China Aiming for Growth by Innovation: Private-sector companies as the leading force

Since shifting to reform and open-door policies at the end of the 1970s, China has leveraged an abundant work force and low wages to achieve rapid development and become the "workshop of the world." However, as labor shortages have become increasingly apparent lately, and the country is losing its advantage of low costs, China has been forced to rely on innovation to maintain its high growth. While in the past, innovation was led by the government, as the market economy progresses, some private-sector enterprises, particularly those in the IT industry, have emerged as the leading force. Against this backdrop, the growth engine is shifting from the increased input of factors of production, such as labor, to higher productivity through innovation.

The term "innovation" in China includes (1) original innovation (the invention of a basic or core technology and its application), (2) integrated innovation (the creation of a new product or management system by combining existing technologies organically), and (3) introduction, digestion, absorption, and re-innovation ( Note 1 ). Until now, innovation in China has mainly taken the form of (2) and (3), while (1) has remained a goal for the future. In addition to technological innovation, the innovation of products, services, organizations, business models, and design is also regarded as part of innovation in a broad sense.

While China is rich in advantageous conditions for promoting innovation, it also has many impediments to overcome.

As the largest developing country and widely open to the world, China benefits from the following factors that favor innovation.

First, China is far behind developed countries in its development stage, and, to a large extent, enjoys the advantage of being a latecomer. This means that not only is there a large amount of room for technological advancement, but also China is able to introduce technologies cheaply from abroad without bearing the high costs and risks involved in undertaking its own research and development (R&D).

In addition, 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. (1) Import of capital goods that embody technology
2. (2) Reverse engineering (analyzing the structure of a product by deconstructing something mechanical, observing the operation of a product and analyzing the operation of the software, investigating manufacturing methods, operating principles, designs and source codes, etc.)
3. (3) Direct investment by foreign-affiliated companies
4. (4) Licensing (a patent holder receives compensation from a third party by providing the third party with the right to use its patent or invention)
5. (5) Original equipment manufacturing (OEM: manufacturing products that will be sold under the brand of the ordering company)
6. (6) Movement of personnel between companies
7. (7) Overseas R&D

Among the above-mentioned factors, direct investment by foreign-affiliated companies appears to be playing a major role.

Furthermore, thanks to its large population and high growth over the past 30-some years, China's attractiveness as a market has been increasing. Against this backdrop, China has developed a strong bargaining power in receiving investments from foreign companies, which has enabled it to take an industrial policy of "swapping market for technologies." In fact, while China imposes high import duties on some value-added products such as automobiles, it encourages the local production and sales of these products. Therefore, many foreign-affiliated companies are forced to access the Chinese market in the form of direct investment, instead of exporting their products to China from abroad, in order to avoid high customs duties.

Finally, a massive amount of science and technology-related personnel needed for innovation are cultivated through the enhancement of the education system, particularly the spread of university education. Moreover, the number of students who have acquired knowledge of high technology and returned to China after studying abroad has been increasing in recent years. We can say that such abundant and talented technical personnel are the source for innovation in China.

On the other hand, the market economy is immature, and this has become a factor hindering innovation.

First, the protection of intellectual property rights is still insufficient. The intellectual property system that protects patents and copyrights will promote innovation by balancing the exclusive right of intellectual property with its availability. In China, however, although the development of related laws has been progressing, these laws are not necessarily fully enforced, as symbolized by the widespread availability of pirate copies and counterfeit items. This has become a factor in hindering investments of foreign-affiliated companies in China and, in turn, their technological transfers.

Second, although state-owned enterprises in China are endowed with personnel and capital, they have yet to fully utilize these advantages for innovation. As they monopolize the domestic market and are not exposed to competitive pressure, the efficiency of the R&D done by these companies is lower than that of small and medium-sized enterprises and private-sector companies.

Third, the venture capital industry, which supports innovation companies and high-tech companies in China, lacks both capital and experience. Although there is a start-up business board (ChiNext) in the Shenzhen Stock Exchange, the role it can play as a channel for venture capitalists to recover their investments is limited. This is hindering the growth of venture capital and, in turn, start-up companies that are counted on as the bearers of innovation.

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." ( Note 2 )

The key to promoting innovation will be to make use of these advantageous conditions and eliminate the impediments.

The modernization of science and technology is regarded as one of the "four modernizations," along with the modernization of industries and agriculture, as well as the modernization of national defense that China aims to achieve through reform and door opening. To realize this, the government has been actively and consistently supporting innovation.

Particularly, with the aim of realizing an innovative nation, in February 2006, the State Council announced an "Outline for the National Medium- and Long-Term Program for Science and Technology Development (2006-2020)." In it, the State Council set up specific targets, including boosting the ratio of R&D investments to gross domestic product (GDP) to over 2.5% by 2020, and increasing the number of inventions and patents made by Chinese and the number of quoted Chinese scientific papers to among the top five countries in the world. China also decided to support the following eight areas of advanced technology: (1) biotechnology, (2) information technology, (3) new materials technology, (4) advanced manufacturing technology, (5) advanced energy technology, (6) marine technology, (7) laser technology, and (8) aerospace technology in a focused manner for sustainable innovation and economic and social development. Subsequently, in June 2008, the State Council issued the "Outline of the National Intellectual Property Strategy" and set a target of improving capabilities to create, use, protect, and manage intellectual property rights.

