China Becoming a Major Innovation Power:
Research and development capabilities approaching those of developed countries

Since shifting to policies of reform and opening up at the end of the 1970s, China has accomplished strong economic growth by leveraging its abundant labor force. With labor shortage becoming pronounced, however, the potential growth rate has declined significantly. In response, the government is seeking to transform the country's economic development pattern from one based on expansion labor input to one based on productivity growth by pursuing "the strategy of innovation-driven development."

Innovation in China includes (1) original innovation (basic inventions or the invention of core technology and its application), (2) innovation through technology integration (creating a new product or a new management method by organically combining existing technologies), and (3) introduction, digestion, absorption, and re-innovation (Note 1). While China has been emphasizing innovation centered on those in (2) and (3), capabilities in terms of (1) are also increasing. In addition to technological innovation, innovation in products, services, organizations, business models, and design are also considered to be part of innovation.

In the past, innovation in China was led by the government, with achievements being made in space development, basic research, and large projects. As market-oriented economic reforms make progress, some private companies in the information and telecommunications industry, particularly in the internet industry, have emerged as innovation leaders. Against this backdrop, the international reputation of innovation in China has been increasing rapidly.

In China, the modernization of science and technology has been positioned since the 1970s as one of "four modernizations," the goals of the policies of reform and opening up, along with those of industry, agriculture, and national defense, and the government has been actively and consistently supporting innovation to achieve it.

In particular, with the aim of realizing an innovation-based country, the State Council announced the "Outline of Medium- and Long-term Plan for National Science and Technology Development (2006-2020)" in February 2006. In the plan, the State Council decided to support eight areas of advanced technologies in a focused manner: (1) biotechnology, (2) information technology, (3) advanced materials technology, (4) advanced manufacturing technology, (5) advanced energy technology, (6) marine technology, (7) laser technology, and (8) aerospace technology. In addition, at the 18th Communist Party Congress in November 2012, innovation in science and technology were positioned as "strategic supports to increase social production capacity and overall national strength." The strategy of innovation-driven has been inherited by the government of Xi Jinping that took office following the 18th Party Congress.

Specifically, the following policies were launched to increase the innovation power of China in the "Made in China 2025" initiative announced in May 2015:
（1）Enhancing research and development (R&D) of core technologies
（2）Improving innovative design capabilities
（3）Promoting the commercial applications of science and technology
（4）Improving the country's manufacturing innovation systems
（5）Developing technical standard systems
（6）Strengthening the use of intellectual property rights

In the "Outline of the 13th Five-Year Plan for the Development on National Economic and Social Development" adopted at the National People's Congress in March 2016, "innovation" is listed first and foremost as one of five key "concepts of development," along with "coordination," "green development," "opening up," and "sharing." Specifically, it states, "We must constantly undertake innovation in all areas, including innovation in theories, innovation in institutions, innovation in science and technology, and innovation in culture, by putting innovation in the core position in all aspects of national development, so that innovation will be consistent with all activities of the Party and the country and will become the general atmosphere for the entire society." As part of this effort, the government plans to implement the following 15 important projects toward 2030 mainly in the area of science and technology (Table 1).

In addition, the "13th Five-year Plan on National Scientific and Technological Innovation" released in July 2016 sets specific goals for 2020, which include (1) making China an innovation-based country that ranks in the world's top 15 in terms of overall national innovation strength, (2) increasing the contribution of the rising total factor productivity to the economic growth rate from 55.3% in 2015 to 60%, (3) raising the ratio of the value added of the knowledge-intensive service industry to gross domestic product (GDP) from 15.6% to 20%, (4) lifting the ratio of R&D expenditures to GDP from 2.1% in 2015 to 2.5%, and (5) doubling the number of international patent applications from its level in 2015 (Table 2).

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Source: Compiled by the author based on the "13th Five-year Plan on National Scientific and Technological Innovation" (July 28, 2016) of the State Council.

In addition to support from the government, the ability to introduce advanced technologies from overseas as a developing country and to increase innovation capabilities by absorbing and digesting technologies through imitation, as well as the advantages of having a huge domestic market and accumulated human resources through improved education, provide China with advantageous conditions for innovation.

