CSR 2019: An Innovation-Driven Economy with Chinese Characteristics

By Kevin Garrahan

Introduction

Over the past twenty-five years of China’s economic rise and expanding influence, politicians, business leaders, and economists have questioned whether China is capable of innovation. In more recent years, this issue has taken on even greater significance. From the perspective of the US and other advanced economies, China’s progress in high-tech fields threatens their hold on innovation-based industries and economic power. This has been true for some time, but plays a larger role now in the context of the ever-escalating US-China trade dispute. From China’s perspective, their new economic realities and shifting growth model mean that innovation, and the productivity increases it fuels, must now become the key driver of the economy. The country has swiftly entered middle-income status, with higher wages and slower growth rates, and is seeking to upgrade, and ultimately converge with high-income nations, through innovation. Xi Jinping and the rest of the Chinese leadership have gone all-in on this strategy, but the underlying question remains – can China successfully transition into the ranks of the world’s innovation leaders?

This paper’s answer is a resounding yes, albeit with a few caveats. This assessment, far more bullish than most, is centered on China’s impressive innovation track record to-date and the strengths and early results of its upgrading efforts. In 2018 along, rather than rely on the loose, often cultural-based predictions of the past, we can observe substantive empirical evidence of innovation successes and their broader economic impact in China. We are also able to analyze the economic policies that underlie this transition, and their initial outputs in innovative, next-generation sectors like artificial intelligence (AI).

There will be barriers, as well as broader structural constraints that will shape China’s ultimate future economy. But these issues and considerations aside, the takeaway remains; China is well on its way to becoming a leader in innovation, and its plans for a full-scale transition are making headway. As the McKinsey Global Institute’s (MGI) Jonathan Woetzel, an expert on the topic, succinctly states, “China’s got what it takes.”[i]   

Progress on Innovation

“Anyone who says that China is not innovative or entrepreneurial is kidding themselves,” an Amazon employee in China recently proclaimed.[ii] The staid conventional wisdom that China simply cannot innovate must be rebutted for two reasons. One, it mistakenly conflates pure invention with innovation, missing its underlying importance. Two, it relies on a 1990s-esque image of the Chinese economy that revolves around fake products and copycat businesses.

For China, as for all countries, innovation is critical because of its potential positive economic effects on productivity, added value, employment, and overall upgrading. It need not be “breakthrough” innovation to be successful in this regard. As the Economist explained, “The proof of successful innovation is the ability of companies to expand revenue and raise profits,” and Chinese firms have certainly managed to do that, as will be seen below.[iii] Introducing new technologies or processes, regardless of the source of their creation, also raises productivity and, ultimately, economic growth. This is the core tenet of the innovation-driven economy concept. In China’s case, further advances (and their application) in computing, AI and robotics will boost productivity. These advances could add an estimated $450-780 billion of value each year in manufacturing and $500 billion to $1.4 trillion in the services sector.[iv] To make a simplified historical comparison, Japan was not the first to make cars or semiconductors, but it used new manufacturing processes, management practices, and supportive policy to become competitive with the original producers in the industries, propelling the country to the top tier of wealthy nations. There are numerous differences between Japan and China’s paths. From this perspective, China’s goal of sustainable growth through innovation seems more within reach, whether they invent the world’s next semiconductor or iPhone or not.

Regarding the second point – that China is only good at copying others – there is a growing consensus that China has developed its own core strengths in certain types of innovation, mostly within the last five to ten years and mostly focused on commercialization. The oft-cited MGI report, “The China Effect on Global Innovation,” groups Chinese innovation in the two categories of “improving consumer products the business models used to sell them; and in making manufacturing processes cheaper, quicker and better.”[v] China’s broader internet sector offers the best example of the first category. As MGI describes it, “Nowhere have Chinese entrepreneurs shown a greater flair for innovation than in internet-based businesses.”[vi] China’s tech powerhouses, Baidu, Alibaba, and Tencent (collectively known as BAT), have skyrocketed to the list of top companies in the world through real business model innovations, rather than just “copycat” models and government protection. The first innovation relates to their customer-facing offerings; they have pioneered the idea of super-apps, or platforms, where “dozens of different services or sub-apps come together.”[vii] Second, China has developed related revenue-generating models. While most US firms rely on advertising to monetize their users, BAT and others have successfully developed other revenue sources. Tencent’s WeChat, the prime example of both, is a social media, messenger, and mobile payment app in one. It relies on game sales, e-commerce, and transaction fees.[viii] It is hard to consider China’s mobile payment commercialization a business model innovation. However, Chinese firms adapted the QR code, originally developed in Japan for the automotive industry, to making payments via smartphones.[ix] These transactions were worth just 1.2 trillion yuan in 2013 but are now expected to total 98.7 trillion (roughly USD $15.5 trillion) for 2017, with estimates rising even more in the coming years. These figures dwarf the US and all other major advanced markets combined; consumers in China now make mobile payments 50 times more often than Americans.[x]

