KIBS research, KIBS-definitions and characteristics as well as dynamics shaping the KIBS sector are outlined. Afterwards, analytical approaches relevant to this work, such as spatial features, KIBS-functions in the emerging knowledge-based economy as well as different dimensions of knowledge bases from which KIBS draw their input, are introduced.

2.1 Evolvement of KIBS research

The continuing tertiarization of economies in developed countries as well a structural transformation within the respective service sectors has been subject to increasingly intensive research. In fact, research on de-industrialization and the service economy has already taken shape in the 1960s, which often attributed growth of the tertiary sector to shifting consumer demands (cf. Miles et al. 1995, p. 19). Early research on services was divided into analyzing producer services, referring to services providing inputs on the production of goods, and professional services, focusing on the expertise of individual highly qualified professionals offering services to their clients (cf. Toivonen et al. 2008, p. 176). During the 1980s, the growth of the service sector has been widely explained as an outsourcing/cost-saving phenomenon of manufacturing companies (cf. Böhn 2008, p. 81). Research approaches on the development of knowledge intensive services have become more diverse during the 1990s, when the role of knowledge intensive services as innovators, carriers and creators of knowledge became focus of analysis. In this context, the object of research has been described as Knowledge-Intensive Business Services (KIBS), a term first used by Miles et al. (1995). In recent research, KIBS are widely seen as vital elements constituting the emerging knowledge-based economy^[1]. As such, KIBS have been analyzed as components of innovation systems^[2] and as drivers of knowledge dynamics (this term is explained in section 2.5.1). Current research focuses on the innovation function of KIBS but due to their complex and diffuse nature and the difficulty to grasp all dynamics taking place within and between these service firms, processes of knowledge creation and diffusion, in which KIBS engage, are still not completely understood (cf. Strambach 2010, p. 170-171).

KIBS-specific research in China took shape during the beginning of the 21st century (cf. Shen & Li 2006, p. 531; Wei & Hu 2007, p. xiii). But even though the service sector in China develops dynamically, specific research on KIBS is still not very pronounced and usually does not go far beyond quantitative studies and macro economic implications.

2.2 Definition and characteristics of KIBS

As KIBS are a relatively young field of research, a commonly approved definition of the sector still remains to be developed (cf. Böhn 2006, p. 171). Miles et al. (1995, p. 28) defined KIBS according to employment structure, manner of product supply and client base, as services that:

“ - Rely heavily upon professional knowledge. Thus, their employment structures are heavily weighted towards scientists, engineers, experts of all types. Many are practitioners of technology and technical change. Whatever their technological or professional specialism, they will also tend to be leading users of information Technology to support their activities.
- Either supply products which are themselves primarily sources of information and knowledge to their users (e.g. measurements, reports, training, consultancy);
- Or use their knowledge to produce services which are intermediate inputs to their clients own knowledge generating and information processing activities (e.g. communication and computer services). These client activities may be for internal use or supplied to yet other users in turn.
- Have as their main clients other businesses (including public services and the self-employed). Indeed, knowledge intensive activities will frequently tend to be business-related, since as labour-intensive activities they will be relatively costly. (…)”

In other publications, the same examination object has been referred to as “advanced producer services” (Moulaert and Tödtling 1995, quoted in Strambach 2010, p. 172), “strategic business services” (OECD 1999, quoted in Strambach 2010, p. 172) or profitable private companies which provide knowledge based services to businesses and other organizations (Wood 2002, quoted in Strambach 2010, p. 172). Böhn (2006, p. 72) defines the subject of KIBS by framing the terms “service”, “knowledge-intensive” and “business”: Knowledge intensity and business orientation are commonly agreed features that distinguish KIBS firms from others. Without going into detail on the complication to clearly define the term “service”^[3], the definition of “knowledge intensity” is a matter of debate as well, which illustrates the difficulty of developing a commonly acknowledged definition of KIBS.

"Knowledge intensity" is generally not easy to be systematically measured. Differing kinds of knowledge, particularly non-codified tacit knowledge,^[4] which is connected to persons and/or socioeconomic contexts, are difficult to grasp. A common indicator of knowledge intensity of a firm is the formal education of its employees. However, as practical as this indicator seems to be, it does not cope with the complexity of the matter, because tacit or non-codified knowledge (which is not reflected by formal education) plays a major part in KIBS operations (Böhn 2006, p. 73f).

It is less difficult to frame "business orientation", which is given when private sector- organized enterprises offer services to other enterprises. This usually includes private as well as publicly owned companies on the supplier and on the client side. Complications remain, as not all companies matching KIBS characteristics are offering services exclusively to other organizations. The client base of firms may be composed of organizations and individual customers. Also, the client base of a firm may change over time (cf. Böhn 2006, p. 73). These complications in turn complicate a clear distinction between KIBS and non-KIBS firms in practice.

Focusing on interaction between supplier and client, Strambach (2008, p. 156) identified three main features as the basic commonalities of KIBS:

“ - Knowledge is not only a key production factor of the firms, it is also the ‘good’ they
sell. For the most part the firms provide non-material intangible services.
- The provision of these knowledge-intensive services requires in-depth interaction between supplier and user and both parties are involved in cumulative learning processes. The utilization of knowledge-intensive services cannot simply be equated with the purchase of standardized external services.
- The activity of consulting, understood as a process of problem solving or problem framing in which KIBS adapt their expertise and expert knowledge to the needs of the client, makes up, to different degrees, the content of the interaction process between KIBS and their customers.”

Also, the importance of spatial proximity between KIBS firms and their providers and clients is debated as a distinct characteristic, as is the finding that KIBS are largely represented by small and medium sized firms. Usually, more than 90% of firms within different KIBS sectors have less than 10 employees (cf. Horgos & Koch 2008, p. 194; Strambach 2010, p. 182). The aspect of proximity is outlined in more detail in section 2.4.1.

KIBS firms offer client oriented services with a low degree of standardization. The production of these services usually requires professional knowledge, knowledge about the respective client as well as the ability to learn (which in this case can be understood as the ability to adapt service solutions by accumulating and/or recombining existing knowledge). Personnel from KIBS firms need to clearly understand the requirements of their clients, who are themselves involved in producing parts of the service and closely interact with the KIBS provider (cf. Toivonen et al. 2008, p. 177).

