Discussion Paper No.361
Development of and change in the software andIT-enabled services industry in Dalian, China

Yan Zhang

March 2017

TOHOKU ECONOMICS RESEARCH GROUP
Discussion Paper

GRADUATE SCHOOL OF ECONOMICS AND
MANAGEMENT TOHOKU UNIVERSITY
27-1 KAWAUCHI, AOBA-KU, SENDAI,
980-8576 JAPANDevelopment of and change in the software and ITenabled services industry in Dalian, China

Yan Zhang (Tohoku University)

Abstract

The software and IT-enabled services (ITES) industry in Dalian, China exhibits certain characteristics given
its deep relationship with Japan. However, of late, the proportion of exports to Japan has decreased
substantially. Hence, Dalian must progress from being an offshore base for Japan. T his study discusses thechanges in the domestic and international environments and analyzes their causes to explain the growth in the
ITES industry in Dalian. In recent years, software and ITES companies in Dalian have been upgrading
offshore services to Japan and expanding their business for the domestic market . Meanwhile, the positive
lock-in effect to Japan has effectively advanced to upstream or high value processes in the software industry
through long-term business relationships with Japan ese partners. Furthermore, China’s domestic business isfacing a spillover effect from the use of the human resources and technology accumulated through offshoredevelopment in Japan. However, there are negative lock -in effects, too. For example, some companies cannot
avoid dependence on offshore contractors because their range of business skills and knowledge is limited.
Other companies are familiar with operating in the mature Japanese market, making it difficult for them tofunction efficiently in the highly volatil e Chinese market.

Keywords: Dalian, software and IT -enabled services industry, spillover effect, lock -in effect

1. Introduction（１） The purpose of this researchThis study examines the development of and change in the software and IT -enabled
services (ITES) industry 1 in Dalian, China. In particular, we address the structural transformation of
the industry from offshore development and services for clients in Japan as well as the subsequent
growth of Japanese and local companies.
The development of the software and ITES industry in Dalian has special significance for1China. According to research by the World Bank, the Chinese software and ITES industry is
distinctive in that it has a high ratio of software products for domestic supply in comparison to
India, which provides software services globally (Gregory et al., 2009). Meanwhile, the industry in
Dalian developed as an offshore outsourcing base for Japan, as indicated by the various studies
examined below. The growth in exports based on the principle of comp arative advantage became adriving force in this case. However, the existing comparative advantage is undergoing a shake -up
following changes in both supply and demand, with fluctuations in the Japanese market andincreasing cost pressures within China. The software and ITES industry in Dalian is now facingsome empirical questions: Is the era of growth driven by offshore development for Japan coming toan end? Can the vitality of the industrial organization be maintained? Will new businesses becreated? Will the significance of the relationship with Japan alter?

（２） Theoretical background
Based on the principle of comparative advantage, focusing on exports in areas with anadvantage and supplying to domestic markets to benefit from the advantages of proximity are bothrational directions for industrial growth. China’s transition from factory to market alongside its
economic development, as seen in the manufacturing industry, is also occurring in the ITES
industry. For a more specific examination of this transit ion, one must consider that the ITES
industry in Dalian is part of a global value chain (GVC). The software and ITES industry in Dalian
is approaching a stage of development (which can be reached through several paths), beyond
concentrating on labor-intensive processes in the global division of labor. Despite development
possibilities based on economic resources accumulated through previous activities within the GVC,
growth beyond a certain point is constrained by the existing structures of the GVC (Humphre y andSchmitz, 2002).
While economic pressures in development do exist, it is those companies that are subject
to these pressures that bring about specific development. They face concrete questions on how to
use their accumulated economic resources and wh at directions could be pursued. Considering these
possibilities and limitations, we must clarify what strategic choices are made and how
administrative resources are used by companies that constitute the regional industry to grow further.
The changes in the software and ITES industry in Dalian can thus be considered to be a case study
on how growth options can be chosen by management from among several possibilities.

