China’s Drive Toward Innovation

China’s president, Hu Jintao, has said that his country must give priority to independent innovation in science and technology to enable China to be at the forefront of scientific and technological development. This statement is not remarkable for the leader of a major trading nation. U.S. President George W. Bush featured the same objective in his 2006 State of the Union message. He recorded his belief that government must work to help create in the United States a new generation of innovation and an atmosphere in which innovation thrives. In his first policy statement to the Japanese Diet, Prime Minister, Shinzo Abe called for similar steps. The European Union Commission has proposed a 10-point program for immediate actions to make the business environment in its member states more innovation-friendly.

What makes Chinese government statements any more or less remarkable or credible than those of other governments’ highest officials? Answering that question requires a look at what China is planning as follow-up on its stated objective and an evaluation of the likelihood of its achieving success.

In the Chinese system of governance, statements by the leadership shape national and local policies to a degree not seen in other major trading nations. There is a singularity of purpose in China rarely found in Western governments. The pronouncements of China’s top leaders have been accompanied by an amazing array of detailed policy measures at all levels of government. China already is well into a process of industrializing. What Beijing has decided to do is “to move China from an imitation to an innovative stage of production …from ‘made in China’ to ‘made by China.’ ”

China’s leadership sees innovation as essential for the country to continue its economic growth, maintain political stability, support advanced military capabilities, and retain its global trade and geopolitical power. Ma Kai, minister of China’s National Development and Reform Commission, recently gave a compelling rationale for this policy. “China’s economic growth largely relies on material inputs and its competitive edge is to a great extent based on cheap labor, cheap water and land resources, and expensive environmental pollution,” he said. “Such a competitive edge will be weakened …with the rising price of raw materials and the enhancement of environmental protection. Therefore, we should enhance [our] independent innovation capability . . . and increase the contribution of science and technology advancement to [our] economic growth.”

In short, for China, innovation is a policy of nearly unrivaled importance.

Architecture of innovation

The overarching document of China’s innovation planning and strategy is the State Council’s Medium- and Long-Term Program on Science and Technology Development (20062020), issued in January 2006. To achieve the plan’s objectives, China is using a variety of policy tools to promote, favor, and reward indigenous innovative technologies. An overall goal is to increase R&D spending to 2.5% of gross domestic product by 2010, a doubling of the current rate. China’s 2010 target is comparable to the current rate of spending by the United States, 0.6% less than Japan’s, and 0.6% more than the European Union’s. The expected doubling of China’s spending is to be accompanied by the implementation of key state projects launched to generate important strategic products. The breadth and scale of these projects are huge. In the United States, comparisons might reasonably be found in investments during the period 1945-1991 in telecommunications, space exploration, communication, aeronautics, and energy.

The Chinese plan identifies 16 key state projects covering a number of priority sectors. These sectors include core electronic components, high-end general chips, basic software, technology for manufacturing extremely large integrated circuits, new-generation broadband wireless mobile telecommunications, high-end numerically controlled machine tools and basic manufacturing technology, development of large oil and gas fields, large nuclear power plants with advanced pressurized water reactors or high-temperature gas-cooled reactors, control and treatment of water pollution, development of genetically modified biological species, development of important new drugs, control and treatment of AIDS and other major contagious diseases, production of large aircraft, high-resolution Earth-observing systems, and launching manned space flights, and lunar exploration projects.

By any measure, this is an ambitious agenda. But these initiatives do not stand alone. The central government has committed to releasing this year 99 plans to implement specific policy goals of its strategic plan. Among other efforts, these plans are expected to call for accelerating creation of independent “well-known” Chinese brands, supporting the technology innovation of small- and medium-sized enterprises, issuing corporate bonds for qualified high-technology enterprises, regulating the management of start-up investment funds and the debt-financing ability of start-ups, suggesting ways to establish and improve regional intellectual property, standardizing foreign acquisition of key Chinese enterprises in the equipment manufacturing industry, building research-orientated universities, promoting state-supported high technology and new technology industry development zones, establishing guidelines and funding for venture capital investment, creating tax policies supporting the development of start-ups, and establishing “green channels” to help bring talented individuals who have studied abroad back to China.

