Understanding China's innovation agenda

Image: Thomas Peter/ Reuters

In late 2017, a headline in the South China Morning Post declared that “China’s chance to lead global innovation may lie with 5G mobile technology development.” The accompanying story began as follows: “China is on the cusp of recasting itself as a leading technology innovator from a mere follower in the telecommunications industry”—a statement that conveys its growing ambitions to create new technologies rather than adopt existing ones.

Such lofty ambitions are rooted in China’s history—as global viewers were reminded of by the elaborate opening ceremonies at the 2008 Beijing Summer Olympics. Troops of performers colourfully celebrated China’s historical record as the inventor of gunpowder, the compass, paper, and moveable type as well as its use of hydraulics and iron smelting ahead of the rest of the world.

Since 2006, China has been in fast-forward mode as government ministries have rolled out successive ambitious plans to make the country an innovative society, with a growing emphasis on science and technology and the declared aim to become a world leader in advanced manufacturing and, more recently, artificial intelligence (AI).

Can China meet its lofty goals? In this excerpt from my latest book, I will summarize some of the advantages it enjoys over other countries—as well as the challenges it will face in making its dreams a reality.

The State of Innovation in China
Innovation includes activities that range from discovery and invention to the adaptation and incremental upgrading of existing products and processes. To date, much Chinese innovation has been characterized as the latter. But over the past 40 years, China has been catching up to more advanced economies through industrial upgrading, encouraged and facilitated by policy and regulatory actions.

A turning point occurred in 2013, when Xi Jinping stated his focus on facilitating China’s emergence as a global technology leader moving towards the technological frontier. China 2030, a joint research report published by the State Council’s Development Research Centre and the World Bank, proposed a market-based strategy to promote increased competition in all sectors, and even the withdrawal of government from direct involvement in production, distribution and resource allocation.

Xi changed direction in 2015 by expanding state-led intervention with the introduction of the Made in China 2025 (MIC 2025) industrial innovation strategy. The focus shifted from market-based reform to a mixed approach relying on market forces in some areas and in others, a concerted push by the state for Chinese economic dominance.

Substantial public funding poured into R&D in emerging sectors and AI, where experts now describe China as being mere steps behind the U.S. It is true that China has an impressive record in R&D spending and is a world leader in patents filed. But these are ‘input’ measures, when what matters most are ‘outputs’ in terms of productivity gains.

China’s record of innovation that generates new ideas and commercializes them as new products varies across industries.

In e-commerce and online services, Chinese enterprises have emerged as first movers, responding to demand from the country’s huge, fast-growing and underserved number of middle-class consumers. Other industries have also developed unique processes to improve efficiency and speed up R&D processes. However, evidence of global competitiveness is more modest among China’s large science- and engineering-based industrial firms, where learning and knowledge are essential for success in international markets.

In China’s e-commerce and digital industries, a new breed of innovator has emerged among entrepreneurs with global mindsets who are familiar with cutting-edge technologies. Over the 2014–16 period, China became one of the world’s leading investors in digital technology, pouring an estimated $77 billion in venture capital into Chinese firms, representing a six-fold increase from the 2011-13 period.

The McKinsey Global Institute estimates that China now accounts for 40 per cent or more of the worldwide value of e-commerce transactions. Both growing middle-class demand and the digital revolution, which facilitates input supply and product delivery, have supported scale economies in producing and paying for consumer goods and services. Insulated from foreign competition, significant parts of the Chinese market took on a life of their own. Moreover, the spectacular development of online consumer markets in China still has far to run as digitalization moves beyond consumers to industrial and services producers.

China has unique advantages in such innovation—the most obvious being its 100-million-strong ‘consuming class’, whose numbers are expected to double by 2025. It also has well over 700 million Internet users supporting a vast scale of production. In such a large market, incremental innovations frequently produce more-than-incremental returns. Additionally, the size of the online population provides plenty of space for new small firms to enter the market.