（３） Previous research
Many studies of the software and ITES industry in Dalian, and in China as a whole,
highlight the close relationship with Japan and primarily discuss Japan -oriented offshoredevelopment and services. Moreover, an ever -increasing number of studies discuss the changes inthis industry in Dalian and new development paths. The mai n arguments are outlined below.
The first point pertains to the theoretical framework through which one can understand theeconomic pressures pushing for change in Dalian. Tajima (2008) considered the international
2division of labor in the software industry between Japan, the developed regions of China, andmidwest China to be an example of the flying geese pattern of development. The relocation toVietnam, which became notable in the 2010s, may also be interpreted through this lens (Nishizaki,2014). However, in these studies, whether the change aims at overseas business or businessdiversification intended for the domestic market was not discussed.
The second point pertains to an empirical understanding of the changes in the industrialorganization of the software and ITES industry in Dalian. Since 2005, an annual report on thisindustry has been published. 2 In addition to combining data on aspects including business lines,
exports, companies, and human resources, the report focuses on the government’s in dustrial policies
and business rankings, However, this report describes changes based largely on statistics and does
not delve into the theory of industrial development. Further, while the features and formation
processes of Japan-oriented offshore development and services in Dalian were discussed by Zhang
and Kawabata (2012), they studied the formation processes of the industry and did not examine
subsequent changes. There have been several situational analysis studies of the growth,characteristics, and issues of Dalian as a base for Japan-oriented offshore development (Fuchida,2013; Tajima, 2008; Li, 2010; Inoue, 2009; Katoku, 2005; Kobayashi, 2016). While arguing theimportance of exports to Japan, Fuchida (2013) asserted that business diffusion toward the regional
cities of China and southeast Asia is important for Japan. The studies by Inoue (2009) and
Murakami and Liu (2008) are based on surveys of the conditions in Dalian. However, these studies
aim to clarify the general issue of developed countries ’ influence on offshore regions. Takahashi(2013) added to this perspective of the influence on Japan. Li (2010) analyzed industry integration
through comparative methods, using the cases of the Dalian Economic and Technical Development
Zone, Dalian Hi-Tech Zone (DHZ), and Dalian Software Park (DLSP). These studies analyze theindustrial organization of Dalian and survey the anticipated directions of change; they do not,however, adequately address what types of change have actually occurred. Some studies p oint to theimportant role of business bases in Japan as indicators of offshore business growth toward thecountry (Zhang and Kawabata, 2013; Takahashi, 20 09; Zhang, 2016); however, no comprehensive
investigation has appeared thus far.
The third point is how we should evaluate the influence exerted on the software and ITES
industry in Dalian as a base for Japan-oriented offshore development. There are two differing
opinions about this. Most of the existing studies noted in the previous paragraph are optimi stic.
They indicate that Japan-oriented business expansion and demand have raised capital, advanced
technology, and grown markets in relation to the software and ITES industry in Dalian. Further, theexistence of Dalian as an offshore base has contributed to Japan’s information services industry(Kawabata, 2014). Zhao and Watanabe (2008) found that the growth of Japan and China is co evolutionary because of the existence of Japanese markets, but also pointed out that the stagnationof Japan’s innovation systems is a hindrance. On the contrary, Parthasarathy and Palavalli (2011)
noted that participation in Japanese markets is a double -edged sword. Although the technology
transfers by Japanese companies to the information services industry in Dalian was made p ossible3

by entry into Japanese markets, entering Japanese markets with their closed systems creates a lock in effect that limits growth possibilities, unlike in Bangalore with its open markets that allow global
access. However, more evidence-based analyses need to be conducted on the advantages anddisadvantages of this lock-in effect and how they interact. Furthermore, from a business research
perspective, we should consider whether the capabilities accumulated by companies throughprevious work are being used in new growth pathways. This may be understood as a spillover effect.
When a spillover occurs, we should be aware of the positive and negative aspects of the lock -in
effect, which leads to continued relations with previous business partners.

（４） Analytic perspectives and research methods
Based on the above empirical and theoretical background, this study examines the growth
possibilities and limitations for the software and ITES industry in Dalian from the changes indomestic and overseas conditions; it also examines how this industry and individual companies arelooking for new growth paths in line with these changes. Section 2 clarifies these circumstantialchanges and Section 3 examines whether business development and healthy competition are
observed in the industrial organization. Section 4 examines how software and ITES companies arepromoting business diversification for domestic markets and business growth beyond offshoredevelopment (Humphrey and Schmitz, 2002). 3 Here, particular attention is paid to the use of thebusiness resources accumulated within companies and the workings of the spillover andpositive/negative lock-in effects on these.
The primary research method used is qualitative analysis based on interviews,
supplemented by a literature review. In addition, statistical analysis is conducted mainly using
DLISSO (annual) for the overall trends in the industry. The records of the interviews undertakenwith software and ITES companies, industry groups, and government bodies between 2010 and 2 016
were used for individual details. Interviews were conducted six times in Dalian, once in Shenyang(also in China), and four times in Japan.