Because of the difficulty to define KIBS by their specific characteristics, sectoral definitions have been adopted in various studies. Miles et al. (1995, p. 29ff) differentiated between traditional professional services and new technology KIBS, the former referring to marketing, advertising, design and management consultancy and the latter referring to younger service fields such as software, technical engineering, computer networks, research & development (R&D) consultancy and other services involving new technologies.

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Table 1: KIBS branches and aggregations according to the NACE Rev. 2 classification (source: Strambach 2011, p. 66)

KIBS do not represent an economic sector in the traditional sense, which is usually defined by its production factor and/or product category. For practical reasons however, the statistical classification of economic activity in the European Community (Nomenclature statistique des activités économiques dans la Communauté européenne, NACE) in different versions has been the base to distinguish KIBS from non-KIBS sectors for a variety of empirical studies (cf. Böhn 2006, p. 75f). Within the current NACE Rev. 2 classification, several divisions inside the chapters J (Information and Communication) and M (Professional, scientific and technical activities) are considered to be KIBS services. Various NACE Rev. 2 divisions featuring related activities are aggregated as "economic services", "data processing", "technical services", "research & development" and "advertisement" (Table 1).

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Table 2: Definitions of KIBS Sectors by different authors (own adaption based on Wei & Hu 2007, p. 28)

The belonging of certain NACE groups to the KIBS sector have partly been matter of dispute. This applies to activities such as accounting, bookkeeping, labor recruitment as well as computing machinery maintenance and repairs (cf. Böhn 2006, p. 79). The apparent lack of uniformity among empirical studies regarding the definition of service branches as KIBS is highlighted in Table 2: While most authors classify R&D, computer related services, advertisement, technical services, legal services and management consulting as KIBS sectors, some authors also count telecommunications, human resources activities or even educational and healthcare activities to the KIBS segment (Table, 2; cf. Wei & Hu 2007, p. 28).

In Chinese service research, services are frequently categorized as “modern services” and “traditional services”. In this context modern services constitute a field that is defined in a similar form as KIBS, but tends to include more sectors (cf. Tan & Xiang 2007, p. 4ff). In contrast to conventions in Europe, Chinese KIBS research usually includes financial services such as banking and insurance. Similar to the definition of KIBS sectors according to the NACE-classification, Wei & Hu (2007, p. 31ff) defined KIBS in China according to the Chinese National Economic Industrial Classification, which, like NACE, is broadly based on the International Standard Industrial Classification of all Economic Activities (ISIC) of the United Nations (cf. Wei & Hu 2007, p. 31ff; Shen & Li 2006, p. 531ff).

Regarding KIBS studies on European enterprises, the definition of KIBS branches according to the NACE classification system is for the time being the most practicable way of conducting comparable empirical studies. There are however significant deficits to this categorization that need to be addressed in the future. The NACE system for instance does not clearly differentiate between business and consumer oriented services, neither does it clearly point out which service branches are knowledge intensive. KIBS firms frequently offer products in more than just one classification, sometimes creating overlappings between various KIBS branch aggregations (cf. Horgos & Koch 2008, p. 193; Strambach 2010, p. 172). Horgos & Koch (2008, p. 195) suggested to create a new system of sectoral definition, using variables that reflect the main characteristics of KIBS, such as innovation activity, functional integration with other firms and the role of spatial proximity. For the empirical study of this thesis, KIBS firms are for practical reasons classified according to the KIBS-branch aggregations of the NACE Rev. 2 classification.

2.3 Explanations and drivers of KIBS dynamics

In earlier research the growth dynamics of KIBS have been widely described as an externalization and cost-saving phenomenon (cf. Strambach 2011, p. 67f). Manufacturing companies could achieve economies of scale by outsourcing specific service operations to highly specialized KIBS. These service firms were able to supply a larger number of clients and optimize service performance through interaction and competition, reducing the cost of the service itself and creating a higher degree of flexibility by giving the client firm a variety of contracting options. This phenomenon takes place in the context of restructuring industrial environments, where manufacturing firms tend to focus on their core competencies. The contribution of this aspect to the growth of the service sector in general is not disputed, but it does not sufficiently explain the extraordinary growth of KIBS during the last years (cf. EMCC 2005, p. 5).

Technology is seen as one driver of KIBS growth. Manufacturing firms require highly complex technological solutions which they often cannot solve internally in an efficient way. In order to keep up with the rapid development of new technologies (in particular information and communication technologies, ICT), firms need to source new knowledge. While larger firms tend to have internal IT departments, external IT- and technical services provide an alternative knowledge base particularly for small and medium sized enterprises (cf. EMCC 2005, p. 5 & 6; Miles et al. 1995, p. 33).

An increasingly complex regulatory environment constitutes a major driver of KIBS as well. Restrictions on environmental and health protection, social insurance and rapidly changing regulatory structures in foreign markets pose challenges to firms that are required to comply with diverse standards and restrictions. Rather than using internal resources in examining options to adapt to regulations, it may be more efficient to purchase specialized knowledge input. In this aspect, specialized service firms can provide expertise such as advice on organizational implementation or consult on the status of certain regulation standards (cf. EMCC 2005, p. 6; Strambach 2010, p. 193f; Miles et al. 1995, p. 33).

Different views exist on the role of competition as a driver of KIBS development. Strambach (2010, p. 195f) argued that competitive pressure for KIBS firms of highly developed countries is increasing due to KIBS foundations in emerging markets of developing countries. Also, competition between private KIBS and the public sector grows, as private KIBS increasingly offer R&D services (traditionally a domain of public organizations) and state owned firms increasingly provide typical KIBS-services such as business consulting. On the other hand, many KIBS may actually not be so much exposed to competition since their specific service combinations are to some extent unique. The prominent importance of tacit knowledge in service delivery, diverse national regulations as well as cultural and language barriers make market entry for international competitors difficult (cf. EMCC 2005, p.7). Furthermore, mutual trust and long-term commitment build the foundation of client relationships, which makes them difficult to replace by a different provider (cf. Böhn 2006, p. 91f). It seems likely, that the impact of competition depends on the respective sector.