Another advantage is that Chinese consumers are unusually receptive to new products and technologies. Mobile payment is a notable example of a new technology that has attracted a huge consumer response because it is easier to use than the more conventional and cumbersome credit and debit card services banks provide. As a result, China is becoming a cashless society far in advance of any other nation, with mobile payments estimated at $8.6 trillion in 2016. In the United States that year, the total was $112 billion.

This preference for mobile payments has also facilitated China’s development of financial technology (‘fintech’) industries. Not surprisingly, the three original Chinese e-commerce giants—Baidu Baidu (a search engine), Alibaba (online shopping), and Tencent (social media), collectively known as BAT—have established financial affiliates to provide simple and quick payment services. Alibaba’s Alipay runs its own digital payments business, while Yu’e Bao, a financial affiliate of BAT, provides digital wealth-management services. Both are owned by Ant Financial, valued at $150 billion in a 2018 fundraising initiative.

Tencent has also established payments services through Tenpay and online banking through WeBank. Together the two control most of the mobile market in China, estimated to be worth some $16 trillion. In recent years as many as three new lending platforms were reported to be coming online each day—and an average of two others failed. A belated crackdown on online fraud failed, however, to prevent a collapse in P2P lending in mid-2018 because of the powerful effects of the deleveraging campaign on small borrowers and on lending platforms.

These networks of services allow users seamless movement across retail transactions and payment as well as savings and investment transactions in what is called a ‘digital ecosystem’ that provides one-stop shopping for an ever-widening variety of goods and services available through ‘super apps’. The conveniences provided to WeChat and Alipay customers are also effectively exchanged for a treasure trove of data about preferences as they purchase increasingly diverse services ranging from tuition to physical activity tracking, news services and entertainment. WeChat’s super app includes 40 functions; Alipay’s has 90.

The formidable volumes of data from more than 700 million internet users are a major source of China’s emerging capabilities in AI. These data can be used by software engineers, if privacy laws permit, as inputs to the machine learning that is fundamental to artificial intelligence. In July 2017, the State Council issued a New Generation AI Development Plan and a roadmap for AI to become a $150 billion industry by 2030.

Indeed, the absence of data-protection laws in China is a significant facilitating factor in the development of AI tools in fields such as healthcare and finance, but also in the nascent ‘social credit’ system being developed by the Chinese authorities to evaluate both financial creditworthiness and personal trustworthiness. A cyber-security law that took effect in June 2017 mandates data localization, requiring foreign firms to store their Chinese data in China and forbidding them from using these data to offer services to third parties. Such a requirement prevents non-Chinese enterprises from pooling data across countries. But as experts point out, data are only one dimension of AI capabilities; other key dimensions include algorithms, insights, and research, which know no borders.

The volume and diversity of information on China’s consumers is already providing the basis for AI applications. Baidu Medical Brain, for example, is intended to address structural problems in the healthcare system, such as the imbalance in available resources between rural and urban areas. Newer digital entrant Xiaomi is diversifying its smartphone applications for a wider range of aspects of consumer behaviour, while NetEase, an Internet technology company with a large mobile news application, is also building a digital ecosystem.

As noted, government is relatively absent from this discussion of China’s burgeoning e-commerce and online activity, particularly as owner and regulator. State-owned enterprises (SOEs) are virtually absent from the list of large privately owned firms such as BAT, although they still predominate among listed companies. Instead, increasing numbers of privately-owned enterprises appear as publicly listed companies. As recently as 2012, only 73 such firms had a market capitalization of more than US$1 billion and sufficient trading volumes; by 2017, the number had grown to 847. Many are in consumer goods, health care, and technology, while SOEs remain in traditional energy, materials, industrials, utilities, and real estate.