Blueprint of actions

What is being attempted is to achieve in a short period nothing less than what more developed market economies have achieved with a head start of decades and, in some cases, more than a century. China is attempting to put into place the economic, educational, and legal infrastructure to achieve accelerated future growth based substantially on innovation.

Even within the China context, the new innovation policy is remarkably different from prior Chinese government initiatives. It is different in depth, because it involves long-term technology planning beyond single-ministry technology development programs. And it is different in breadth, because its execution is broadly dispersed among a half-dozen ministries at the central-government level and a large number of agencies at the provincial and local levels, and because it is strengthened by powerful policy tools.

To reach its considerable goals, China will draw on an array of direct and indirect policies and actions:

Policy tools. Given China’s political history, it should come as no surprise that its policies to promote innovation tend to be more interventionist than those of many other countries. China’s first policy steps were intended to seek foreign direct investment in high-end manufacturing and innovation, both areas that lagged other economies. In this, China followed a very different path than did Japan or Korea. This acceptance of foreign capital and technology was not seen as contradicting ideological precepts. According to China’s Ministry of Commerce, foreign direct investment “is an important element of China’s fundamental principle of opening up to the outside world” and “one of the great practices of building up [a] socialist economy with Chinese characteristics.” To attract foreign investment, China grants substantial tax incentives. A key aim is to foster technology transfer and specific tax measures that make those transfers tax-advantaged transactions.

China also recognized that it needed to substantially increase its protection of intellectual property if foreign investors were to introduce proprietary technology. As a result, China developed a National Intellectual Property Rights Strategy. Lu Wei, deputy director general of the Technical Economic Department, Development Research Center of the State Council, described the policy, in part, in the following terms: “To adapt the strategy to China’s development situation…we shall not only encourage self-innovation, but also encourage absorption, consumption, and innovation of introduced technologies.”

In addition, China has invested substantially in human resources in order to foster foreign direct investment, technology transfer from foreign firms, and indigenous innovation capability. In some news accounts, China is estimated to have produced 600,000 college and technical school graduates in science and engineering in 2004, whereas the United States produced an estimated 70,000 graduates the same year. Although China’s number is overstated, because it counts undergraduate degrees and technical school training as well as internationally competitive graduate engineers, the numbers are large and growing, and therefore so is the talent pool. In addition, China is facilitating the return to China of Chinese engineers working in other countries. If the experience of Silicon Valley and similar locations is an indicator, the greatest amount of technology transfer takes place through the process of diffusion as engineers change jobs.

In policy actions that lie somewhere between broad support and industry-specific intervention, China is developing high-technology incubation parks on a scale and with a determination not seen in any other country. According to Chinese officials, in 2004, high-tech parks had 38,565 participating companies, representing $226.4 billion in production and $19.7 billion in investments in infrastructure. The government says it plans to establish 30 more parks by 2010. Particular emphasis is given to attracting foreign R&D facilities. Fifteen Korean companies have R&D centers in China, 14 of which have been established since 2000. Samsung and LG Electronics have three each, which concentrate on developing technology and product models for the Chinese market.

Typical of such parks is the 16-square-kilometer Shanghai Zhangjiang Hi-Tech Park, which aspires to become both China’s Silicon Valley and its Pharmaceutical Valley. In the pharmaceutical area, the park has attracted $10.6 billion in foreign capital from 42 companies, including Roche, GlaxoSmithKline, and Medtronic, and has established 31 R&D institutes and a hospital for clinical trials. In the field of electronics, the park has attracted 70 “fabless” computer chip companies (which design, develop, and market their products but do not manufacture them), three foundries, two photomask producers, 12 packaging and test companies, 34 equipment vendors, and numerous systems application companies.

Need for standards. A tool various Chinese government officials say they intend to use to promote indigenous innovation—and to restrain foreign competition—is the process of setting standards. The recently promulgated Shanghai Municipal Government Intellectual Property Strategy demonstrates the possibilities. This strategy calls for the government to “actively promote the formulation and implementation of technical standards with self-owned intellectual property rights and translate that technological advantage into a marketplace advantage to maximize the benefits of intellectual property rights.” The National Medium- and Long-Term Program on Scientific and Technological Development takes this one step further, calling for the government to “actively take part in the formulation of international standards and drive the transferring of domestic technological standards to international standards.”