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Figure 1: Fields of tension for KIBS-related horizontal and vertical knowledge domains (source: Strambach 2010, p. 198)

These drivers of KIBS development are embedded in and closely interrelated with the development of the global economy. The rapid advance of ICT and liberalization of international trade, the emergence of new markets and a fragmentation of value chains triggered an internationalization of economic activities. Manufacturing firms internationalize their operations and outsource parts of their value added. As knowledge becomes increasingly tradable, a fragmentation of KIBS operations can also be noted, enabling KIBS to source their knowledge inputs from internal and external suppliers from almost any location. Thus, last but not least, a fragmenting value chain is another important driver of KIBS development. In the manufacturing sector, this trend increases the need for KIBS to take over a coordination function. KIBS themselves are actually simultaneously a result as well as a prerequisite of the fragmentation of industrial value chains (cf. Strambach 2010, p. 197).

KIBS respond to these dynamics in various ways. In strategic terms, KIBS have the choice between specialization or offering comprehensive solutions in regard of their horizontal knowledge domain and between product standardization and client specific solutions with respect to their vertical knowledge domain, creating a field of tension, which forces KIBS to position themselves in the most competitive way (Figure 1; the term “knowledge domain” is explained in further detail in chapter 2.6.3). KIBS may actually well position themselves in between the respective poles, by offering a mixture of standardized and client specific products. Generally, larger KIBS tend to offer more comprehensive solutions, while smaller KIBS operate in certain “niches” as highly specialized service providers (cf. Strambach 2010, p. 199f). Internationalization, the increasing tradability of knowledge and development of ICT partly reduce the requirement of spatial proximity, as ICT are capable of creating virtual proximity (different kinds of proximity are outlined in section 2.4.1). These factors favor spatial disintegration between KIBS firms and their clients, as well as a concentration of KIBS on their core competencies as they externalize less knowledge intensive, more standardized modules of their service production. The prevailing dynamics lead to a high degree of uncertainty and intransparency within markets, which makes KIBS seek long-term relationships with their clients (cf. Strambach 2010, p. 199ff).

2.4 KIBS - Spatial features and the role of proximity

Proximity generally favors the economic interaction of entities, but it is not limited to the spatial dimension. Besides spatial proximity, which can be measured by the physical distance between different actors, other kinds of proximity are also likely to play a role in interaction patterns and geographic allocation of KIBS (cf. Böhn 2006, p. 47).

2.4.1 Dimensions of proximity

Different dimensions of proximity, which shape interaction patterns of actors in different ways, include the following:

Cultural and institutional proximity describes a uniform cultural and economic context in which different entities operate. Specific cultural and regulatory environments shape behavior, communication and priorities of actors. If cultural/institutional proximity is given, a common communication platform is provided which favors the exchange of knowledge, reduces the risk of misunderstandings and increases the predictability of other entities operating in the same context.

Social proximity refers to social structures in which actors are embedded and is articulated through characteristics such as interpersonal loyalty and trust, which favors mutual understanding. The process of developing social proximity between actors is timely, but does not necessarily require frequent interaction, nor cultural or spatial proximity, even though it may be promoted by these factors.

Virtual proximity is constituted through information and communication technologies, which advanced quickly during the last decades. ICT enable users to exchange knowledge and information without a significant loss of time or other costs. Thus, through virtual proximity, the simultaneous exchange can be decoupled from spatial proximity. The possibility of substitution however is limited by the choice of communication media available to the interacting parties as well as the kind of information or knowledge that needs to be transferred. The emergence of virtual proximity between actors also depends on their social context and the degree of acceptance of different ICT (cf. Böhn 2006, p. 47ff).

Further dimensions of proximity that are considered to be relevant in knowledge processing and innovation processes are economic proximity, which points out complementary patterns of production (this is for example given in different production phases of the same product) and organizational proximity, indicating the level of horizontal and vertical integration between economic actors, which influences the degree of coordination and problem solving ability (cf. Hyypiä & Kautonen, p. 3f). Furthermore, proximity of strategic interest is introduced by Hyypiä & Kautonen (2005, p. 13f) as a relevant dimension regarding the interaction between KIBS and their clients. This dimension describes the strategic interest of different actors to establish a relationship. A high mutual strategic interest in interaction can contribute to overcoming the absence of other kinds of proximity, in particular the spatial dimension.

In the context of industrial clusters, spatial proximity in form of a permanent concentration of horizontally and vertically integrated actors has been regarded as a main feature for triggering interactive innovation activities (cf. Ganesan et al. 2005, p. 44f). In the KIBS sector however, permanent spatial proximity between actors does not seem to be a prerequisite for service delivery. Torre & Rallet (2005, p. 53f) pointed out, that permanent proximity can be substituted by temporary spatial proximity in the form of meetings, workshops and other forms of non-permanent co-localization, arguing that due to the high mobility of personnel, permanent spatial proximity was largely obsolete.

Different dimensions of proximity can partly substitute each other. Generally, at least one kind other than spatial proximity is assumed to be required in order to initiate interaction between actors, as co-localization is neither a necessary nor a sufficient condition to initiate interaction. Hyypiä & Kautonen (2005, p.3ff) actually consider spatial proximity to be only of secondary importance for KIBS, while other dimensions favor knowledge exchange to a greater extend. Relational proximity was suggested as an alternative to spatial proximity as a prerequisite factor that initiates interaction between KIBS firms and other actors. This concept suggests the interest to access specific knowledge as the basic requirement to initiate exchange, which then can be conducted through any distance. In this context, it was argued that relational proximity is a requirement for economic exchange, while spatial proximity does not necessarily lead to interaction between different parties (cf. Böhn 2006, p. 47ff). Spatial proximity however remains an important aspect when it comes to explaining permanent or temporary agglomeration patterns as it favors knowledge spillovers between actors. The concentration pattern of KIBS is outlined in the following section.