2. Environmental changes in the software and ITES industry in
Dalian（１） Dalian as a base for Japan-oriented offshore development
The software and ITES industry in Dalian has traditionally focused on being an offshore
service base for Japan (Zhang and Kawabata, 2012). In 2014, the Dalian industry, with an export
rate of 19.3%, easily overtook the rate of 9% for C hina as a whole and ranked second in exports
across the country (DLISSO, 2014). Furthermore, when a business in Dalian is contracted foroffshore services, a part of which is later subcontracted, the subcontracted work is classified in thestatistical data as being for the domestic market. Therefore, the proportion of work undertaken forexport is effectively higher than the reported estimates. The proportion of exports to Japansurpassed 90% at its peak (DLISSO, annual).
The software and ITES industry in Dalian has formed clusters, with the DHZ accounting
4

for 81% of 2012 sales, 61.2% of which was concentrated in the DLSP (DLISSO, 2013). While local
companies 4 such as Neusoft, DHC, and HiSoft (now Pactera) played a central role in theestablishment of the DLSP, overseas companies were also extremely important. In 2013, 90
companies on the Fortune Global 500 list invested in the DLSP. Both Japanese and Westerncompanies in the DHZ and DLSP have focused on business for the Japanese market (DLISSO, 2014).
The Japan connection was also exploited for human resource development. Dalian was abase for Japanese language education in China; many students specialized in Japanese and the
proportion of the population that had taken the highest level (N1) of the Japanese language
proficiency test was the highest among major cities in China. Starting with the three major local
companies, many software and ITES business founders and managers had experience of studying inJapan and/or working for Japanese companies. Dalian h as also helped returnees establish companies,
such as by setting up the Dalian Hi -Tech Business Incubator (Zhang and Kawabata, 2012).

（２） Domestic and overseas economic changes triggered by the global
financial crisis
Japan-oriented offshore development was greatly affected by the global financial crisis
triggered by the collapse of Lehman Brothers in 2008; the Great East Japan Earthquake in 2011; andthe long-lasting depreciation of the yen since 2013. Growth in the Japanese information services
market slowed after the onset of the crisis and became negative in 2009. This lasted for threeconsecutive years until 2011 as a result of the subsequent Great East Japan Earthquake (JISA,
annual). Meanwhile, the total value of offshore orders registered negative growt h in 2009
(Association for the Promotion of Information Processing IT Personnel Training HQ, 2011).
However, this trend reversed in the following year, with almost no decrease in offshoredevelopment orders for China. Cost-cutting motivation actually supported the move from onshore to
offshore locations. However, strong cost -cutting pressure led to performance deterioration in small
and medium-sized enterprises. Moreover, since the unit costs of offshore development were
calculated in yen, the depreciation of the yen from 2013 caused sales converted into Chinese yuan
to drop by as much as 30–40%. 5
In addition to cost pressures such as the sharp increase in commodity prices across China
and the rise in personnel costs, new low-cost offshore development bases have emerged in areas
such as the inland regions of China and Vietnam, increasing competition with companies in Dalian.
Although the rental prices of office space in the DHZ have not increased appreciably, theinfrastructure costs for setting up Internet environments, for example, are increasing rapidly. Labor
costs in Dalian’s IT industry have also reached high levels, ranking just under those in the financeand real estate industries and thus becoming a great burden on management (Fuchida, 2013).
Meanwhile, the severe labor shortage continued to be a significant issue. During the formation
period of the industry in Dalian, the focus areas in software development processes were coding andunit testing; accordingly, even personnel without Japanese language ability or expert knowledge
could work in the industry. Later, however, with the increase in specialist work such as business5

process outsourcing (BPO), language skills and expert knowledge became necessary. Furthermore,
emerging fields such as mobile communications and Internet industries need large numbers of
relevant personnel. However, universities cannot adjust their subjects and teaching materials to
train students immediately. Shortages of IT personnel (skilled engineers, multifaceted workers, andskilled programmers) therefore continue to plague the industry. 6
New offshore development bases are on the rise, competing with Dalian. Many companies
in Japan have begun to take notice of Vietnam (Association for the Promotion of Information
Processing IT Personnel Training HQ, 2011). Inland cities such as Chengdu, which have an
advantage in terms of human resources and costs, are focusing on the software industry. In fact,some Dalian companies are considering relocating simple data -entry tasks to inland or northernareas.
Meanwhile, In particular, Chinese mobile communications and Internet industries havebeen developing rapidly in recent years. The Chinese e -commerce retail market, with a total valueof 630 billion dollars (about 75.6 trillion yen) in 20 15, surpassed the equivalent US market. 7
Although this trend may create opportunities in Dalian’s industry, it also leads to competition for
talent because personnel are lured away from software development and BPO to other emerging
fields. For instance, the wage costs of Japan-oriented offshore development companies have been
influenced by the high salaries offered by Huawei, which came to Dalian in 2015. 8
On the whole, the software and ITES industry in Dalian is losing the advantage of low
wages and availability of labor for offshore software development; the industry is thus approachinga turning point in its business.