The e-commerce example also illustrates how regulation lags innovation. Such a lag is not unique to China: Explanations of the genesis of the 2008 global financial crisis prominently include the lag in the U.S. between the spread of financial innovations and regulators’ responses. In China, regulators were absent during the first decade of online activity. Only in 2016—11 years after Alipay introduced online money transfers—did regulators move to cap individual permitted values. Scandals erupted as some online operators developed Ponzi schemes to defraud their customers. At least two multi-billion-dollar Ponzi schemes disguised as transactions between peer-to-peer lenders, and many smaller frauds, have taken investors’ funds or invested them badly.

After the regulatory crackdowns began, P2P lending grew 43 per cent in outstanding loans between June 2017 and when the collapse began in June 2018. The core reason to regulate commercial banks is prudential: To create incentive frameworks that ensure appropriate leverage and modern risk management by banks entrusted with household and business savings. Yet when regulators fail to understand the risks of innovative financial products, they are slow to apply the fiduciary principles of oversight.

This relatively hands-off approach towards privately-owned enterprises in the online industries contrasts sharply with the state’s quantitative targets and interventions in manufacturing, where it aspires to become a superpower.

China’s 10-Year Agenda
In 2015, the Ministry of Industry and Information Technology rolled out MIC 2025, a ten-year innovation agenda influenced by Germany’s Industry 4.0 strategy to become a leader in advanced manufacturing production. MIC 2025 builds on key aspects of the existing ‘factory of the world’ ecosystem, particularly the size of the supplier base. China has five times the size of Japan’s supplier base, 150 million factory workers, and good infrastructure, all of which give it supply chain advantages. This is most spectacularly evident in the cost advantages of the solar panel industry, where China has become the world’s leading producer.

MIC 2025 identifies ten priority sectors that overlap and expand upon the emerging industries identified in 2006: advanced IT, robotics and automated machines, aerospace and aeronautical equipment, maritime equipment and hi-tech shipping, advanced rail transport equipment, new-energy vehicles and equipment, power and agricultural equipment, new materials, and biopharma and advanced medical products.

Massive state funding is now available for what appears to be a direct challenge to advanced manufacturing in the U.S., East Asia, and Europe. This is intended to increase import substitution and reduce China’s dependence on foreign suppliers of sophisticated equipment, particularly digital and communications equipment.

Domestic content has been set at 40 per cent of core components and materials by 2020, and 70 per cent by 2025. Outward investment is encouraged and supported in order to acquire core technologies through mergers and acquisitions.

The U.S. administration’s decision to label China a ‘strategic competitor’ has increased the risk of China’s continuing to rely on foreign technologies, and turned a spotlight on established discriminatory Chinese practices that restrict market access for foreign investors and force technology transfers in joint ventures. There are some exceptions. ‘Innovation demonstration zones’, announced in July 2017, are intended to treat foreign and domestic investments largely the same.

Market forces play a role, mainly in consumer goods and services production and distribution, where MIC 2025 calls for market institutions, stronger protection of intellectual property for small and medium-sized enterprises, more effective use of IP in business strategy, and recognition of technology standards.

All levels of government in China are involved. Local governments, in particular, have pushed projects forward, speeding progress towards national goals, especially in robotics. Impressive indeed, but performance has to be weighed against evidence that funds are being misallocated and efforts duplicated in the rush. The heavy state role raises questions about the implications of such politicization for the innovation ecosystem. Will political goals and quantitative targets crowd out individual initiatives, fund raising, and risk taking?

A careful assessment of MIC 2025 by Germany’s Mercator Institute for China Studies (MERICS) predicts that mismatched priorities between government and industry and overemphasis on quantitative targets, among other factors, will send mixed messages to investors.

Tensions between political and economic goals are inevitable. Excessive focus on quantitative targets is likely to divert energies from bottom-up entrepreneurial innovation, and promises of generous funding will cause distortions and waste. As Barry Naughton and others have pointed out, China is ignoring the lessons of the success of Japan, South Korea, and Taiwan—particularly their decisions to reduce the role of the state in setting the economic framework, producing public goods, and improving productivity performance by freeing up market forces and promoting competition.