First, China is aggressively promoting the policy of opening the country to foreign businesses and introducing and absorbing foreign technologies mainly through the following routes:
(1) Import of capital goods that embody technology
(2) Reverse engineering (analyzing the structure of a product through mechanical deconstruction; observing the operation of a product and analyzing the operation of the software; investigating manufacturing methods, operating principles, designs, and source codes, etc.)
(3) Direct investment by foreign companies
(4) Licensing (leasing of intellectual property rights including patents)
(5) Original equipment manufacturing (OEM: manufacturing products that will be sold under the brand of the purchasing company)
(6) Movement of personnel between companies
(7) R&D overseas

So far, direct investment by foreign companies has played the key role, but recently, R&D overseas have been also grown in importance. Some Chinese companies that have gained momentum have established research institutes in Silicon Valley and acquired overseas high-tech companies in some prominent cases (Table 3) (Note 2).

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Source: Compiled by the author based on "PwC: Many large acquisitions by Chinese companies up until the third quarter of 2016: Portfolio investors play an active role," Diyi Caijing, October 20, 2016.

Next, to achieve innovation, it is necessary not to simply introduce technologies from overseas, but to add refinements to them by digesting and absorbing them as well. Imitation plays a major role in this process, and China is a model student in this skill.

Although imitation is generally recognized as standing in the way of innovation, it may also facilitate it. For example, Google Inc. is not actually the inventor of the search engine, and smartphones existed before Apple Inc. launched the iPhone, so innovation is simply the creation of better things based on the fruits of the R&D of predecessors. Reverse engineering, follow-the-leader strategy, and kaizen, which characterizes Japan's approach to innovation, all begin with imitation.

As Shenkar (2010) pointed out, the main reason why many companies have become successful through imitation is that imitators are able to take a free ride on businesses and markets that innovators and pioneers have already developed by making an investment. Imitators can save not only R&D expenses but also marketing expenses because customers already know how to use new products and services. Imitators can also avoid making a major bet and ending in failure. On top of this, it is not innovation itself, but the refinements that follow that significantly improve productivity. Thus, imitators are usually in an advantageous position to provide customers with better products than the original ones at lower prices.

Of the three types of innovation mentioned above, China is better at innovation through technology integration based on imitation and introduction, digestion, absorption, and re-innovation than at original innovation. One example is the fact that China has reached the world's most advanced level in the area of high-speed rail less than 10 years after it introduced the technology from overseas by fully taking advantage of being a latecomer.

The huge domestic market is also one of the advantageous conditions for innovation in China. A virtuous cycle of expanding the market and accelerating innovation has taken root in many areas, and online shopping is a good example. The size of online shopping in China amounted to 3,877.3 billion yuan ($622.5 billion) in 2015, significantly exceeding the $341.7 billion in the United States (Figure 1) (Note 3). To meet customer needs, innovation has emerged in the areas of order management, as well as associated operations such as home delivery and payment. Forbes (online version) lists the following eight industries in which China leads the world, and among them, (1)-(5) are closely related with online shopping (Swanson, 2014).
(1) Micropayments
(2) E-commerce
(3) Delivery services
(4) Online investment products
(5) Cheap smartphones
(6) Hydroelectricity
(7) DNA sequencing
(8) High-speed rail

Source: Compiled by the author based on data from the U.S. Department of Commerce, the National Bureau of Statistics of China, and the China Internet Network Information Center (CNNIC).

Finally, the accumulation of human capital is progressing in China. The massive amount of human resources needed for innovation is being cultivated, thanks in particular to the growth of higher education. From 2000 to 2015, the number of fresh university graduates increased rapidly, from 950,000 people per year to 6.809 million, and the number of those who completed graduate school also rose sharply, from 59,000 people to 552,000 people (Figure 2). The reputation of Chinese universities has also improved, with Peking University (29th) and Tsinghua University (35th) ranked higher than the University of Tokyo (39th) and Kyoto University (91st) in the World University Rankings in 2016-2017 announced by Times Higher Education.

Source: Compiled by the author based on data from China Statistical Yearbook 2016

In addition, an increasing number of Chinese students who have studied abroad and acquired advanced skills have returned to China in recent years. The number of Chinese students going abroad to study reached 4,042,100 between 1978 and 2015, and 523,700 in 2015 alone (Ministry of Education, "Status of Chinese Students Going Abroad to Study in 2015" March 16, 2016). For a long time, the majority of Chinese students studying abroad remained overseas after graduation, reflecting a very large gap between domestic and foreign wages. In 2001, the number of Chinese students returning home was only 14.6% of the number of those going abroad to study. However, as the gap between domestic and foreign wages has been rapidly narrowing against the backdrop of high economic growth and the labor shortage in China, the number of Chinese students studying abroad who are returning home is increasing, reaching 409,100 in 2015, equivalent to 78.1% of the number of students going abroad in the same year (Table 4). Returnees include many engineers who have acquired advanced skills through education and practical experience.