China’s tech market is still not on par with its US counterpart, but it is rising fast. According to analysis by the Economist, China’s tech sector was 42% as powerful as the US’s as of early 2018, up significantly from just 15% in 2012.[xi] Looking to the future, “China’s unicorns, a proxy for the next generation of giants, are in total worth 69% of America’s, and its level of venture capital (VC) activity is 85% as big as America’s based on money spent since 2016.”[xii] Tencent and Alibaba play a large role in supporting these new firms, funding about a quarter of venture deals, and growing the broader ecosystem. A recent CSIS report on the sector states that, “many innovative and vital internet companies have emerged, playing an important role in promoting stable growth and employment, and benefitting the people.”[xiii]

In the second category of innovation that has developed in China – cheaper, faster, and better manufacturing – the wind and solar energy sectors stand out as good case studies. After years of “good enough” production in traditional industries, China’s low-cost model is upgrading to rapidly speed up design and scale, and improve products for both Chinese and export markets at the same time.[xiv] “Chinese companies have shown that they can move from idea to commercial product or service in far less time than companies in other markets,” including through much quicker prototyping, shorter product cycles, and a focus on customer feedback.[xv] In the renewables sector specifically, Jonas Nahm and Edward Steinfeld describe a unique “innovative manufacturing” process that sits “at the intersection of upstream R&D and manufacturing.” [xvi] Chinese firms innovate at this juncture on processes, inputs, and even the final product, to commercialize new-to-the-world technologies.[xvii] This is often done with global partners that are the original owners of the idea or concept, but the authors’ on-the-ground interviews indicate that the Chinese role goes “well beyond traditional emulation and assembly, reaching deep into new product and process design.”[xviii] This has translated into remarkable commercial performance, with China accounting for 60% of world solar production and playing a leading role in wind turbine manufacturing, as well. This is similar to the stories in other high-end manufacturing sectors. DJI dominates the global commercial drone market, now controlling 85% of production. Huawei has transformed into a major global player across information and communications technologies (ICT). It is set to play a decisive role in the coming 5G wave. [xix] Economically important, these firms are operating throughout the value chain, including in the high value-added early stages of design and development and later stage of sales and marketing.[xx]

Finally, in assessing recent progress, it should also be acknowledged that China has shown increased indications of the more frontier-type of innovation. China has the two fastest supercomputers in the world and 202 of the world’s top 500. The leader, TaihuLight, is more than five times faster than the US’ top performer, and it uses Chinese processors, rather than Intel chips.[xxi] China has also touted the world’s first quantum satellite, Micius, which has scored a number of pioneering achievements, including the first quantum-encrypted satellite video call.[xxii] In biotech, another key “breakthrough” field, Chinese firms have excelled at genome sequencing.[xxiii] These are a few cases and should not be taken to mean that China now competes head-to-head with the scientific power of the US. But they may be harbingers of things to come. “At least parts of Chinese industry,” Nahm and Steinfeld conclude, “have reached a new stage of competitiveness, one situated at the frontier of global technology development, and deep within global innovation networks.”[xxiv]

Realizing an Innovation Economy

Moving broader segments of the economy towards the technology frontier is now the linchpin of China’s development strategy. The central government and provincial governments are utilizing forceful industrial policies and massive financial support “to speed up China’s technological catch-up and to leapfrog stages of technological development.” [xxv] These efforts are aided by a stronger position and role of private firms than in past periods in Chinese history, including BAT, countless start-ups, and venture capital (VC) investors. Their combined strengths and potential are already having an impact, propelling China away from its middle-income peers in next-generation sectors expected to drive the global economy in the coming decades. “A technology revolution is sweeping the world,” Eurasia Group president Ian Bremmer proclaimed, “and the countries that most effectively seize the opportunities it creates will dominate the 21st century.”[xxvi] China seems to be seizing that opportunity.