3. Maintenance of a competitive industrial organization and growthof local companies（１） Industry growth
The software and ITES industry in Dalian began to develop in earnest after the city
government made clear its stance of invigorating the software industry in 1998, and the DLSP was
set up with this support (Zhang and Kawabata, 2012). Since then, this industry has developed
rapidly in the space of under 20 years. Sales figures stood at 200 million yuan in 1998, but reached
147 billion yuan in 2014. Of the 2,063 companies in 2014, 252 were foreign owned. Around
247,000 people are now working in this industry. Moreover, Dalian accounts for aro und 4% of thesales in the domestic software and ITES industry in China, ranking ninth among all cities (DLISSO,
2014).
The industry in Dalian grew at an average rate of over 20% annually until 2013; however,
the growth rate dropped to single figures in 2 014. While sales in the software and ITES industry in
China increased in 2014 by 20.2% over the previous year to 3.7 trillion yuan, sales figures for theindustry in Dalian stood at 147 billion yuan, an increase of 8.9% over the previous year.
6（２） Market diversification
Over the past few years, the software and ITES industry in Dalian has been diversifying
beyond its role as an offshore base for Japan. First, the industry’s export ratio gradually dropped
from 27.8% of sales in 2005 to 19.2% in 2014. Although J apan has remained the focus for exports,
its share is decreasing rapidly. The export ratio for Japan decreased by around 40 percentage points,from 90.9% in 2009 to 52.8% in 2014. Meanwhile, the ratio for Europe and the United States
increased sharply from 5.6% in 2009 to 30.2% in 2014. The ratio for other countries and regions(e.g., other Asian countries, Latin America) increased from 3.5% in 2009 to 17.1% in 2014
(DLISSO, 2010, 2015). While the dampening of export growth in China as a whole may be
explained by the plateauing of the global economy, the decrease in the ratio of Dalian’s exports toJapan is notable, as are the increases for Europe, the United States, and other countries and regions.
IBM, Citigroup, and India’s Tata Consultancy Services (TCS) , for example, have recently been
expanding their operations in Dalian for the European and US markets. In particular, India’s TCS
established a global delivery center in 2012 (DLISSO, 2014), and the US pharmaceutical company
Eli Lilly set up a global IT innovation center in 2013, both in Dalian. 9（３） Rise of local companies
In recent years, local companies in the industry in Dalian have enjoyed notable growth.
First, the number of employees in local companies grew from 55,200 in 2011 to 180,70 0 in 2014; bycontrast, the number of employees in foreign companies dropped from 66,900 in 2011 to 62,800 in2014 (DLISSO, annual). The substantial decrease in the number of foreign company employees isthe direct result of the decrease in the number of fo reign companies.
Second, local company sales increased from 33.5 billion yuan in 2011 to 98.1 billion yuan
in 2014. In 2011, sales by foreign companies, which amounted to 34.2 billion yuan, were slightly
more than local company sales but less than half of local company sales in 2014 at 46.2 billion yuan
(DLISSO, annual). Hence, sales by local companies have grown by a far greater extent than those offoreign companies.
Meanwhile, the profit ratios for foreign and local companies were 1.3% and 5.3%,
respectively in 2014 (DLISSO, annual). While the profit ratio for foreign companies has dropped
substantially in recent years, this has not been the case for local companies.
Regarding sales rankings, of the top 10 companies, five in 2009 and three in 2014 were
foreign. The number of local companies increased from five in 2009 to seven in 2014. Of the top 20
companies in 2014, 16 were local and four were foreign. Regarding the ranking in total sales,
exports, and sales in each business sector, foreign companies may be somewhat stronger than local
companies in exports and in the IT consulting sector. However, in all other sectors, local companies
are stronger (Table 1).

7

Table 1: Dalian software and ITES industry rankings: comparing the number of top local
and foreign companies
Ranking name
Local
Foreign
Software business sales
9
6
Software business exports
78
System integration business
14
1
Software development sales
11
4
IT consulting business
7
8
Data processing business
10
5
Combined Dalian software business
11
4
IC design business
100Note: “IC design business” features the top 10 companies; all other sectors feature the top 15
companies.
Source: Author, compiled from DLISSO (2014) .
By the end of 2014, 11 Dalian companies had successfully entered the new over-the-countermarket. 11 Since 2012, 12 Dalian companies—of which 10 are software companies—have entered theDeloitte DDT High Tech China Top 50 ranking (DLISSO, 2014). Further, the slowdown in Japan oriented offshore development may be linked to the withdrawal of foreign companies. Meanwhile,
the growth of local companies has compensated for this.

（４） Competitive industrial organization
The number of companies decreased sharply in 2008 owing to the impact of the financial
crisis, but increased afterwards, reaching 2,063 in 2014. The average number of company
employees peaked in 2009, but this has been slowly decreasing since. Judging from the number ofcompany personnel, we may say that this industry has shown a tendency toward more a diverse
company size since 2008. Although the proportion of small companies (i.e., those with fewer than
100 people) has fallen, the proportion of companies with 100 –299 people has increased (Figure 1).