China has achieved remarkable development in the area of science and technology in recent years. This is symbolized by the accomplishments described below in the areas of space exploration, computer science, and communications.

First, in the area of space exploration, China succeeded in landing a probe vehicle on the moon in 2013, following human space flight in 2003. At the moment, China is proceeding with the construction of a space station on its own. As part of this endeavor, China succeeded in docking Shenzhou 11, a two-seat spacecraft, with Tiangong 2 space laboratory on autopilot in an orbit 393 kilometers above earth on October 19, 2016. On September 25, 2016, FAST (Five-hundred-meter Aperture Spherical radio Telescope), the world's largest radio telescope for space observation built in Guizhou province, commenced operations. It is expected to be used to search for extraterrestrial intelligence.

Next, in the area of computer science, Sunway TaihuLight, which uses purely China-made chips, held the top position in the TOP500 performance ranking of supercomputers announced at the International Supercomputing Conference held on November 14, 2016 in Salt Lake City, United States, as it did the previous time as well (June 2016). Another Chinese supercomputer also came second, and China, with 171 units out of the top 500 units, was ranked first along with the United States in terms of the number of supercomputers.

In the area of communications, China launched the world's first quantum communications satellite into orbit on August 16, 2016 to conduct quantum communications experiments with the aim of preventing hackers from acquiring confidential information.

The leap forward made by China in the area of science and technology is also represented in widely used indicators such as the number of papers published in major scientific journals and the number of patent applications.

First, in terms of the number of papers published in major scientific journals compiled by Nature (Nature Index), China, with 6,478 research papers, is ranked second after the United States (17,204) in 2015 (Table 5). By institution, of the world's top 50, China makes up the second largest share with seven institutions, following the United States (25 institutions) (Note 4), and the Chinese Academy of Sciences is ranked first, outclassing Harvard University. In addition, of the 100 institutions with the largest increase in the amount of literature from 2012 to 2015 (the so-called "rising stars"), Chinese institutions make up 40, and all of the top nine institutions are Chinese.

According to the World Intellectual Property Organization (WIPO), China was the third largest international patent applications (PCT) filer in 2015 with 29,837 applications, following the United States (57,385) and Japan (44,235) (Figure 3). By institution, China's Huawei and ZTE ranked as the top and third PCT filer respectively (Table 6). China's total number of patent applications that includes both domestic and overseas applications has surpassed that of the United States since 2012 to become the largest in the world.

Source: Compiled by the author based on WIPO, WIPO Statistics Database

As the R&D capabilities of the whole country increase, world-class innovation companies are also emerging from China. Five Chinese companies ranked in the "50 Smartest Companies 2016" selected by MIT Technology Review including Baidu (2), Huawei (10), Tencent (20), Didi Chuxing (21), and Alibaba (24) (Table 7) (Note 5). China is behind the United States' 32 companies, but ranked second, surpassing Japan's three companies (Toyota (17), Fanuc (27), and LINE (38)).

The criteria for choosing companies are those that best combine "truly innovative technology and a business model that is both practical and ambitious, and strategic management capability." Specific reasons for the Chinese companies to be selected are as follows.

Baidu (Search engine)
Outside of its core business of Internet search and ad sales, Baidu is doing notable work on speech recognition and conversational interfaces. In 2015, it announced the development of a speech recognition engine using artificial intelligence called Deep Speech 2. Baidu is also aggressively pursuing the autonomous car market and recently established a team in Silicon Valley to lead research and engineering in computer vision, robotics, and sensors, among other areas.

Huawei (Communication devices)
Huawei has been selling cell phones for more than a decade and smartphones since 2009, but it long struggled to break into the premium device and U.S. markets. Its 2015 launch of the Nexus 6P phone, which it co-designed and manufactured for Google, showed it can make high-end, high-quality smartphones. Continued strength in entry level devices, coupled with growing clout in more expensive phones, have helped Huawei become the no. 3 smartphone vendor worldwide.

Tencent (SNS and games)
Tencent is Asia's largest Internet company with a well-used Web portal and a messaging app, WeChat, that is China's largest. The company recently branched into the enterprise market by launching a business-focused version of WeChat that facilitates communication (messages, phone calls, e-mails) between colleagues, as well as employee expense reports and other record keeping. Tencent derives most of its revenue from online and smartphone games, and it has been investing in mobile-games companies.