The Chinese government has created a slew of economic and sector plans to achieve their goals. This includes Made in China 2025 (MC2025), its well-known blueprint for manufacturing modernization that became a sticking point in the trade conflict with the United States.  Other key plans include the Guidelines to Promote National Integrated Circuit Industry Development and Internet Plus plans, and the 2017 Next Generation Artificial Intelligence Development Plan. These plans have specific production targets, as well as broader objectives in automation, supply chain localization, promotion of national champions, and productivity gains. Some notable production targets include producing 70% of “basic core components” for aerospace and electronics, 40% of mobile phone chips, 70% of industrial robots, and 80% of new energy vehicles (NEV) within China by 2025.[xxvii] To realize these goals, governments will marshal billions of dollars of public financing through subsidies, specific funds, and bank lending; support foreign acquisitions for technology transfer and domestic mergers for consolidation; and use a range of competition and procurement policies to promote domestic players over foreign firms.[xxviii] National-level funds include the Advanced Manufacturing Fund, the National Integrated Circuit Fund (also known as the Big Fund), and the Emerging Industries Fund. There is a plethora of provincial-level funds as well. At the end of 2015, there were 720 of these funds with assets of $328 billion, numbers that have likely gone up since.[xxix]

“China is pulling ahead because it has a strategy to build a high-tech economy and is willing to spend heavily and consistently over years,” James Lewis from CSIS summarized.[xxx] The strategy is forward-looking, focusing especially on nascent industries not yet dominated by the OECD nations. It is supported by both theory and empirical successes.[xxxi] Every country that converged with high-income nations in the post-war period, including but not limited to the East Asian Tigers, utilized some form of state policy for technological development.[xxxii] As Chinese policymakers point out, even the US employed significant government intervention for infant, innovative fields, helping to give rise to Silicon Valley today.[xxxiii] China is undoubtedly using much more heavy-handed interventions than the US ever did, causing some to decry the Chinese plans as  neo-mercantilist.[xxxiv] This may not be the most efficient or equitable economic approach, but this is no less reason to take it seriously.

Moving from strong potential to real-world results, China’s progress in next-generation sectors further supports the overall conclusion that China will transition into an innovation-driven economy. Prime among them is AI, which will drive further developments in both new and traditional industries. In AI, as opposed to most traditional industries, China has surpassed the rest of the world and is competing directly with the US. This leapfrogging has been supported by government efforts, flourishing private sector activity, and China’s clear advantage in the data needed to “train” AI algorithms. “The size of available datasets is the most important source of competitive advantage in AI,” and China’s resulting advantage in that regard will be insurmountable for other countries.[xxxv] The report also categorizes four types of AI and China’s performance in each. In internet AI, focused on new-age operating systems and elsewhere, BAT are competing well with their US counterparts, despite Google’s current AI global dominance. In business AI, China notably lags due to slower implementation of earlier data and enterprise applications, but 4th Paradigm stands out as a global player providing AI for financial institutions. The third type the authors identify, perception AI, is where China really shines. They appear to be a global leader in cutting-edge face and voice recognition, with firms like Face++, iFlyTek, and SenseTime, recently named the most valuable AI firm in the world at $3 billion.[xxxvi] Lastly, in autonomous AI, China is catching up and could ultimately be on par with the US, they posit, in areas like autonomous vehicles, robots, and connected things. Importantly, AI seems to be providing an opportunity for China’s semiconductor industry to also make progress, after years of slower progress. Cambricon and Bitmain are examples of Chinese firms that could jump into competitive positions in niche chip markets.[xxxvii] With these developments, and its impressive performance in three out of four AI categories, the government’s goal to catch up on AI technology and applications by 2020 and become the leading AI hub by 2030 must be considered within reach., Former Alphabet chairman Eric Schmidt notably expects China to overtake the US in AI as early as 2025, besting the government’s target by five years.[xxxviii] China’s AI progress indicates that it is well on it way to realizing the potential trillion-dollar productivity gains from future sectors.       