100.0%
80.0%
Under 100 people

60.0%

100-299 people

40.0%

300-999 people

20.0%Over 1,000 people

0.0%2008 2009 2010 2011 2012 2013 2014
Figure 1: Trends in the proportion of workforce size in Dalian s oftware and ITES companies
Source: Author, compiled from each year’s DLISSO (annual) .

8

100
75.6
80
60
%

80.1
60.4
45.2

86.3 82.4
66.6

52.2

59.3

51.6
38.5

40

33.3

20
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Figure 2: Share of the top 30 companies in total software industry sales
Source: Author, compiled from the various editions of DLISSO (annual) .
Furthermore, the sales of the top 30 companies as a proportion of total software industry
sales peaked in 2008 and has been falling since then (Figure 2).
The growth rate of the software and ITES industry is lower in Dalian than in China as awhole. However, the industry has witnessed continuous growth, and the number of companies has
been increasing. Local companies are growing, supplanting foreign companies; the share of the top
30 companies’ sales is decreasing, and small and medium -sized enterprises are growing inprominence. Considering these circumstances, we may say that the industry is healthy andcompetitive.

（５） Changes in the business sector
Owing to the extremely intense technological changes in the software and ITES industry
on the one hand and intense changes in statistical standards on the other, business changes cannot
be discerned in detail, even from DLISSO (annual). Figure 3 shows only a rough categorization.
The proportion of software technology services has been overwhelmingly higher thanother categories. This is considered to be due to the large intake of labor -intensive work such ascoding through offshore development. Furthermore, there has been a rapid rise in software products
since 2009, growing to around the same level as software technology services in 2013, in terms of
the proportion of business. We may consider this to be a manifestation of the industry’s ability tohandle original brand software development. Meanwhile, software technology services also show
continued growth. Because of the considerable revision to the statistical classification, this factcannot be conclusively proven; however, according to the several examples that follow, thisindustry segment in Dalian may be undergoing a change toward more advanced busine ss solutions.
We may surmise that this segment is developing beyond simple coding work and service offerings
are becoming increasingly important.

9

600.0Software goods

500.0
Systemintegration

400.0
300.0
200.0
100.0
0.0
2007

2008

2009

2010

2011

2012

2013

Softwaretechnology
services
Built-in systems(software)

Figure 3: Trends in software and ITES industry sales per business segment 15
Note: “Software technology services” = Data processing and management services + IT consulting
services.
Source: Author, compiled from DLISSO (annual) .

4. Progress beyond Japan-oriented offshore development（１） Transaction structures of Japan-oriented offshore development
The growth of the software and ITES industry in Dalian was driven by Japan -oriented
offshore development, which was characterized by specific transaction structures.
Japan’s software industry is the world’s third largest in market size. Offshore developmentin this industry amounted to 1.4 billion dollars in 2014, and 75% of orders were to China. 12
According to surveys, the driving forces for Japanese IT vendors to undertake offshore softwaredevelopment are cost reduction and the availability of technical experts lacking in Japan(Association for the Promotion of Information Processing IT Personnel Training HQ, annual). The
core offshore services of Dalian companies ordered by Japan thus initially focused on offshore
software development, and later included large amounts of labor -intensive ITES businesses.
Offshore development in Dalian has been in fluenced by the following structuralcharacteristics of Japan’s software industry. First, it is not strongly competitive in packaged
software for market sale. In Japan, demand for individual software that reflects the needs ofindividual customers is strong (Umezawa, 2007). Second, this bespoke software is often developed
through a waterfall model process. 13 Third, it has a multi-layered subcontracting structure, where
the original vendors (also called “primary vendors”) contract out part of the development work tosmaller secondary subcontractors, who in turn subcontract some of their work to tertiary
subcontractors (Satō, 2008). Fourth, the Japanese language is used in development documentationand communication.
Under the structures above, the offshoring process started from the most labor-intensive
process on the bottom layer and proceeded toward the upper layer. In other words, it initiallyinvolved coding and unit testing (termed the “first stage”) and then detailed design and integration
testing (termed the “second stage”). This is how the international division of labor in software
10

development evolved between Japan and China. In the formative stages, Dalian -based software
companies would act as vendors in the second tier or below in the subcontracting system. There
were some “floating” deals in subcontracting, but companies would gradually accumulate long standing continuous deals. Being a one -off production system, many changes in specifications
would occur in the waterfall model development of bespok e software, necessitating frequent
communication between the original contractor and subcontractors. This often led to various issues(Kochi, 2008). Thus, purchasers would come to select superior subcontractors for continued orders.