2.4.2 Spatial distribution - Concentration of KIBS in urban areas

Regarding the geographical distribution of KIBS in the EU, two trends can be noted: First, a strong concentration of KIBS firms in urban areas is apparent (Hyypiä & Kautonen 2005, p. 8). As KIBS rely on access to information and knowledge, they are likely to seek proximity to related actors. In urban areas, social- cultural and spatial proximity to external actors is either given or relatively simple to establish, which simplifies exchange of implicit knowledge and access to information. Also, urban areas provide access to highly qualified personnel, a developed communication infrastructure and access to national and international markets. Developments of information and communication technologies, having made knowledge transfer over large distances easier in recent years, has so far not visibly countered the spatial concentration of KIBS in metropolitan areas. In Germany for example, the KIBS sectors in main metropolitan areas showed employee-shares that lied significantly above the country's average of 6% in the year 2000: Munich, the Rhine-Main area and Hamburg featured KIBS employee shares of 8 to 11%. In the more centralized structure of the UK, London was the dominant KIBS-centre with a KIBS employee share of 11.5%, significantly lying above the country’s 2000 average of 7.2% (cf. Simmie & Strambach 2006, p. 33ff).

Second, regional-specific focuses on certain KIBS branches is empirically evident. This development can be attributed to development paths which usually can be traced back to the initial presence of a localized demand for KIBS and is in some cases triggered by political initiatives. Interactive learning processes and knowledge spillovers are favored by spatial proximity and personal interaction. These processes provide local advantages that further attract related KIBS. For this reason, regional specialization in KIBS sectors evolved gradually over a longer period of time, making it difficult for areas without an initial KIBS-base to establish themselves as KIBS location (cf. Simmie & Strambach 2006, p. 36).

2.4.3 Network connections of KIBS

The geographic scope of its external relationships defines the openness of an innovation system. Closed systems, without major interactions with external actors are at risk to fall into a structural lock-in path in which they solely rely on internal knowledge exchange. This situation leads to a slow down of innovative activity and can be countered by promoting exchange with external innovation systems. KIBS are assumed to be intra-regionally or internationally connected, which makes them key actors when it comes to establishing an open innovation system (these assumptions, however, are derived from theoretic considerations with further need of empirical foundation; cf. Böhn 2006, p. 98).

Studies were conducted on KIBS relationships with clients (e.g. Kautonen & Tukuhnen 2008; Kautonen & Hyypiä 2005) rather than relationships to other actors such as cooperation partners. Client relationships are, as mentioned above, based on personal trust. Small and medium size firms tend to cooperate with KIBS which are geographically proximate while large firms usually choose KIBS providers based on service quality and reputation rather than geographic proximity, which may favor the establishment of intra-regional or international KIBS-client relationships. The reason for this difference in client relationship patterns is that smaller firms tend to be less familiar with geographically distant KIBS and prefer firms which were either personally recommended or proven reliable through earlier experience. Dynamic developments, outlined in section 2.3 led to an internationalization of some KIBS as they were following their client locations in international markets either by regular travels or by establishing a location abroad (cf. Kautonen & Tukuhnen 2008, p. 238f). To what extent this process contributes to the openness of innovation systems as well as the patterns and geographic scope of relationships to cooperation partners will need further examination to shed some light on external KIBS knowledge sources and KIBS network relationships in their entirety.

2.5 KIBS - Functions in the knowledge-based economy

KIBS are not only subjects to above mentioned dynamics. They are an active element shaping the emerging knowledge-based economy as “facilitator, carrier or source of innovation” (den Hertog 2000, p. 492). The term “innovation” can be understood as the commercial realization of a new idea. This can refer to product- process and organizational innovation (cf. Böhn 2006, p. 31; OECD 1997, p. 32). In innovation research, KIBS have long been neglected because traditional indicators, which focused on formalized structures of innovation activities, failed to grasp the bulk of innovation activities inside KIBS firms, in which tacit knowledge has a prominent role. The Oslo manual of the OECD (1997) provides indicator concepts for innovation activities. Even though the increasing importance of the service sector is acknowledged, the Oslo manual proposes statistically measurable indicators such as R&D expenditure, which is mainly feasible for examining firms which engage in explicit, formalized innovation activities. However, particularly the organization of innovation activities of KIBS firms differ significantly from those taking place inside the manufacturing sector, making it difficult to apply traditional indicators (e.g. patent application number) on KIBS innovation activities (cf. Doloreux et al. 2008, p. 148; OECD 1997, p. 30).

In this section, the complex process of knowledge generation inside KIBS firms and the role of KIBS as innovators and intermediaries shall be briefly introduced.

2.5.1 KIBS as innovators - The process of knowledge generation inside KIBS

Product- process or organizational innovation is a result of knowledge dynamics, which Strambach (2008, p. 154) understood as “dynamics that are unfolding from processes of the creation, using, transforming, moving and diffusing of knowledge”. Thus, in order to understand how KIBS create innovations, their process of knowledge generation and diffusion needs to be examined. Three phases of knowledge generation and diffusion by KIBS can be identified as 1. knowledge acquisition, 2. recombination of knowledge and 3. knowledge transfer to the client. During the first phase, various sources for knowledge acquisition come into consideration: These can be internal sources such as experience or tacit knowledge of employees or codified internal knowledge based on databases or internal R&D. Possible external sources include competitors, clients or cooperation partners which can be either private or public organizations, universities and research institutions. During the second phase, a combination of the newly acquired knowledge with previously existing knowledge takes place. As soon as the new knowledge combination is at least partly codified, it is in the position for being sold as a (partly) standardized module to different clients. The third phase describes the transfer of knowledge to the client firm. The interaction between KIBS and client thereby points out new opportunities of knowledge generation and transfer, initiating a continuing process in which KIBS firms are constantly required to accumulate and recombine knowledge based on earlier knowledge outputs (cf. Strambach 2001, p. 54 quoted in: Böhn 2006, p. 86).

The innovation activities of KIBS firms are to a high degree informal. Most KIBS do not feature specific R&D departments. Accumulation and combination of knowledge to develop a new product follows a less systematic approach than in manufacturing firms, is highly project focused, to a large part driven by client demand and often realized in close interaction with the client (cf. Böhn 2006, p. 85f; Miles et al. 1995, p. 67ff). Besides creating innovations independently, KIBS also act as co-innovators by engaging in innovation processes initiated by the client. In the course of this interaction, KIBS and client firms are able to combine and extend their respective knowledge base. Thus, innovations are not only the result of intra-firm processes, but also an outcome of interactions between KIBS and their clients (cf. Böhn 2006, p. 92f).