China’s performance in two other next-generation sectors is also worth mentioning. In vehicles, China is taking advantage of timing. Anand Shah, a senior advisor with the Albright Stonebridge Group, recently explained that two trends – electric vehicles and autonomous vehicles – are shaking up what was a stable, decades-old model for incumbent automakers. This change initially caught US firms flat-footed, while the Chinese, driven by BAT and other firms, have acted swiftly in developing production and spurring demand.[xxxix] China could skip the painstaking process of trying to gain ground in the crowded traditional industry and move right into a strong position in the next wave of vehicles. In robotics, China is still behind the global curve, but is rushing to catch up. They are by far the largest market in the world, spending $10 billion annually to install some 600,000 total robots to meet the MC2025 targets. Provincial governments have especially thrown their weight behind the industry. Both of these new-age sectors would be propelled by further AI advancement in the country, adding to the potential of a breakthrough, catching-up moment.

Barriers and Constraints

Despite all of its progress and future potential, there are both weaknesses in China’s efforts and larger issues that will affect its transition to an innovation-driven economy. Many of the barriers are politically related. This includes the top-down nature of its upgrading plans, which do not necessarily meet firm-level needs or demand. Much of the spending flowing from these plans will be inefficient, leading Scott Kennedy of CSIS to claim that, “these are fat years for innovation in China.”[xl] There is also an argument to be made that a strong party hand in universities and state-owned enterprises (SOEs) will restrict further development beyond the current stage of innovation.[xli] Private firms are leading the way on innovation, yet the state has maintained SOEs in recent years, backsliding on years of reform efforts. International politics, especially the US-China relationship, have also created significant barriers to market access. The US is cracking down on Chinese tech-related investments, prohibiting firms like Huawei from selling into its market and others, drying up investment with new investment approval reforms, and threatening to cut off the supply of key components for firms like ZTE.[xlii] These efforts by the Trump administration could be extremely detrimental to Chinese firms and could prohibit technological learning and upgrading. In the long-term, closed or restricted access to the US market makes it very difficult for companies to become truly globally competitive and amass needed profits.[xliii] An expanded, wealthier consumer base in China will help, but it is still nowhere near the prize of the US market. Finally, China’s pure innovation inputs – in human capital, the value of intellectual property, and applied research and development (R&D) – are still lagging. China has, to date, made up for these shortcomings with a focus on experimental R&D (80% of all R&D in China) and commercialization. Reports indicate that they have been improving on these metrics in recent years.[xliv] In order to push larger parts of the economy forward, China will have to continue this progress.

There are also two rather unique factors that will shape China’s innovation push. The first one, structural in nature, stems from the size of China’s economy. China’s massive manufacturing base and employment is without compare.[xlv] It will be extremely difficult to fully propel all sectors and firms into a new model. The innovation-driven economies of the world are largely smaller, denser places, such as those in Europe and elsewhere East Asia. The US is the prime exception with its large, innovation-based economy. But it too has grappled with its own issues of sector, firm, and employment shifts as a result of it is grappling with its own issues resulting from the transition away from manufacturing over the past decades (at least in part).[xlvi] The second issue concerns the unique “China effect” on global innovation. China mobilizes overwhelming resources to support sector growth, as discussed, which can drive down margins and drive out the high-end firms that spend heavily on R&D to innovate. This was the case in the solar PV market, which suffered from Chinese-led overcapacity and the worry is that it will happen again. “To put it plainly,” Scott Kennedy says, “China could do to semiconductors, artificial intelligence, and pharmaceuticals what it has done to steel and aluminum. This could, in turn, result in a downturn in overall productivity, the most important source of growth for countries and the global economy.”[xlvii] On this “China effect,” the future is less certain, but a largescale shift away from innovation-led growth seems unlikely at this point.