The highly contested case of China’s recent proposal to impose its own domestic “WAPI” wireless security standard rather than use an international standard, for products such as pagers and laptop computers rather than use an international standardis an example of this policy in practice. Although China was within its rights to impose a standard for domestic consumption, the plan would have required foreign suppliers of wireless devices to share their proprietary technology with a Chinese partner company. In turn, the Chinese partner would have supplied an essential encryption algorithm needed for serving the Chinese market. After receiving strong presentations from very high level U.S. officials, the Chinese government put the plan on hold indefinitely. That was not the end of WAPI, however, as China has attempted to have its WAPI domestic standard recognized and accepted at the World Intellectual Property Organization. As yet, China has made little progress in attaining that objective.

Government procurement. Many countries have used government procurement to provide preferences and protection to domestic industries. The World Trade Organization’s Government Procurement Agreement (GPA) is designed to ensure that member governments use open, transparent, competitive, unbiased, merit-based, and technologically neutral procurement procedures. In 2001, China committed to initiate negotiations for membership in the GPA “as soon as possible,” and at the April 2006 meeting of the U.S.–China Joint Commission on Commerce and Trade, China declared the “negotiations on China’s entry to the GPA will be launched no later than the end of December 2007.” However, recent Chinese policy documents indicate that China intends for its state institutions to go against the basic tenets of the GPA. According to one document, for example, “Finance departments at the provincial level shall work with the science and technology departments at the same level to establish implementation plans for developing indigenous innovation government procurement policies for their provinces.”

Given the prominent role that China’s centralized governmental structure plays in the nation’s economy, discriminatory government purchasing policies at the central, provincial, and local levels can provide a significant amount of protection to foster indigenous innovation and have a very powerful negative effect on trade. China’s State Council has decreed that: “The government shall set a priority procurement policy on important high-tech equipment and products developed by domestic enterprises with independent intellectual property. [We shall] provide policy support to enterprises purchasing domestic high-tech equipment, and support the formulation of technological standards through government procurement.” The government procurement policy with respect to software has been the subject of consultations between China and its trading partners.

Import policies. Under international rules, governments can much more easily manage foreign investments than imports. Although it is not yet clear how China will proceed, there is some evidence of the country’s current thinking on imports. In a statement relating to the equipment manufacturing industry, the State Council said that imports of key equipment using foreign capital will be subject to “strict examination and study.” Given World Trade Organization commitments, there is little that can be done legitimately through direct controls to slow the inflow of undesired imports. But whenever governments can confer or deny a benefit, there are possibilities to influence the kind and quantity of imports brought in by a particular investor. The State Council’s stated goal is to establish by 2010 competitive Chinese equipment manufacturing companies with their own intellectual property to meet China’s needs in the energy, transportation, raw materials, and defense sectors.

Competition policies. China has proposed, but not yet implemented, an Anti-Monopoly Law intended to foster innovation. Where they exist, competition laws have served various purposes. In the United States, Canada, the United Kingdom, and Germany, the primary stated goal of such laws is to protect consumers. In other places, economic development, industrial policy, or social objectives may be the primary policy drivers. In China, there is clearly a concern by top-level policymakers that an imbalance between China’s indigenous companies’ portfolio of intellectual property and those of its trading partners’ companies is highly problematic. Wang Xiaoye, a professor at the Chinese Academy of Social Sciences, noted that multinational companies possess capital and technological advantages that enable them to quickly dominate markets. She concluded that the “adoption of an Anti-Monopoly Law will serve as an important tool for China to check the influence of multinationals.”

In a similar vein, the Fair Trade Bureau of the State Administration for Industry and Commerce in 2004 released a report claiming that certain multinational companies used their technological advantages and international property rights to dominate sectors of the Chinese market. The report specifically names Kodak, Tetra Pak, and Microsoft, among others, as potential targets of the forthcoming Anti-Monopoly Law. Additional news reports indicate that other advanced technology and innovative companies, such as Intel, could also be a target of the legislation.