Didi Chuxing (Ride-hailing app)
Didi Chuxing and Uber are battling for market share. Didi claims its drivers complete 14 million rides, surpassing Uber's one million (Note 6). The company's ambitions do not end at China's borders. It has partnerships in India and South Asia.

Alibaba (E-commerce)
Alibaba, which runs an eBay-like store, a popular virtual mall, and other e-commerce services, is now the world's largest online marketplace as measured by annual gross merchandise volume. The growth of mobile and video ads also favors Alibaba, which already dominates the Chinese mobile-ad market and recently acquired Youku Tudou, China's largest online video service. Beyond China, Alibaba has become a backer of other technology companies.

These Chinese enterprises with recognized innovation capabilities are all-sector companies. As symbolized by this fact, private companies are taking the place of state-owned enterprises in innovation.

The international reputation of innovation in China has been rising not only at the company level but also at the national level. China ranked 25th among 128 economies around the world according to the Global Innovation Index 2016 (Cornell University, et al., 2016) jointly published by Cornell University, INSEAD, and the World Intellectual Property Organization (WIPO) (Table 8). All of the countries that are ranked higher than China (e.g., Switzerland (1), Sweden (2), United Kingdom (3), United States (4), Germany (10), Japan (16), and France (18)) have per capita GDP higher than that of China's. Meanwhile, China's rank shows a big lead over other emerging economies (e.g., Russia (43), South Africa (54), and Brazil (69)). Generally, there is a strong tendency that the more advanced the economic development stage presented by per capita GDP is, the higher the comprehensive evaluation of innovation presented in the Global Innovation Index becomes. However, the innovation capabilities of China are exceptionally high compared with other countries at a similar stage of economic development.

The Global Innovation Index score is the simple average of the input and output sub-indices (Table 9). China ranked only 29th in the former and 15th in the latter (Note 7). This implies that China is producing significant innovation outputs with relatively smaller innovation inputs. Reflecting this, China ranked seventh in the innovation efficiency ratio, which is the ratio of the output sub-index over the input sub-index (Note 8).

Thus, China is showing successful results in innovation by exerting its own superiority. On the other hand, however, many factors that could hinder innovation still remain, reflecting the immature market economy.

First, the protection of intellectual property is still insufficient. An intellectual property system that protects patents and copyrights, etc. promotes innovation because it strikes the right balance between the interests of innovators and the wider public interest. In China, however, the relevant laws are not necessarily fully enforced, as symbolized by the fact that pirate editions and forged products are widespread, although the development of these laws is being undertaken. This becomes a factor that hinders investments of foreign companies in China, and eventually their technology transfer.

Second, state-owned enterprises in China, which are blessed with human resources and financial power, are unable to fully realize these advantages in innovation. They are inefficient in terms of R&D compared with private companies because, with their monopoly power, they are not exposed to competitive pressures.

Third, the venture capital industry, which supports innovation and high-tech companies in China, lacks funds and experience. There is a startup board in the Shenzhen Stock Exchange, but the role it can play as a channel for venture capital to recover its investments is limited because the size is small. As the case of Alibaba clearly shows, many venture companies in China have no other choice but to rely on foreign capital and aim to be listed on a foreign stock exchange.

Finally, as Ronald Coase, the founder of new institutional economics and a professor at the University of Chicago who received the Nobel Prize in Economics in 1991, points out, "[W]hile the Chinese market transformation has spawned a booming market for goods and services and allowed China to become a leading global player in manufacturing, it has not yet created an active market for ideas. Indeed, the whole process of creating, spreading, and consuming ideas, from the education system to the media, has remained under tight ideological control and state surveillance. The state monopoly in China has severely curtailed the production of ideas." (Coase and Wang, 2012)

Eliminating these hindrances will become the key to the further advancement of innovation in China. Fortunately, as the amount of intellectual property such as patents held by Chinese companies increases, requests to strengthen the legal system to protect it are growing, and the government is attempting to respond to them. The leaders of innovation are also being replaced by private companies. Although the main source of venture financing was foreign capital in China for a long time, it has been overtaken by domestic capital in recent years, and the domestic listing of emerging companies is also increasing. However, the creation of an active market for ideas requires the easing of censorship imposed on the media, which appears to be difficult from a political perspective for the meantime.

The original text in Japanese was posted on December 6, 2016.