Conclusion

Innovation in China still suffers from some persistent shortcomings. That is true today and will likely be true in the foreseeable future. But, in returning to the original question, this doesn’t mean that China won’t ultimately succeed in its overall economic transition. Chinese-style innovation is now rightly recognized as a powerful global force, as exemplified by the internet and renewable sector examples. The government’s policies to realize its objectives are largely the right ones; incomparable financing and support buoy these policies. Finally, an ascendant private sector is poised to potentially leapfrog its competitors in the US and other advanced economies in a meaningful way. These trends are too powerful to slow, meaning the lasting challenges will only affect China’s transition at the margins – creating an innovation-driven economy, with Chinese characteristics.


[i] Jonathan, Woetzel, “Will China ever be on the cutting edge of global innovation?” ChinaPower Project CSIS,  February 27, 2016, https://chinapower.csis.org/will-china-ever-be-on-cutting-edge-of-global-innovation/.

[ii] Lillian Rogers,“China’s Tech Titans, From Another Planet,” LinkedIn, September 22, 2017,https://www.linkedin.com/pulse/chinas-tech-titans-from-another-planet-lilian-rogers/.

[iii] Shang-Jin Wei, Xie Zhuan, and Xiaobo Zhang, “From ‘Made in China’ to ‘Innovated in China’: Necessity, Prospect, and Challenges,” Journal of Economic Perspectives 31, no.1 (2017): 49-70.

[iv] “China Effect on Global Innovation: Executive Summary,” McKinsey Global Institute, October 2015, 15, https://www.mckinsey.com/~/media/McKinsey/Featured%20Insights/Innovation/Gauging%20the%20strength%20of%20Chinese%20innovation/MGI%20China%20Effect_Executive%20summary_October_2015.ashx.

[v] “Calibrating Chinese Creativity,” The Economist, July 9, 2015, https://www.economist.com/news/business/21657376-sceptics-exaggerate-some-industries-chinese-firms-are-innovative-calibrating-chinese.

[vi] “China Effect on Global Innovation,” 11.

[vii] Ibid, 15.

[viii] “Calibrating Chinese Creativity.”

[ix] “The Mobile Payments Race: Why China Is Leading the Pack — for Now,” Knowledge@Wharton, University of Pennsylvania, January 17, 2018,  http://knowledge.wharton.upenn.edu/article/how-will-chinas-overseas-mobile-payment-systems-fare/.

[x] Kai-Fu Lee and Paul Triolo, “China Embraces AI: A Close Look and a Long View,” Eurasia Group, December 2017, 7, https://www.eurasiagroup.net/files/upload/China_Embraces_AI.pdf.

[xi] “How Does Chinese Tech Stack Up Against the US,” The Economist, February 15, 2018, https://www.economist.com/news/business/21737075-silicon-valley-may-not-hold-its-global-superiority-much-longer-how-does-chinese-tech.

[xii] Ibid.

[xiii] Samm Sacks, “Disruptors, Innovators, and Thieves: Assessing Innovation in China’s Digital Economy,” CSIS, January 2018, https://csis-prod.s3.amazonaws.com/s3fs-public/publication/180108_Sacks_DisruptorsInnovatorsThieves_Web.pdf?22jQMv.fUUhvJsneUUmP767drezraCX.

[xiv] “China Effect on Global Innovation: Executive Summary,” 104.

[xv] Ibid, 108.

[xvi] Jonas Nahm and Edward S. Steinfeld, “Scale-up Nation: China’s Specialization in Innovative Manufacturing,” World Development 54 (2014): 290.

[xvii] Ibid, 290.

[xviii] Ibid, 294.

[xix] Sacks, “Disruptors, Innovators, and Thieves: Assessing Innovation in China’s Digital Economy.”

[xx] Sacks, “Disruptors, Innovators, and Thieves: Assessing Innovation in China’s Digital Economy,”14.

[xxi] “America Just Can’t Match China’s Exploding Supercomputing Power,” MIT Technology Review, November 13, 2017, https://www.technologyreview.com/the-download/609468/america-just-cant-match-chinas-exploding-supercomputing-power/.