（２） Growth and specialization of Japan-oriented offshore development
Japan-oriented offshore development is nearing a turning point because of the slowdown
in the growth of Japanese markets and emergence of low -cost offshore bases such as China’s inland
regions and Vietnam.
On the one hand, Dalian-based software companies, on the basis of long -term, continuous
partnerships with Japanese vendors, will continue to receive orders for more advanced work inJapan-oriented offshore development or for specialist ITO work relate d to offshore development.
With regard to the former, we may observe local companies branching out into requirement
definition and integration testing. Several local major companies have installed business anddevelopment bases in Japan. They not only disp atch engineers from Dalian to Japan to handle
requirement definition and basic design, but also hire and train in Japan. They established businessprocesses in which requirement definition and basic design are conducted at their bases in Japan,
rather than in the main offices in Dalian. 14 The business diversification of large -scale local
companies I and Z are examples of the latter. New businesses of Company I include migration andtesting, software conversion for the change to an open system, and checking software compatibility
for version upgrades to IT equipment. Company Z is diversifying into IT system management,
including technical support, helpdesk services, system operation, and monitoring. 15 Examples ofsmaller companies are also available. To avoid large differences in press and slack in businessfollowing new developments, a local small company (Company E), aiming at continued work orders,made efforts toward business expertise acquisition and sales promotion for Japanese insurancecompanies, and succeeded in securing direct contracts in maintenance work with major insurancecompanies. 16 In such cases, local companies were able to make profits easily by dealing directlywith Japanese user companies; additionally, it became easier to acquire sector expertise.
However, some companies could not venture into new businesses because of the deep
dependence on Japan-oriented offshore software development and limited range of technical skills
and business expertise. For instance, a move to higher -level work and production processes withhigher added value would clearly be desirable for Company A, a local BPO company created in the
1990s. Nonetheless, with no incentives to change its behavior that brought success in the past as atried and tested formula, the company continues to focus on data entry alone. 17 Similarly, Company
D, another small local business long engaged in Japan -oriented offshore development, had nochoice but to close down all bases but its headquarters in Dalian to cut costs due to the depr eciation11

of the yen in 2013. 18
Japan-oriented offshore business faces a fundamental problem in that it is restricted to theJapanese market. Japan’s software and ITES industry is not globally competitive, with a constantsoftware trade deficit. Accordingly, there are constraints for companies that still pursue Japan oriented offshore business expansion, meaning that industry export ratios and the share of exports
to Japan have dropped. The expansion of business oriented to the Chinese market is therefore a n
effective alternative.

（３） Expansion of business oriented to the Chinese market
The software and ITES industry market in China grew from 757.3 billion yuan in 2008 to
3.1 trillion yuan in 2013, exhibiting a far greater growth rate than that of the Japan -oriented
offshore software market. The move toward this market was a natural progression. The financial
crisis and subsequent long-lasting depreciation of the yen became a driving force behind thistransition. Let us analyze China-based Japanese companies and local companies separately.
Company Q Software Dalian is a software development base for the major Japaneseelectric and electronic home appliance manufacturer, Company Q. It expanded business for thefactories of Company Q in China in response to the ex pansion of home appliance markets. However,
because of the poor performance of the headquarters in Japan and rapid depreciation of the yen, thecompany faced no choice but to accelerate its market change toward business for Chinese clients.
One obstacle here was that Company Q Software Dalian, as an offshore development base,had employed only technical experts. Accordingly, the company had to seek the support ofCompany Q’s sales bases in China to develop sales programs involving various technical propos als
to customers. Company Q Software Dalian even pitched to Chinese a home appliance company, arival of parent campany. 19
Since second-tier Japan-oriented offshore development became unprofitable under the
global financial crisis, Company B, a smaller Ja panese company, used its technology and personnel
acquired in the course of its Japan-oriented offshore development to switch to packaged softwaredevelopment and domestic sales. The CEO of Company B was a former manager of a manufacturing
company. He took control of the development and sales business and sold production management
software to Japanese manufacturers in the Dalian Economic and Technological Development Zone.
Later, the company was liquidated because of insufficient funds, but the CEO reorgan ized thecompany and continued its activities. 20
Meanwhile, three major local companies in Dalian—Neusoft, DHC, and Pactera—are eachfocusing on Chinese domestic markets. For Neusoft, domestic business does not yet have high profit
ratios, but it does account for 60% of the company’s resources. Its main domestic businesses arehealth, government markets, and health insurance. 21 In recent years, it has set up around 60 health 12