A counterargument put forward in China is that misallocation of capital and living with excess capacity might be the acceptable costs of reaching the technological frontier. High-speed trains provide one example. To build them, firms were attracted from Japan, Canada, and France as joint venture partners and expected to share their technologies. As supply chains were localized, the Chinese partners benefited while their foreign partners lost their technological advantages and began to face their former joint venture partners as competitors.

Although it is premature to predict MIC 2025’s potential for success, some draw a parallel with China’s experience with semiconductors. The industry was initially marked by excess capacity and lack of competitiveness, but after 20 years of effort, China has created a vast electronics base, one internationally competitive producer in Lenovo, and a largely indigenized electronics supply chain. Significantly, however, efforts to catch up and master the design and manufacture of semiconductors have yet to bear fruit: China imports more than 95 per cent of its high-end chips, and the Trump administration is using investment restrictions and export controls to slow progress.

The Role of the State
While government ministries orchestrate plans for China to become an innovative society, tensions are apparent between the Party’s primary concern with preserving political and economic stability and the economic freedoms and openness associated with a vibrant market economy. Seasoned outsiders and China watchers have warned of the potentially negative implications of this ambiguity.

In his book Dealing with China, former Goldman Sachs chairman and U.S. treasury secretary Henry Paulson observes that success in an innovation-rich economy is driven by human ingenuity that thrives on free and open exchange: “You can’t run a successful business cut off from the world.” In a 2014 Harvard Business Review article, “Why China Can’t Innovate,” the authors argue that China has been successful with creative adaptation but has not led. The problem, they assert, is not innovative or intellectual capacity, but the restrictive political framework in which business and education must operate, which is “very much bounded.”

A number of other studies show that state intervention is successful in industries in which enterprises rely on substantial accumulation of knowledge and engineering skills. High-speed trains are an example of state ownership and support, both to increase local demand and to negotiate joint venture agreements with foreign producers. China’s share of the global market for such trains is now 41 per cent. Wind power and communications equipment provide other examples featuring Chinese producers.

In wind power, the original approach was to allow open bidding, which led to a flood of foreign imports. In response, SOEs were required to source 70 per cent of their components from domestic suppliers. These policies forced the creation of joint ventures in local production and diffused knowledge from foreign producers to local firms. By 2009, six of the ten top wind power firms were and by 2010, they accounted for 93 per cent of world sales. 

Science-based innovation is another priority area where state investments are being used to build institutions and capabilities, notably in pharmaceuticals, biotech, semiconductor design, and specialty chemicals. Such innovation takes a long time to pay off, and is hampered by slow regulatory processes, IP protection, inefficient allocation of government funding, and underinvestment by the private sector.

In telecommunications, in contrast, Huawei Technologies provides an example of the opposite behaviour: its response was to globalize.

In this case, however, foreign partners were reluctant to share their cutting-edge technologies, and state support was not forthcoming. Huawei had to invest in developing its technology through expensive trial-and-error processes, but it eventually succeeded in creating its own sophisticated designs, albeit with R&D expenditures totalling 12 per cent of revenue. The strategy also included localizing innovation among centres situated around the world.

China has not achieved its goals for the design and manufacture of semiconductors and semiconductor equipment, but continues to depend on foreign technologies and IP. The U.S.—the still-undisputed industry leader—has screened foreign bids for U.S. firms in order to deny Chinese investors access to key technologies. In response, China is now investing heavily in state-funded research through MIC 2025 and other state plans to develop a world-class semiconductor industry. Its reported aim is to produce 40 per cent of its requirements for semiconductors by 2020, up from 16 per cent in 2018.

Implications for Western Leaders
What are the combined implications of all these factors for China’s innovation performance? First of all, it must be recognized that China has a huge advantage of scale in developing digital services, AI, and machine learning in industries of the future. Looking ahead, the surge in digital services is providing the abundant processing power and data that, along with the rapid growth of available technical talent, are needed at the AI research frontier the Chinese government seeks.