2.5.2 KIBS as intermediaries and innovation carriers

The role of KIBS as innovators is complemented by the function of KIBS as intermediaries. KIBS operate in markets which are highly diverse and intransparent. Manufacturing firms choosing to source external knowledge may save transaction costs by engaging specialized KIBS which are frequently active in markets related to their knowledge domain and feature comprehensive network connections in their respective professional area. That way, KIBS tend to have a broader understanding of solutions available to the client. Connecting business contacts and extending the network of the client firm is an aspect in which the KIBS function as contact agent applies (cf. Bessant & Rush 2000, p. 157ff quoted in Böhn 2006, p. 90). This channel function is particularly important for small and medium sized manufacturing firms, which often lack the resources for establishing their own networks in specific sectors (cf. Böhn 2006, p. 90).

Speaking of KIBS as innovation carriers, mechanisms are similar: Embedded in a comprehensive network, KIBS are able to transfer an already existing innovation (which may already be applied by another client) to their client firm (cf. Böhn 2006, p. 89). From a macroeconomic perspective, the function of KIBS as knowledge and network agent has been debated within the context of national and regional innovation systems. As manufacturing firms often lack the capability to efficiently source the knowledge they require, a mediator between knowledge producer and knowledge user becomes necessary. KIBS seem particularly appropriate for this function because of their interconnectedness. Basic requirements of an effective knowledge transfer in innovation systems are the transfer capacity of the knowledge provider and the absorption capacity of the knowledge receiver. The knowledge distribution potential of an innovation system is also affected by factors such as codification of the transferred knowledge, confidentiality, degree of specialization and copyright regulations (cf. Böhn 2006, p. 93ff).

The rise of KIBS in the above mentioned functions as innovators, co-innovators and intermediaries leads different authors to the conclusion that KIBS gradually constitute a “second knowledge infrastructure” (den Hertog 2000, p. 518), complementing and partly substituting the traditional first knowledge infrastructure, which consists of research and technology organizations and higher education institutions. The second knowledge infrastructure constituted by KIBS partly generates and facilitates knowledge in a non systematic and informal way (as opposed to the formal and largely public traditional knowledge infrastructure). A certain functional division between first and second knowledge infrastructure is outlined by den Hertog (2000, p. 520f): While the first knowledge infrastructure (in form of universities, R&D institutions etc.) mostly interacts with firms from the manufacturing sector, KIBS supply a broader range of clients which largely consists of relatively small enterprises.

2.6 Dimensions of the KIBS knowledge base

As described above, KIBS are active in knowledge creation, acquisition and recombination. These activities require a knowledge base from which KIBS draw their input. Knowledge bases in which KIBS operate and on which KIBS rely upon differ significantly among different KIBS sectors. The knowledge base shapes innovation activities and determines what a firm produces. Because of the cumulative nature of knowledge, the respective knowledge base of a firm points out the direction of future knowledge generation and innovation activities. Different KIBS sector aggregations outlined in section 2.2 can be more or less clearly allocated to different categorizations of knowledge bases. These include: The knowledge category, the horizontal and vertical knowledge domain as well as different phases of the knowledge value chain.

2.6.1 Knowledge categories

The knowledge categories are composed of analytical knowledge, synthetic knowledge and symbolic knowledge. These knowledge types differ in their content and the way they are generated. Analytical knowledge is particularly important in science based sectors. It is generated by systematic, highly organized and formalized research aiming to contribute to the basic understanding of a matter. Because of its high degree of formalization, explicit knowledge is the main constituting element for the analytical knowledge base. For KIBS, this kind of knowledge generation is of minor importance, as it is usually applied by R&D firms, which constitute only a small part of the KIBS sector (cf. Strambach 2008, p. 158).

Synthetic knowledge is mainly important for technical and economic services such as IT, engineering, data processing etc. It is basically generated by a re-combination of existing knowledge and relies on previous experience. In this knowledge category, tacit knowledge is an important element. The anticipated result is the solution of a user-specific problem.

The symbolic knowledge base is relevant for creative services such as marketing, advertising and design. The focus of symbolic knowledge is the understanding and interpretation of socially constructed interrelations such as cultures, habits, norms or symbols, making tacit knowledge the main constituting element of this knowledge base (cf. Strambach 2008, p. 158).

KIBS sectors generally do not solely rely on their dominant knowledge base. R&D services for instance may also require synthetic knowledge as well as technical services in parts rely on analytical knowledge. As explained in section 2.1.5, pressure to offer comprehensive solutions makes KIBS offer services that are based on different knowledge categories. Thus knowledge categories are open divisions with rather blurry borders (cf. Strambach 2008, p. 159). This also applies for knowledge phases, as shown in the following part.

2.6.2 Knowledge value chain

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Phases of the knowledge value chain (not to be confused with the phases of knowledge generation inside KIBS as described in section 2.5.1) offer a complementing way of categorizing the knowledge KIBS rely on. These phases describe a value chain from the exploration of an idea or new opportunities over the examination of its feasibility to the exploitation, the commercialization of an idea. As in knowledge categories, various KIBS sector aggregations have focal points in different phases of the knowledge value chain, which are however largely diffuse. The activity of R&D services mostly focuses on knowledge exploration, while economic services are mainly active in the knowledge examination and exploitation phases. Technical services and marketing/advertising do not show a specific focus and are active in all three phases of the knowledge value chain (Figure 2, cf. Strambach 2008, p. 160 & 161).

2.6.3 Knowledge domains

The concept of knowledge domains describes the knowledge environment in which a KIBS firm operates in terms of branch and business function. Vertical knowledge domains describe knowledge about different economic sectors (e.g. automotive, finance, chemical etc.), whereas horizontal knowledge domains are defined according to business functions (such as marketing, management etc.). These knowledge domains tend to be increasingly complex due to the above mentioned ongoing restructuring of value chains as well as technological and organizational changes. These developments force KIBS to combine knowledge units from various areas in a flexible way to create new knowledge products and meet client demands in a dynamically changing environment. Different KIBS sectors can usually supply various vertical knowledge domains as different branches usually feature similar business functions. Regarding horizontal knowledge domains, KIBS tend to focus on one specific business function as the knowledge bases, that supporting services for different business functions require, are highly diverse. This scheme illustrates that KIBS can act as a connecting link and knowledge distributor between business branches (Table 3, cf. Strambach 2008, p. 162f).