related companies in China and has launched the healthcare management platform XIKANG
throughout China. 22 DHC has broken into the Chinese domestic market from three angles: industrial
software development, the Internet of Things (IoT), and company support platforms. 23 For industrial
software development, DHC acquired local software companies in Dalian to obtain the relevant
technology and personnel. For the IoT, it set up a new a company in Dalian focusing on work suchas linking and controlling all household electronic goods within a house under one system. For
company support platforms, DHC supports software development for smaller companies. 24 Pactera
previously specialized in pure outsourcing; however, in recent years, it has focused on smart cities
within China, which is being put into practice in Beijing. 25
Additionally, smaller local companies in Dalian are venturing into Chinese domestic
markets and acquiring the relevant personnel and technology. For instance, Japan -oriented offshoredevelopment constituted 100% of Company L’s business until 2012; however, in the past three
years, business with Japan has not made much progress and the company has begun to venture into
projects aimed at Chinese domestic markets. While Japan -oriented offshore development stillaccounts for 80% of its business, it sells its business management sof tware, used internally within
the company, to other Japanese companies located in the building in which Company L is located ,and is extending its activities to the Chinese domestic sales market. The company is also
participating in the Internet industry, providing its own in-house platform to the Taobao C2C web
shopping mall in China and offering a service for consumers to make s hopping recommendations. 26
Company Z established a call center and has started offering services for the domestic mobile
industry, beginning with customer satisfaction surveys for Xiaomi. The company is also contracted
for mobile device and PC software development for Tencent, at a scale of around 500 people. 27
For companies engaged in Japan-oriented offshore development—be they local or foreigncompanies—venturing into the Chinese domestic market is no easy task. There are issues regarding
the capacities of the company, such as expanding the range of technology and strengthening sales
capacity, and issues with the market environment, such as payment recovery and other“normalization” issues in the software and ITES market. 28
In general, the service quality of Japan-oriented offshore companies is high because they
have been trained under the strict monitoring of Japanese customers. However, they lack technicalexpertise concerning the development process as a whole, since they have come to shoulder only
part of a waterfall model development process. Furthermore, companies positioned below secondary
vendors in the multi-tier subcontracting system have poor resources for engaging with customers
directly.
The Chinese market is harsh on such capacity deficiencies. A delay in market
standardization is a problem. 29 Companies accustomed to doing business with mature Japanesemarkets would be unfamiliar with certain aspects of domestic customers’ business processes andsystems with highly arbitrary behavior. For instance, one-sided specification changes could be made13

without providing extra funds for development. Obtaining payment can also be difficult fornewcomers regardless of whether they are foreign or local companies. This problem can be a greatrisk, particularly for a smaller company, where a single unsuccessful payment retrieval could leadto a crisis of bankruptcy.
As a countermeasure, many Japanese companies first sell only to Japanese companies
established in China and then gradually broaden their customer base to include Chinese companies.
Except for extremely large deals with Japanese businesses, local companies will retrieve payment
for most of the items developed in under six months; with domestic busin ess, however, numerous
companies use the “4, 5, 1” approach. They reduce risk by retrieving 40% of payment in thecontract stage, 50% upon the completion of development, and the remaining 10% a year later. 30

5. Conclusion（１） Conclusions of this study
The software and ITES industry in Dalian started as a base for Japan -oriented offshoredevelopment. In recent years, it has been strongly affected by changes in both domestic andoverseas circumstances, including the slowdown of growth in Japanese markets, emerge nce of lowcost offshore bases such as Vietnam and the inland regions of China, and expansion of Chinese
domestic markets. In such conditions, the industry has begun to shift away from being a base forlabor-intensive, Japan-oriented offshore development based on the principle of comparativeadvantage. While it has met with a sharp decline in the ratio of growth and exports to Japan, theindustry as a whole maintains an actively competitive industrial organization by virtue of thegrowth of large-scale local companies and increase in small- and medium-sized enterprises.
The software and ITES enterprises are opening new development pathways in response tochanges in economic circumstances such as increasing cost pressures and growth in domestic
markets. They are trying to upgrade Japan-oriented offshore development and diversify intobusinesses for the domestic market by venturing into new development pathways using theiraccumulated business resources. From these developments, we can discern a spillover effe ct, where
the technology and personnel acquired in Japanese offshore development are put to use. We alsofind a positive lock-in effect, where long-standing trade relationships with Japanese vendors
encourage progress toward high value-added procedures in Japan-oriented software development
processes. Meanwhile, we also observe negative lock -in effects. For example, companies are unable
to break free from their dependence on Japan -oriented offshore development because they areunable to expand to other businesses with their limited range of skills and sector knowledge.
Further, companies accustomed to doing business with mature Japanese markets are unfamiliar with
Chinese customers, who can be capricious. However, efforts are being made to overcome these
problems.
Overall, the software and ITES industry in Dalian has begun to move away from being abase for labor-intensive Japan-oriented offshore development. While more time will be needed to14

discern the respective consequences, this study concludes, from th e competitive nature of theindustrial organization and the way in which both Japanese and local companies are engaging indevelopment, that new developments are likely to occur.

（２） Remaining issues
This study considered industrial organization and company b ehavior in the software and
ITES industry in Dalian. However, during the industry’s formative stages and thereafter, local
government policies for encouraging it have played an important role. An assessment of thesepolicies is thus a task that remains to be undertaken in future research.

