China’s thirst for innovation

The pessimistic noises that emanate from western economies about their inability to compete with the juggernaut that is the Chinese economy are usually centred around the sheer scale of investment being pumped into Asia’s – and the world’s second – largest economy. However, this eye-watering level of investment (around 50 percent of the country’s GDP) is unsustainable, particularly as China becomes more economically entwined with international markets.

Whereas the country was once able to profit from exports produced by low-cost labour, it is slowly having to face up to the rising wages and demands of its workforce, as well as increased pressure to respect intellectual property rights. Although it has heavily invested in research and development, China has failed to see the sorts of innovations emerge from its laboratories that the likes of the US and Germany have so successfully produced.

Itís argued that this is a consequence of the tight controls the Chinese authorities have over all aspects of what is taught and researched at its universities. Last November, the country welcomed a new leadership – spearheaded by Communist Party chief Xi Jinping ñ that it hopes will continue the economic success of its predecessors, while reshaping the Chinese economy to better suit the global marketplace it currently operates in.

Growth through investment
China’s remarkable growth over the last 30 years has been fuelled by low-cost labour, heavy state investment and a somewhat relaxed attitude towards intellectual property rights. The country’s considerable investment in infrastructure has transformed it into a modern, industrialised country, but sustaining this level of investment is impractical.

According to the World Bank, the past 30 years worth of economic growth has been dominated by government investment, with the average GDP growth of 9.8 percent over this period being partly made up of between six and eight percent investment.

The imbalance in China’s economic model will need to be addressed by the newly installed leadership. While the investment-led strategy has helped position the country as the world’s second-largest economy, the current levels of spending are unsustainable. According to a recent study by the IMF, China’s over-investment needs to be rebalanced.

The study said: “China’s capital-to-output ratio is within the range of other emerging markets, but its economic growth rates stand out, partly due to a surge in investment over the past decade. Moreover, its investment is significantly higher than suggested by cross-country panel estimation. This deviation has been accumulating over the past decade and, at nearly 10 percent of GDP, is now larger and more persistent than experienced by other Asian economies leading up to the Asian crisis.”

“However, because its investment is predominantly financed by domestic savings, a crisis appears unlikely when assessed against dependency on external funding. But this does not mean that the cost is absent. Rather, it is distributed to other sectors of the economy through a hidden transfer of resources, estimated at an average of four percent of GDP per year.”

R&D spending
According to the report ‘2013 Global R&D Funding Forecast’ by research firm Battelle and R&D Magazine, China is set to pass the US in levels of spending on R&D over the coming decade. Whereas total US investment is expected to rise 1.2 percent to $424bn this year, China will increase funding from public and private sources by 11.2 percent, to $220bn.

China is set to pass the US in levels of spending on R&D over the coming decade

Even the US government concedes China will overtake it eventually, with President Obama’s Council of Advisors on Science and Technology saying recently: “China’s investment as a percentage of its GDP shows continuing, deliberate growth that, if it continues, should surpass the roughly flat US investment within a decade.”

Multinational companies are also looking to China to conduct R&D. Last November, PepsiCo opened its largest R&D centre outside the US in Shanghai. In a recent report by McKinsey, it was shown that multinational pharmaceutical firms had invested over $2bn in R&D in the country over the past five years. The report said: “Chinese R&D sites are opening or growing almost as quickly as European and US sites are closing or shrinking.”

Stifling innovation
A recent study by Deloitte that ranked each country’s competitiveness in manufacturing placed China at number one and concluded its dominance would continue for the next five years. However, the 2013 Global Manufacturing Competitiveness Index also highlighted the country’s need to invest further in R&D, and specifically science, if it is to match the US and Germany in getting the best out of its available talent.

The report said: “At the country level, executives participating in the 2013 GMCI survey see developed nations, such as Germany and the US, as the most competitive nations with respect to their ability to promote talent and innovation. This is especially interesting when looking at specific talent and innovation metrics, which might signify that although Germany and the US have strong Innovation Index scores, countries – such as South Korea and Singapore – are very competitive on multiple measures like researchers per million of the population, and basic math and science test scores.” All this R&D spending is laudable, but the difficulty China faces is in the types of research that are conducted, and the freedom with which iys best brains are able to explore new ideas and develop fresh ways of doing things. For all its investment, the results are somewhat lacklustre.

The regime has a firm grip on its universities, with the Ministry of Education dictating what should be researched and professors very much toeing the party line. In contrast, western universities defend their intellectual independence, and it is this creative freedom that often leads to the most successful innovations.

As pioneering companies like Apple develop the latest industry-leading products in the US, they outsource much of their production to China. However, rarely is it mentioned that a Chinese firm has produced a revolutionary product from its own research. As western firms such as Apple come under pressure to keep at least some production in their domestic markets, and the labour costs in China rise, the country must develop its own innovations that it can export to the world.