A key concern about the Anti-Monopoly Law, a draft of which was circulated in January 2006, relates to how “monopolistic conduct,” which includes “abuse of dominant market position,” is defined. The draft states that entities within a “relevant market” are considered to hold a dominant market position if the individual market share of one entity in a market accounts for more than half, the joint market share of two entities accounts for more than two-thirds, or the joint market share of three entities accounts for more than three-fourths. Of course, much will depend on defining the relevant market. In China, a foreign company with a strong patent portfolio might easily command a large portion of a product market. As China’s strategic plan states,“[We shall] prevent the abuse of intellectual property that unfairly restricts the market mechanism for fair competition and may prevent scientific-technological innovation and the expansion and application of scientific-technological achievements.” Foreign companies have already been put on notice that administrators (not yet chosen) of the new Anti-Monopoly Law might find tempting targets in Western companies that have the strongest intellectual property positions.

Direct funding. Direct government financial support will be an important part of Chinese government innovation policy, just as it is for all countries seeking to promote innovation. Thus, for the most part, China is not out of step with its competitors. But when the funding focuses on one or more particular sectors, investment and trade distortions are likely to occur. An example of what China may decide to do can be seen in the measures that the government has taken to promote the development of a domestic equipment-manufacturing industry. These measures include preferential taxation for the sector, incentives for the purchase of Chinese-made machinery, value-added-tax rebates on imported parts and materials, allocation of special funds for technologically advanced products, and giving enterprises relief from certain social responsibilities. Although the government has not fully defined what relieving enterprises of social responsibilities means, executives of U.S. automobile and steel companies can testify that if this means relieving them of “legacy costs,” including the health and pension costs of retired workers, such steps can mean the difference between profitability, stunning losses, and sometimes even bankruptcy.

By far the highest profile recent instance of government funding is the announced agreement by two Chinese municipalities to attract semiconductor fabrication facilities by funding all of the capital costs of a private company. The beneficiary is the Shanghai Manufacturing International Corporation, a major semiconductor foundry. The company has announced that it will receive the benefit of construction of two new chip fabrication facilities, from Chengdu and Wuhan (and Hubei) local government agencies. This amounts to a grant of billions of U.S. dollars. According to news reports, the company also will receive a “management fee” and will have the option to buy the plants in the future. The company will retain all profits… Chongqing has announced very recently that it will also offer similar support to create an indigenous semiconductor industry.

Drivers of innovation

A variety of factors are driving the prospects for homegrown innovation in China. In the broad picture, China is experiencing an impressive rate of growth in its gross domestic product. Although such growth can be something of a double-edged sword, in that resources can be scarce in a rapidly growing economy, the general rule is that individuals who seek rewards for innovation are more likely to find them in a buoyant economy.

China also has a huge talent pool. Enormous resources are being poured into graduating engineers and scientists, and given the immense population base, this is an effort that in sheer numbers can equal the combined output of many of China’s foreign competitors.

China’s large domestic market is both an incentive to indigenous production and a magnet for foreign direct investment. Indeed, it is a market that a global company cannot afford to ignore. China hopes to learn much from these foreign companies, enabling it to leapfrog the painful earlier steps in innovation that were required of the technology-donor companies. The fact that the Chinese market is growing increasingly sophisticated also helps attract higher-end foreign investment.

China is increasing its protection of intellectual property rights, but much more remains to be done. Formal intellectual property protection, poorly developed to nonexistent in much of China until relatively recently, is making strides, particularly in Beijing and Shanghai. A number of cases have resulted in satisfactory outcomes for foreign and domestic holders of intellectual property rights. This movement is being bolstered by the incentives for indigenous patenting that create domestic stakeholders in a functioning intellectual property–rights system.

On top of these advantages is a government—or more accurately, a series of governments, at the central, provincial, and municipal levels—pledged to full economic mobilization to support innovation. At the provincial and local levels, there even is something of a rivalry to achieve often grand objectives. The setting of priorities may be particularly effective where the objectives are specific, such as those related to integrated circuits as spelled out in the current Five-Year Plan of the Ministry of Information Industries. The plan calls for China to “significantly increase the self-sufficiency ratio to over 70% for integrated circuits used for information and national defense security, and to over 30% for integrated circuits used in communications and digital household appliances…. We should basically achieve self-sufficiency in key products supply.”