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Table 3: KIBS linkages to vertical and horizontal knowledge domains (source: Strambach 2008, p. 162)

3. Conceptual context: Legal and economic framework conditions for foreign service companies in China

3.1 Chinese government policies on the service sector

3.1.1 The reform and opening period

Since the beginning of the reform era in 1978, the Chinese economy has undergone fundamental structural changes. Generally speaking, government policy measures included the gradual privatization of state owned enterprises, the opening up to foreign trade and investment and a regulatory liberalization of the domestic economy, enabling private individuals to open businesses and sell at market prices. Regulations on foreign trade and investment have been gradually liberalized by establishing special economic zones (initially in the southern province Guangdong and during the 1980s along the whole coast line). By the mid-1990s, geographic restrictions on foreign direct investment have been removed for most sectors. The Chinese state has however maintained control over sectors which it considers strategically important through continued restrictions of market access and price regulation (cf. OECD 2008, p. 140). Market access for foreign firms remains limited in service sectors such as financial services and insurance (cf. NDRC 2007, p. 21f).

China’s accession to the WTO marks a further step towards market liberalization. In this Context, China agreed to further reduce trade barriers on goods and services by removing trade-restricting mechanisms such as import tariffs and customs. This step increased competition on the Chinese market, forcing domestic firms to improve their efficiency. I turn, the WTO membership simplifies access for Chinese companies to western markets (cf. Konrad & Paul 2009, p. 19).

Foreign direct investment (FDI) in China increased largely since the beginning of the 1990s and has been dominated by industrial firms outsourcing production and making use of China’s competitive advantage to establish large scale production at low costs. In this context, the service sector has played a minor role in FDI. However, in recent years, an increase of the service sector in the share of FDI is apparent, as further market liberalizations were implemented in the tertiary sector during the last decade (these aspects are discussed in more detail in sections 3.2 and 4.2.1 respectively; cf. EAC 2007, p. 15; EUCCC 2010, p. 638).

3.1.2 Trade and investment policies

The general goal of the Chinese trade and foreign investment policy is stated as to “accelerate the opening of its [China’s] economy to the outside world, to introduce foreign technology and know-how, develop foreign trade, and promote economic development that is ‘mutually beneficial’ with its [China’s] trading partners” (WTO 2010, p.11). It is apparent however, that China prioritizes an agenda of protecting certain sectors from competition and acquiring knowledge from foreign firms over a complete liberalization of its economy.

In general, the Chinese government aims to utilize FDI to achieve national goals. The main objectives of the economic transformation during the last two decades have been the modernization of the domestic industry through knowledge transfer from foreign invested enterprises (FIE), the creation of competitive jobs as well as increasing foreign currency reserves through exports (cf. Liefner 2006, p. 25). An important policy instrument for fostering knowledge transfer from FIEs to local firms was the obligatory cooperation between FIEs and Chinese firms in form of a Joint Venture (JV). Until China’s accession to the WTO in 2001, JV-partnerships were the mandatory legal form for FIEs in China, requiring the foreign party to share a specified amount of knowledge with a Chinese partner firm and localize parts of the production (cf. Liefner 2006, p. 24ff; Kroeber 2006, p.1ff).

The Chinese government tries to channel FDI towards directions which it considers desirable. In 2007, the “Catalogue on the Guidance of Foreign Investment Industries” was published by the National Development and Reform Commission. This catalogue specifies in detail, which economic sectors are promoted, restricted or forbidden for foreign investment (NDRC; cf. Abele 2007). Investments are encouraged in most areas, which also include KIBS sectors like several fields of scientific research, technical services and business services (cf. NDRC 2007, p. 24ff). Endorsements of encouraged sectors can include tax subsidies or reduced import tariffs for necessary products. These are not specified in the catalogue, since the decision as to whether or not to accept an investment has been delegated from the central level to local governments (cf. WTO 2010, p. ix). Restricted investments include several mining and resource intensive products as well as services such as real estate, finance and insurance, market research and legal consulting. Many of the restricted areas of investment require the foreign investor to establish a joint venture with a Chinese firm. Foreign companies in the financial sector are supposed to hold only a minority share (cf. NDRC 2007, p. 21f). Prohibited investments include air traffic control, manufacture of weapons, “projects that endanger the safety and performance of military facilities” (NDRC 2007, p. 24) and postal services (cf. NDRC 2007, p. 23f). The catalogue for investment guidance generally reflects the political goal to shift towards an economy that is driven by resource saving high-technology production and the service sector (cf. Abele 2007).

In this context, a stronger emphasis on fostering domestic innovation was visible during recent years. China’s innovation policy focuses largely on developing R&D capacities. Restructuring of the R&D sector has taken place since the beginning of the reform period. But it is only since 2003/2004, that total R&D spending has sharply increased from 128.8 bil. Chinese Yuan (Renminbi, RMB) in 2002 to 300.3 bil. RMB in 2006. R&D spending as a share of gross domestic product (GDP) has significantly increased from 1.07% in 2002 to 1.42% in 2006 (cf. OECD 2008, p. 496). The Chinese government attempts to increase the efficiency of the country’s R&D landscape, trying to bring together the research sector with the needs of the industry. The private economy has taken over a share of more than 60% of the country’s R&D activities through emerging private spin-offs of public research institutes and universities as well as new R&D departments in industrial firms. Foreign invested R&D companies establish R&D units mostly in Beijing and Shanghai, with a focus on the IT sector where these firms contribute 86% of IT-related exports (cf. OECD 2008, p. 138f, 143).Geographical proximity to cooperation partners and low human resource costs make Beijing and Shanghai favorable locations for this sector. The IT sector is an example of a successful technology transfer from FIEs to Chinese firms like Huawei, which were able to upgrade their technological capability accordingly and offer their products on the world market (cf. OECD 2008, p. 144).