At the 18th National Congress of the Communist Party of China ("Party Congress") held in November 2012, the innovation of science and technology was positioned as a "strategic support to increase social productivity and the comprehensive national strength." The promotion of a "development strategy through innovation" was taken over by the Xi Jinping government that was born out of the 18th Party Congress, and, in particular, the following five tasks have come to be emphasized. (Xi Jinping, "Implementation of Development Strategy through Innovation," a talk at the ninth Group Study Session of the Central Committee of the Communist Party of China, September 30, 2013.)

The first task is to adjust the division of roles between the government and the market to make sure that the market can play a decisive role in allocating resources for innovation, and that companies will become real agents for innovation. The government should play an active role in areas related to public welfare and areas underpinning key industries through coordination and planning. It should also aim for the top echelon by focusing on important scientific and technological research and projects.

The second task is to acquire core technologies by enhancing indigenous innovation capabilities. The priority is to improve the incentive system and the policy environment. Innovation should be linked to the development of industries, and funding should be made available for that purpose. Also, the innovation capability of the country as a whole should be enhanced by eliminating obstacles that restrain the transfer and spread of scientific and technological achievements.

The third task is to improve the mechanism for developing human resources. Systematic and structural obstacles that hinder the transfer, hiring, and promotion of human resources should be eliminated, while support and assistance should be given to innovation and business startups by technical personnel. In addition, educational reforms should be deepened and educational methods should be renovated. Efforts should also be devoted to attract more talents from overseas.

The fourth task is to build a favorable policy environment. The government should increase funding for science and technology, encourage companies to spend more on R&D, strengthen the protection of intellectual property rights, and develop a tax environment that favors innovation. The capital market should play a larger role in supporting high-tech companies.

The fifth task is to promote indigenous innovation by deepening international exchange and cooperation. China should work hand in hand with the international scientific and technological community to address common challenges facing the world.

As China had relied on most of its technologies from overseas imports for a long time, the country was deemed to have little to do with innovation. However, as symbolized by the fact that the number of patent applications by China since 2012 has been the largest, the situation has been changing significantly ( Note 3 ). The international reputation of innovation in China has been rising rapidly, partly due to the rapid progress made by some high-tech industries and companies.

First, at the country level, China ranked 29th among 143 countries and economies around the world according to the GII jointly published by Cornell University, and INSEAD, and the World Intellectual Property Organization (WIPO) ( Note 4 ). All countries ranked higher than China (e.g., Switzerland (1), United Kingdom (2), Sweden (3), United States (6), Germany (13), Japan (21), and France (22)) have per capita gross domestic product (GDP) higher than that of China's. Meanwhile, China's rank showed a big lead over other emerging economies (e.g., Russia (49), South Africa (53), Brazil (61), and India (76)).

In addition, at the industry level, Forbes (online version) lists the following eight industries as the ones in which China leads the world ( Note 5 ).

1. Micropayments
   Chinese IT companies offer their games and web services for free, and then charge small fees for individual pieces of content. This business model helped many companies earn profits despite rampant piracy.
2. E-commerce
   Chinese e-commerce is simple and broad reaching. It has leapfrogged traditional retail in China, bringing goods to developing rural areas instead of brick-and-mortar stores.
3. Delivery services
   In general, courier services in China are fast and very cheap.
4. Online investment products
   Alibaba's Yu'e Bao has become the largest money market fund in China and is among the biggest in the world.
5. Cheap smartphones
   For many Chinese people, a smartphone is their sole way of accessing the internet. Although Apple and Samsung are still hugely popular in China, many people are turning to cheaper domestic brands to acquire the same bells and whistles at a fraction of the price.
6. High-speed rail
   The extent of China's high-speed rail network accounts for half of the length of the entire world, making it a major force in transforming the social system.
7. Hydroelectricity
   Today, China is the world's largest producer of hydroelectric power, with 11 of the world's largest 25 hydroelectric plants.
8. DNA sequencing
   The cost of sequencing a complete genome has fallen from $3 billion in 2003 to just a few thousand dollars today. That accomplishment is in large part due to a Chinese biotech firm called Beijing Genomics Institute (BGI), which today accounts for about half of the world's global genetic sequencing capacity.

At the company level, in "The 50 Most Innovative Companies 2014" compiled by Boston Consulting Group based on the survey responses from more than 1,500 senior executives, China's Lenovo Group (23), Xiaomi Technology (35), Tencent Holdings (47), and Huawei Technologies (50) ranked in (Table 1) ( Note 6 ). In addition, Huawei ranked in the Top 100 Global Innovators for the first time as a Chinese company, which is published annually by Thomson Reuters and names the companies that are leading the world business by turning creative ideas into protected commercialized inventions ( Note 7 ).

All of these companies, which were selected based on their innovation efforts, are private-sector companies. This is in contrast with the fact that most of the Chinese companies ranked based on sales in the Global 500 of Fortune (in 2014, 91 Chinese companies excluding those in Taiwan and Hong Kong) are state-owned enterprises ( Note 8 ). Given that innovation is the key to the growth of companies, the day when private-sector companies will become the leading players for the Chinese economy, taking the place of state-owned enterprises, seems no longer so far off.

The original text in Japanese was posted on February 4, 2015.