A problematic feature of this surge, however, is the data-localization requirement the government imposed in June 2017. In strategic terms, restricting such significant technologies to Chinese institutions prevents foreign competitors from being active in the Chinese market, and it protects Chinese IP. But it also reduces the likelihood that Chinese AI researchers, for example, will be permitted to work with foreign technology companies to develop global safety standards. The application of Chinese AI technologies such as facial recognition to public surveillance and security screening also raises questions about the differential treatment of privacy in China and abroad.

A second issue with global implications relates to China’s learning about and acquiring new technologies through outward FDI and mergers and acquisitions . Many of the enterprises involved are SMEs and job creators as well as entrepreneurial leaders among privately owned enterprises in a range of industries that the Chinese government has encouraged to obtain foreign technology through joint ventures with and acquisitions of foreign companies – and by controversial means such as forced technology transfers. Between 2013 and 2015, outward mergers and acquisitions surged in technology-based industries, and some Chinese technology firms located R&D centres abroad. Huawei has 16 R&D centres around the world while Haier and Sany have done the same. Lack of reciprocal market access for U.S. investors seeking to enter the Chinese market, together with the rising public profile of the state-supported MIC 2025, has, as noted, prompted stepped up U.S. scrutiny of Chinese investment in the United States and export controls of critical technologies.

The third, and related, issue is outright Chinese theft of IP from both U.S. and European sources. In a 2017 report, the Blair-Huntsman bipartisan Commission on the Theft of American Intellectual Property published estimates of the cost of stolen trade secrets in the hundreds of billions of dollars, particularly in biotechnology.

Critics, however, argue that such numbers are likely inflated by including perfectly legal scientific cooperation. Further, recent reports of U.S. patent recipients show Chinese inventors receiving 11,241 patents in fiscal year 2016/17, a 28 per cent increase in a year, but still only 3.5 per cent of the total number of 320,003 patents Issued that year. Huawei alone had received nearly 1,500 patents by the end of 2017, showing that electronic manufacturers are beginning to develop their own technologies and branded products.

Other data, however, show evidence of a growing market for the purchase of intellectual property. Nicholas Lardy has pointed out that China’s payments for foreign IP have risen rapidly, reaching almost $30 billion in 2017, ranking it as the fourth-largest acquirer, behind Ireland, the Netherlands and the U.S.

In closing
Is China on its way to becoming the world’s leading technology innovator? As indicated herein, there are differing views of its innovation capabilities, but one thing is certain: Size matters. China can afford failures on the road to success. Even incremental changes in the huge Chinese market can have major effects, and already China has a record of notable achievement in e-commerce, consumer services, and, increasingly, financial services. Not to be overlooked, however, is the protection these sectors enjoy from competition with foreign entrants.

Services –including finance, telecommunications, transportation, and media, each of which is dominated by less-productive SOEs – are one of the sectors closed to foreign investment, yet they are also among the fastest growing as the economy rebalances. Opening this and other sectors to foreign competition, skills, and technologies could be growth promoting.

The policy environment and incentive frameworks in China are sending mixed signals about the roles of the market and the state. MIC 2025 sends a clear message that the state knows best how to reach the technological frontier. The state still believes in top-down targets and quantitative evaluations, rather than in bottom-up innovation in response to market-based incentives—although there is encouraging evidence of breakthroughs in some industries.

More evidence is required of market-opening measures to attract investment and increased protection for intellectual property. The adoption of a new FDI law in March 2019 by National People’s Congress is a positive development, although the regulations to implement the law have yet to be written. That is when differences over the role of the state will become clearer.

Wendy Dobson is Professor Emerita and Co-Director of the Institute for International Business at the Rotman School of Management. Her latest book is INSERT TITLE (Rotman UTP Publishing, 2020).