China’s policies on trade and foreign investment are closely interrelated and complement each other. The most important initial driver for FDI was the country’s competitive advantage of low labor costs. This was capitalized by foreign companies which set up labor intensive (and job creating) production bases (e.g. in textiles and consumer goods industries) for export. Pursuing the goal of economic development, China intends to move up the value chain and produce and export higher technology goods (cf. OECD 2006, p. 5). Regarding international trade in goods and services, the Chinese government pursued a gradual liberalization in order to maintain control over the developments and avoid unintended tensions (cf. WTO 2010, p. vii). When China joined the WTO in 2001, the country committed itself to remove tariff and non-tariff trade barriers in specific sectors. The continuing process of liberalization led to the emergence of a strongly export driven economy. However, the strong dependence on exports left the country vulnerable to trade restrictions of foreign countries (cf. WTO 2010, p. vii). Thus, the accession to the WTO provided a platform to solve trade disputes according to an internationally institutionalized process. Also, improved legal security and predictability for foreign enterprises as it relates to trade matters are a desired effect of the country’s WTO accession (cf. OECD 2006, p. 13). Internationally, China’s trade policy is not only institutionalized by the framework of the WTO. During the last years, China has increasingly pursued the establishment of bilateral and regional free trade agreements, which it considers complementary to the global framework of the WTO (cf. WTO 2010, p. 11). Bilateral free trade agreements (FTA) for instance exist between mainland China and its special administrative regions (Hong-Kong and Macau) as well as with countries like Pakistan, Singapore, Chile, New Zealand and Peru. These FTAs usually specify tariffs and quota restrictions for specific goods and services (cf. WTO 2010, p. 17ff). Specific terms of the WTO framework regarding Chinese trade in services are discussed in section 3.2.2.

3.1.3 The 12th Five-Year Plan - Implications regarding the service sector

In the 12th Five-Year Plan (in force from 2011-2015), the increasing importance of services for the development of the Chinese economy became apparent. Five year plans generally provide guidelines for governments at all administrative levels, formulating the desired economic and social development for the years to come. These plans specify national and regional development targets as a guideline for policy makers on all administrative levels (cf. APCO Worldwide 2010, p. 1f). As outlined in the 12th Five-Year Plan, the government aims to foster the service sector in order to transfer the export-led growth model of the economy to a growth model driven by domestic consumption. The service sector constitutes a key factor in sustaining economic development because it is assumed to be a potentially large job creator, while being less resource intensive than the secondary sector, providing a way to mitigate the country’s increasingly serious resource scarcity and environmental problems (cf. Roach 2011, p.2f). During the period of the 12th Five-Year Plan, an increase of the service sector as a share of the total GDP from 43% to 47% is anticipated. This concept however mostly targets distributive services like retail, logistics or leisure - services that do not require significant investments in human resources, but which are necessary in order to establish a more consumer oriented infrastructure and potentially create a large number of jobs (cf. Roach 2011, p.3). Even through KIBS sectors are not emphasized in the 12th Five-Year Plan as sectors of promotion, the goal to technologically upgrade the manufacturing sector to increase productivity and reduce environmental pollution are likely to stimulate the development of technical KIBS such as engineering services (cf. Roach, p. 6).

3.2 Legal conditions of foreign invested enterprises

German KIBS in China are subject to various regulatory frameworks that generally affect the operations of foreign companies in China. The first step of establishing a legal framework on foreign investment in China was the law on joint ventures from 1979. During the 1980s, further legal forms of foreign investments as well as regulations on the operation of foreign entities were defined (cf. Jing & Song n.d., p. 22). Bilateral agreements between Germany and China on reciprocal protection of investments were made in 1983 and 2002, in which both countries agree to encourage and permanently protect capital investments of the other party in domestic territory and to refrain from discriminative treatment, expropriation and arbitrariness (cf. Bundesministerium der Justiz 2005, p.733ff). The WTO accession of China in 2001 is a step that marks the adaption of the legal framework based on international standards (cf. Jing & Song n.d., p. 15). The current regulatory framework may be sophisticated but significant problems exist in enforcing existing regulations (this issue is explained in more detail in section 3.3).

3.2.1 Legal forms of foreign operations in China

The legal form of a commercial presence determines which action it is legally allowed to take. Thus, the decision on the legal form of a foreign company in China is a highly strategic one and needs to be considered according to the specific purpose of the entity. The most frequent legal forms of foreign business operations in China are joint ventures, wholly foreign owned enterprise (WFOE) and representative offices (RO).

The Joint Venture, as above mentioned, has been the mandatory legal form for most foreign invested enterprises until the early 2000s. A JV is a cooperation between a Chinese and a foreign firm, in which ownership and management are shared between the involved parties (cf. Cheok et al. 2010, p. 26). Two kinds of JVs can be distinguished: The equity JV and the contractual JV. An equity JV forms a legal entity of its own and is regulated by the “Sino-Foreign Cooperative Joint Venture law”. In an equity JV, both sides share costs and profits according to their ownership share. A contractual JV is a more flexible form, in which both parties determine the division of costs, profit and registered capital according to a negotiated contract. This form of JV may as well constitute a legal entity of its own but is not required to. The capital share of the foreign investor in both JV forms is supposed to be at least 25% (cf. Norton Rose LLP 2010, p. 7f; JLU Consultants 2011, p. 2). For an FIE, a JV holds a significant risk that comes along with shared management control, as the Chinese and the foreign side usually have different motivations and interests. Issues like forced or illegal technology transfer, unilateral change of agreements and management inefficiencies have come up in this context (cf. Albrecht n.d., p. 7). The obvious advantage of a JV is the possible participation of the foreign side in the relationships of the Chinese firm, making the exhaustive process of establishing a network partly obsolete (cf. Cheok et al. 2010, p. 26).

A wholly foreign owned enterprise is another common legal form of foreign invested operations in China. This is a legally independent entity, of which the parent company (or a foreign national) holds complete ownership. WFOEs have been increasingly common as a form of investment since China joined the WTO. This legal form avoids the risks of a JV, as the management is under direct control of the parent company. However, a WFOE also lacks the advantages of a JV, as it does not necessarily have quick access to relevant Chinese actors (cf. Cheok et al. 2010, p. 26f).