These various factors have enabled China to achieve a variety of concrete measures of success. High-tech exports have been growing at an annual rate of more than 40% over the past five years. China ranks third among nations in R&D expenditures. Another crude measure of success is the increasing number of domestic patents being filed with the State Intellectual Property Office. In 2005, a total of 171,619 patents were filed, up from 99,278 patents in 2001—a 73% increase. Whether this represents true innovation can be assessed only with hindsight, as the high-tech exports are probably very heavily the products of foreign multinational corporations and their Chinese joint ventures, and the products exported may often consist of DVD players and similar electronics items, which some would describe as tech but not high-tech products.

Hurdles to innovation

Imbedded in some of the very factors underlying China’s successes, however, are a number of factors that can and do inhibit innovation. Clearly, there is a major overhang of the vestiges of a command economy. The people who make local and national plans may not always be those closest to the cutting edge of innovation and may be unlikely to fully understand its needs. Nonmarket factors tend to skew economic activity. This same pattern played out in Japan. When the cheering died down a bit, observers of the “Japanese miracle” began to note that Japan suffered deeply from problems of crony capitalism that saddled its banking system with nonperforming loans and contributed to depressing its economic growth for over a decade. In China, some two-thirds of the economy is accounted for by state-invested companies and state-owned companies. No one considers these companies as a group be on the leading edge of innovation. Although these companies tend to be favored for government support, they are on the whole unlikely to become hotbeds of innovation.

The influence of the state can be too pervasive. Complicating the positive story of the dominance of market forces today are stories of the recent resurgence of the Communist Party’s involvement in business. It is too early to determine what impact this will have, but it is likely to reinforce a relationship-based pattern of transactions that often may run counter to the dictates of the market.

China also faces a number of pressing workforce issues. In the rest of the world—particularly in the United States, Europe, and Japan, but also in India and other nations in competition with China—the huge number of Chinese students receiving engineering degrees annually is causing concern. But a number of recent studies have found comparisons between China and, in particular, the United States, to be misleading. For example, a study by Duke University researchers found that in 2004, China produced 351,537 graduates in the engineering, computer science, and information technology fields—just over half the number widely reported in news accounts. Further, the quality of Chinese graduates often has been sacrificed to achieve quantity. China’s state-centered and rote learning approach to education is heavy on theoretical and Marxist learning, producing “ivory tower” engineers with few problem-solving and teamwork skills. Engineering curricula are often crowded with ideological courses that detract from the quality of the graduates entering the workforce and from their ability to innovate. The Ministry of Science and Technology, along with other Chinese planners, is not unaware of these defects and has issued new state guidelines and opinions to “further strengthen the cultivation of talents in short supply.” But this is an enormous hurdle to overcome.

A key impediment to accelerating innovation is the inadequate protection of intellectual property. This exists, in part, because there is relatively little history or culture of protecting intellectual property rights and only a recent history of private property. One result is that China’s share of world patents is extremely low, and Chinese officials report that some 99% of Chinese companies own no patents. Officials further acknowledge that the quality of many Chinese patents is poor. This situation may be changing. The State Intellectual Property Office has provided figures on shares of Chinese patents that do show an improvement. In 2005, foreign companies accounted for 54% of patents issued in China, whereas domestic companies accounted for 27%. In 2002, the figures were 73% for foreign companies and 46% for domestic companies.

But enforcement of intellectual property rights in China is likely to remain a problem for some time to come. Even with the best intentions, there is and will remain a serious shortage of intellectual property specialists within the Chinese legal system and companies’ management. Outside observers also believe that the Chinese government faces something of a policy dilemma with respect to accelerating the enforcement of intellectual property rights. Counterfeit goods are far less expensive than branded items. With China’s great divide between people with disposable income and those living in poverty, the balance between the desire to enforce intellectual property rights and to alleviate poverty may easily weigh in favor of the latter.