Labour changes
The Chinese economy has benefited greatly from its access to cheap labour, as well as the West’s willingness to turn a blind eye to concerns over worker conditions and human rights. However, after a series of scandals in Chinese factories, including a raft of suicides at Foxconn in 2010, the country is beginning to realise it must make sure conditions improve.

China’s remarkable growth over the last 30 years has been fuelled by low-cost labour, heavy state investment and a somewhat relaxed attitude towards intellectual property rights

China is now suffering a worker shortfall because many of the rural workers shipped into factories have left the urban industrial zones to return to their farms. According to The New York Times, Hubai province alone has reported a loss of more than 600,000 workers.

Salaries have also started to rise sharply as workers demand a fairer share of the profits generated by the country. A year ago, Foxconn reported an increase in average salaries by 25 percent, while other companies were seeing average rises of around 10 percent. This trend will undoubtedly continue, and adjusting strategy so the country gets more out of its developments must be a priority for the new regime.

Manufacturing slowdown
In November last year, China’s export growth slowed to 2.9 percent: considerably lower than expected. This was followed by HSBC‘s announcement in late February that its Flash China Manufacturing PMI fell from 52.3 to 50.4 during the second month of the year. The PMI is seen as a key indicator of the manufacturing sector in China, so this continued decline has worried investors.

HSBC’s chief economist on China, Hongbin Qu, cautioned against panic, saying that, although the figures were disappointing, China was recovering. He said in a statement: “The Chinese economy is still on track for a gradual recovery. Despite the moderation of Februaryís flash PMI, the index recorded the fourth consecutive reading below the critical 50 line.”

Singapore-based economist Connie Tse, of Forecast Pte, also told reporters signs of a recovery were modest, and much depended on struggling markets like in Europe. She said: “The external sector remains fragile, although recent manufacturing activities have showed convincing signs of stabilisation and a gradual recovery. I expect export growth to pick up throughout 2013, but this is likely to be gradual and volatile in absence of a material improvement in the eurozone.”

Political changes
The new leadership has inherited an economy that is growing at its slowest rate since the turn of the millennium, and how it reacts to this changing economic landscape will have a knock-on effect for the rest of the world. As the country becomes less competitive with its exports and begins to reduce its investment in infrastructure, reforms are expected to be made in order to shift the economy to one that is both more productive and efficient.

Li Jiange, Chairman of the China International Capital Corporation, recently told reporters that he expected 2013 would see the new leadership unveil market-orientated reforms that would lead to a reduction in government spending and a breaking up of state monopolies.

It is this second point that is most interesting, as it could lead to greater changes in the direction of many important Chinese firms – which have, up until now, been forced to operate with clearly defined directives from the state. The leaderships of these companies, however, may resist any moves to break them up – especially after predecessor Hu Jintao was so supportive of public ownership. In November, Ning Gaoning, a director at leading state-owned oil and food trading company Cofco, responded to Jintao’s parting speech that outlined the next five years of economic strategy. He said: “The signal is very clear. The predominant position of public-ownership is listed among the basic premises of economic construction with Chinese characteristics.”

Focus on science
The country’s new leadership must focus on investing in science and encouraging creative and original thinking, says Peng Gong, a professor at the Department of Environmental Science, Policy and Management at the University of California. He told science journal Nature in November: China’s talent pool is increasing, but there is still a shortage of scientists who are creative and original thinkers.

“In the next 10 years, more foreign scientists must be recruited and China must enhance its own capacity to train original minds. To retain scientists from overseas, specially allocated research support should be provided for at least their first five years in China.”

Gong added that, although investment in R&D had increased over the last decade, research organisations and universities had seen a decrease in their share of investment: In terms of resources, R&D investment in China has grown more than tenfold in 10 years, from around $12bn in 2001 to about $135bn in 2011.

Investment in basic science and applied research increased more than sixfold, but the percentage of investment for public research organisations and universities dropped from 38 percent to 24 percent, indicating greater input from the private and non-governmental sectors. The new leadership should increase investment in these institutions particularly the major research universities.

Future economy
What sort of economy China has over the next decade will rest heavily on the strategies pursued by the new regime. Many believe the emphasis will shift from its industrial dominance, which currently accounts for 45 percent of GDP, towards a burgeoning service industry.

According to statistics, the service industry accounts for roughly the same proportion of GDP as industry, but is much more likely to grow in the coming years. Retailing, finance, transport and scientific research are all areas that many expect to grow – and this is a likely consequence of the move away from exports – as the general population start to consume more.

The new leadership takes over at a time when many are looking to China to prop up the fragile world economy – but if China doesn’t look inwards at more long-term reforms, it may find the constraints on its economy hinder any chance of sustaining the sort of growth it has enjoyed for the past 30 years.

Dedicating resources to research and development, within a free and creative environment, may well transform China into the sort of balanced innovative economy that could dominate for many years to come.