Notes(1) The terms “information services” industry and “information technology (IT) services” industry are used inJapanese and Chinese, but these names do not necessarily capture the content of the services. Rather, it ismore appropriate to recognize them as services that can be implemented because of IT (IT -enabled services);
this is reflected in the English term “IT-enabled services (ITES)” industry, which we use in this paper.
(2) The editors have repeatedly revised the title from the Dalian Information Industry Bureau to the Dalian
Software Industry Association, to the Dalian Economic and Information Technology Committee, and so forth.
However, the edited versions of the 2012 report by the Dalian Software and Service Outsourcing
Development Research Institute (DLISSO) read as the Dalian Software and IT Services Development Report .
Each body is under the supervision of the city government, and the figures can be treate d as government
statistics. The Dalian office of JETRO has translated these reports into Japanese and distributed them under
the title Dalian Software and Information Service Industry White Paper. The Japanese title of these reports incommon use translates as the “Dalian IT White Papers.” To avoid confusion, we use the combined reference
DLISSO [annual] for citations.
(3) Humphrey and Schmitz (2002) considered upgrading within GVCs has having four patterns: process,goods, function, and sector crossing. Th is study, based on the circumstances of the industry in Dalian,
considers two patterns: foreign business growth from offshore development and diversification toward
domestic markets. We may consider the former to encompass relatively more of the process, g oods, andfunction factors and the latter to cover more of the sector crossing upgrade factors.
(4) In this paper, “local companies” refer to Chinese companies.
(5) Based on interviews at DLISSO in August 2014.
(6) Based on interviews at DLISSO in August 2 016.
(7) Based on an April 15, 2016 McKinsey & Company Japan report; cited from Nikkei Business Publications
Inc., April 25, 2016.
(8) Based on interviews at the Dalian Software Industry Association in August 2016.
(9) According to Tencent Holdings Ltd (ht tp://finance.qq.com/a/20130321/000067.htm, accessed November
28, 2016).
(10) Refer to Dalian Information Industry Bureau & Dalian Software Industry Association (2009) and
DLISSO (2014).
(11) The new over-the-counter market is the official title of China’s “national small- and medium-sizedcompany share transfer system,” an over-the-counter securities trade market established in September 201215

and registered under the Securities Law with the approval of the State Council. This market mainly provides
services related to investment, purchase, and public transfer for unlisted companies. This nationwide over the-counter market targets only institutional and professional individual investors (subject to conditions suchas having financial capital of over five mill ion yuan) and, therefore, has low standards for public disclosure,and usually no standards in place regarding figures in financial statements (e.g., assets, income, profit).
(12) Based on the Yano Research Institute homepage(https://www.yano.co.jp/press/pdf/1504.pdf#search='%E3%82%AA%E3%83%95%E3%82%B7%E3%83%A7%E3%82%A2%E9%96%8B%E7%99%BA%E8%A6%8F%E6%A8%A1, accessed November 28, 2016).
(13) According to Furuya et al. (2008), the core processes of software development are defined as
requirement definition, basic design, detailed design, programming, unit testing, integration testing, andsystem testing. The names and abbreviations differ slightly by company and project.
(14) This paragraph was collated based mainly on interviews at several Dalian companies w ith branches inJapan.
(15) Based on interviews at Company Z in August 2010 and at Company I in August 2016.
(16) Based on interviews at Company E in August 2010 and August 2013.
(17) Based on interviews at Company A in August 2016.
(17) Based on interviews at Company D in August 2016.
(19) Based on interviews at Company Q Dalian in August 2013 and August 2014.
(20) Based on interviews at Company B in August 2010 and August 2011.
(21) Based on interviews at DLISSO in August 2016.
(22) Based on XIKANG（http://www.xikang.com/, accessed November 28, 2016).
(23) Based on interviews at DLISSO in August 2016.
(24) Based on interviews at DLISSO in August 2016.
(25) Based on the Pactera homepage (http://www.pactera.com/ja/about, accessed November 28, 2016).
(26) Based on interviews at Company L in August 2016.
(27) Based on interviews at Company Z in August 2016.
(28) Based on interviews at several companies in August 2016.
(29) A direct translation of the Chinese term “guifanhua” would be “standardization,” but the meaning here isa little broader. The software and ITES industry in China is an emerging industry; its related legislation,
policies, trade rules, and so forth are not clear, and it also displays a tendency toward frequent fraudulent
deals and unstable management in its companies.
(30) This paragraph is a summary of interviews at several companies in an August 2016 survey in Dalian.

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*This paper is a translation of the following paper published in Japanese language.
Zhang, Yan (2017), “Dairenshi ni okeru Sofutowea Joho Sabisu Sangyo no Hattenn to Tenki”, The Journalof Asian Management Studies, No.23, Japan Scholarly Association for Asia Management.
*This work was supported by The Telecommunication Advancement Foundation.

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