Forced technology transfer may pose another, perhaps larger, problem—although statistics will never be available to indicate how widespread the problem is. When foreign firms want to enter the Chinese market to sell or produce goods, the price they pay for entry can be an agreement on the kind and amount of technology that will be transferred to Chinese companies. Issues of this kind surface from time to time and indicate that the problem is extensive and important. One example is the nonpayment of royalties to Japanese manufacturers for DVD players, an extremely large market segment. The royalties appear to have been involuntarily waived. Some people in the industry maintain that the Chinese government gave official administrative guidance not to pay the royalties. Certainly, government officials have made many general pronouncements that the payment of royalties by Chinese companies should be avoided wherever possible. Foreign firms undoubtedly tolerate this practice of violation of contractual commitments because being in the Chinese market is profitable or is expected to offer profits in the future.

Forcing technology transfer has its costs. Because of deficiencies in the protection of intellectual property rights, foreign investors withhold core technologies as well as cutting-edge technologies, thus limiting technology transfer to the more routine technologies. There also are reports of companies holding back key process and product components because of concern about intellectual property rights. Chinese planners are well aware of these problems, and such awareness is apparently spurring their increased emphasis on fostering indigenous invention.

Last, a combination of government-promulgated measures impedes innovation. The Chinese government is far from monolithic, and this is true far beyond the division of power with provincial and municipal governments. Some government officials believe that the less intervention, the better; and that the operation of the market, left to some extent unfettered, is the best course of development. But other officials believe in and practice techno-nationalism, implementing policies that ultimately inhibit innovation by alienating foreign firms.

The road forward

On the road into the city of Suzhou, a large rooftop sign proclaims “Development is an Immutable Truth” in English, under massive Chinese characters. The message was from the Chinese leader Deng Xiao Ping, and although it has been translated in various other ways over time, the message is unmistakable: There is one acceptable path for China and that is economic development. Deng was “the great helmsman” for the Chinese economy. His opening of the Chinese economy and his economic reforms transformed China into an economic miracle of its own. Two decades ago, it was common for Asia specialists to say that in geographic terms, Japan was a few smallish islands off the coast of China, but in economic terms, it was China that was an island off the coast of Japan. No one would say that today.

Clearly, it would be a serious error to think that China will not evolve into a major source of innovation in the not-too-distant future. When governments concentrate national resources on achieving specific industrial goals, they can succeed. Moreover, foreign firms still see China as a vast and vital market, as well as a major production platform for export. Although foreign companies may be guarded in transferring technology, the greatest form of technology transfer is human, and there is a very large number of Chinese engineers working for foreign firms who someday, perhaps soon, will repatriate to China. Stock options and other forms of economic and psychic rewards of participating in a new frontier within China, along with an improving quality of life and a lower cost of living, will act as magnets. At the same time, U.S. immigration policy effectively pushes Chinese citizens who received PhD’s at U.S. universities to return home, and home is becoming much more inviting.

China—particularly its capacity for innovation—remains a work in progress. Chinese officials have sought to foster innovation through active intervention as well as allowing much private activity to take place unencumbered. Foreign firms’ participation in China’s economy is essential, as is external collaboration by indigenous firms. To date, the results have been mixed. The key question is whether China can continue with as much state-run intervention as is called for in its current bureaucrat plans and still create a market economy that enables substantial innovation to take place.

The only thing that is sure about China is that whatever is true today will be different in a year, and perhaps unrecognizable in five years. Anyone who traveled to China in the 1980s and saw the empty fields of Pudong across the Huangpo River from Shanghai could not have foreseen the abundance of industrial and scientific development that exists there today.

What one finds generally in China today is a strong will to succeed and an excitement about China’s growth potential and scientific and engineering possibilities. This excitement is somewhat reminiscent of the faith that settlers in the United States had in moving west in the first half of the 19th century. China is engaged in an exciting venture, one of the greatest human experiments of our time. Like the Green Revolution or the manned space flight program, the economic development of a vast continent and even vaster populace is an enormous challenge. Although the world has not seen the first dominant Chinese innovation—an I-pod, wonder drug, or Windows operating system—there is no reason to think that such contributions will not be forthcoming, and perhaps sooner than skeptics think. China has assimilated contract high-end manufacturing and is moving into contract design. It would be a mistake to bet against China’s earning a respectable place in the forefront of innovation. The only question is when.