A common form of market entry in China is the establishment of a representative office, which is strictly speaking not a form of investment but a channel to facilitate trade. An RO does not constitute a legal entity of its own. Compared to a WFOE, an RO is easier to establish in terms of administrative steps (it is for instance not necessary to provide registered capital). This form of market entry also allows the parent company to maintain complete management control. Business operations and employment are however tightly restricted for this form of market entry: As part of the legal entity of the parent company, ROs are not eligible to conduct business operations on their own behalf. Employment of personnel is only possible either by the parent company or through specific employment agencies. A Representative Office mainly serves as local operational base for the parent company. Typical activities include marketing, research, coordination and contact establishment (cf. Albrecht n.d., p. 8ff).

“Limited partnership” and “special partnership” are two other forms of investment which were legally defined in 2007. These forms are similar to the German “Kommanditgesellschaft” in which a number of persons are legally liable for the company according to defined shares (cf. Albrecht n.d., p, 6). These legal forms may gain importance in the future but are not further referred to in this thesis, as they did not turn out to be relevant in the research sample for the empirical macro analysis of chapter 4.

3.2.2 Implications of China's WTO membership and existing restrictions on the service sector

The service sector and the manufacturing sector differ significantly in their respective logic of action when it comes to international trade. In terms of trade policy for goods, physical restraints such as tariffs, customs and others are common instruments. Services are generally intangible and cannot be physically stopped from being moved into a certain geographic area. The WTO (1994, p. 285f) distinguished four modes of trade in services:

1. Cross border service delivery, in which the service is transferred from within the territory of the supplier to the territory of the recipient (e.g. via e-mail or postal service)
2. Consumption abroad: The service is being delivered within the territory of the supplier where the recipient is physically present (e.g. tourism activities)
3. Commercial presence: the service is delivered within the territory of the recipient through an entity of the supplier within the territory of the recipient (e.g. an international engineering firm conducting construction activities for local clients)
4. Presence of natural persons: The service is delivered within the territory of the recipient through staff of the supplier from the territory of the supplier (e.g. education and training activities)

Political measures to restrict market access of services include specific requirements on the form of establishment, the number of competitors allowed to operate, limitations regarding geographic and business scope and regulatory requirements (cf. Mattoo 2002, p. 6; Walley 2003, p. 1 & 7).

The General Agreement on Trade in Services (GATS) is a legal framework on cross-border service trade in China since its accession to the WTO in 2001. The GATS is part of the General Agreement on Tariffs and Trade (GATT), which constitutes the regulatory framework of the WTO. Within the GATS, China is generally obligated to remove limitations on number and value of service operations within its market, remove restrictions on the legal form of service establishments as well as abolish limitations on the participation of foreign capital in a service operation (cf. WTO 1994, p. 297). As for trade in services, China committed itself to gradually implement these liberalizations. For KIBS sectors, restrictions on commercial presence, geographic scope and quantity were removed in the course of the GATS implementation (cf. WTO 2010, p. 69). As a WTO member, China also agreed to establish fair procedures to handle disputes and treat foreign invested firms in a non-discriminative way (cf. WTO 1994, p. 290 & 298).

Some sectors such as insurance and health care are excluded from liberalizations agreed upon in the GATS. Relevant KIBS branches in China are subject to various sector specific restrictions. Urban planning, architecture and engineering services, do not face quantitative limitations, geographic restrictions or restrictions with respect to the legal form of commercial presence anymore but still do face limitations regarding their business scope, which require them to cooperate with licensed Chinese firms (cf. Fei 2007, p. 100).

The legal sector is less liberalized: the commercial presence of foreign legal firms is limited to a representative office. They are not allowed to directly participate in legal operations in China. In this case, they have to entrust a Chinese legal firm dealing with domestic legal affairs on behalf of foreign clients. Thus the business scope of foreign legal firms is basically limited to dealing with legal affairs of their home countries on behalf of Chinese clients or legal consulting and information provision on Chinese legal matters on behalf of foreign clients (cf. Mattoo 2002, p. 7 & 22; Hu 2008, p. 21 & 25f). Computer and related services can mostly only establish JVs as a commercial presence in China, whereas a foreign majority ownership is permitted (two exceptions are data-processing services and consultancy related to computer hardware – these do not face restrictions in terms of commercial presence; cf. Mattoo 2002, p. 23). Foreign advertisement services as well as consulting agencies do not face any of the above restrictions since China’s accession to the WTO (Hu 2008, p. 76 & 222).

3.2.3 Intellectual property rights

The basis for legal protection for foreign investment and intellectual property in mainland China has been established during the 1980s (cf. MOFTEC 1992, p. 1). At the beginning of the reform period, adaptations in Chinese law regarding foreign trade and investment were strongly oriented on equivalent regulations of developed countries (cf. Reisach et al. 2007, p.285ff; quoted in Waltenberger 2008, p.35). In 1984 China adopted a patent law which to a strong extend reflected its German equivalent, defining the applicability of patents for inventions, the process of patent application and legal modes of patent protection. As such, it aims to protect inventions, encourage their creation and spread their application. In the Chinese patent law, inventions and utility-models that feature the characteristic of novelty and usefulness, can be protected as patents which are valid for 20 years (inventions) and 10 years (utility models) respectively. Chinese and foreign owned companies registered in China have the right to apply for a patent (cf. MOFTEC 1992, p. 5&10). Patent protection is an important tool for foreign companies in the service sector: In 2010, foreign companies held 55,343 patents (out of a total of 135,110 granted patents) of which 54,169 were service patents (as the statistics do not specify granted patents by service sector, the relevance of patent protection for KIBS is difficult to evaluate; cf. SIPO 2011). Despite undisputed progress in IPR legislation, significant problems remain when it comes to the enforcement. This aspect is outlined in the following section.

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^[1] For an explanation of the term “knowledge-based economy” see Foray & Lundvall (1996, p. 12ff)

^[2] An innovation system is usually regarded as the sum of actors within a geographically specified area which contributes to the creation of innovations. The basic concept of “a system of innovation” is outlined in Lundvall (1985, p. 29ff)

^[3] Different definition approaches for services are outlined in Cheok et al. (2010, p.11f)

^[4] For a definition of tacit knowledge (as opposed to codified knowledge) see Foray & Lundvall (1996, p. 21f)