[xxii] “Chinese satellite uses quantum cryptography for secure video conference between continents,” MIT Technology Review, January 30, 2018, https://www.technologyreview.com/s/610106/chinese-satellite-uses-quantum-cryptography-for-secure-video-conference-between-continents/.

[xxiii] China Effect on Global Innovation: Executive Summary,” 20.

[xxiv] Nahm and Steinfeld, “Scale-up Nation: China’s Specialization in Innovative Manufacturing,” 290.

[xxv] Jost Wübbeke, Mirjam Meissner, Max J. Zenglein, Jaqueline Ives, and Björn Conrad, “Made in China 2025: The making of a high-tech superpower and consequences for industrial countries,” Mercator Institute for China Studies, Merics Papers on China, No. 2 (2016): 7.

[xxvi] Lee and Triolo, “China Embraces AI: A Close Look and a Long View.”

[xxvii] Wübbeke et al., “Made in China 2025: The making of a high-tech superpower and consequences for industrial countries,” 21.

[xxviii] Scott Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” CSIS, August 2017, 2, https://www.csis.org/analysis/fat-tech-dragon.

[xxix] Ibid, 22.

[xxx] James A Lewis, “China and Technology: Tortoise and Hare Again,” CSIS, August 2, 2017, https://www.csis.org/analysis/china-and-technology-tortoise-and-hare-again.

[xxxi] For example, see: Erol Yayboke, “Innovation-Led Economic Growth: Transforming Tomorrow’s Developing Economies through Technology and Innovation,” CSIS, September 2017, https://www.csis.org/analysis/innovation-led-economic-growth.

[xxxii] Robert Devlin, “Competing in World Markets: New Industrial Policy for Latin America,” Johns Hopkins School of Advanced International Studies Course, Spring 2018.

[xxxiii] Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” 3.

[xxxiv] Gerwin, Ed, “Confronting China’s Threat to Open Trade,” Progressive Policy Institute, June 2018, https://www.progressivepolicy.org/wp-content/uploads/2018/06/PPI_China_2018.pdf

[xxxv] Lee and Triolo, “China Embraces AI: A Close Look and a Long View,” 7.

[xxxvi] Adam Jezard, “China is Now Home to the World’s Most Valuable AI start-up,” World Economic Forum, April 11, 2018, https://www.weforum.org/agenda/2018/04/chart-of-the-day-china-now-has-the-worlds-most-valuable-ai-startup.

[xxxvii] Lee and Triolo, “China Embraces AI: A Close Look and a Long View,” 9.

[xxxviii] “The Battle for Digital Supremacy,” The Economist, March 15,2018, https://www.economist.com/news/leaders/21738883-americas-technological-hegemony-under-threat-china-battle-digital-supremacy.

[xxxix] Anand Shah, “China’s Rapid Drive Into New – Generation Cars Trends, Opportunities And Risks,“ CSIS Event, February 21, 2018, https://www.csis.org/events/chinas-rapid-drive-new-generation-cars-trends-opportunities-and-risks.

[xl] Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” 39.

[xli]Regina M. Abrami, William C. Kirby, and F. Warren McFarlan, “Why China Can’t Innovate,” Harvard Business Review, 2014, https://hbr.org/2014/03/why-china-cant-innovate.

[xlii] Danny Crichton and Arman Tabatabai, “The US Continues to Hammer Chinese tech,” TechCrunch, January 2019, https://techcrunch.com/2019/01/11/the-u-s-continues-to-hammer-chinese-tech/.

[xliii] “How Does Chinese Tech Stack Up Against the US.”

[xliv] “Is China a global leader in research and development?” CSIS, https://chinapower.csis.org/china-research-and-development-rnd/

[xlv] West, Darrel M. and Christian Lansang, “Global Manufacturing scorecard: How the US compares to 18 other nations,” The Brookings Institution, July 10, 2018, https://www.brookings.edu/research/global-manufacturing-scorecard-how-the-us-compares-to-18-other-nations/

[xlvi] Gerstein, Daniel M. “America’s Shifting Labor Market in a Technology-Driven World,” RAND Corporation, November 25, 2018, https://www.rand.org/blog/2016/11/americas-shifting-labor-market-in-a-technology-driven.html

[xlvii] Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” 3.

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