On the Subject of China's Ability to Innovate and Compete in Global Markets

For the 6th year in a row, China remained in the top fifth of economies in the World Economic Forum Global Competitiveness Index, ranking a respectable 28th out of 144 countries in 2015-16.  That put China 47 places above Brazil and 17 places above Russia, its two BRIC peers.  But, China’s current rank in the index does not tell the whole story.  China’s economy moved up in the rankings quickly early last decade, leapfrogging a slew of other developing economies to become one of only two middle-income developing nations to crack the index's top 30, along with Malaysia.  The economy has moved up considerably from its 55th place showing in 2005.  But, since 2012, its move up the ranks has stalled.  Add to that the fact that China has accumulated more debt to achieve its level of competitiveness than many other economies.  China has burned through more capital to improve its competitiveness than most peers (see the chart on the left).

As questions mount over the sustainability of robust growth in China, the issue of competitiveness is highly important.  According to the Asia Development Bank, China exports over 55% of Asia’s low tech goods, a massive amount that has partly funded rapid growth. But, as wages rise, the workforce shrinks as a result of the one-child policy, and consumers become more demanding, Chinese firms need to push their way up the value chain into high-tech and high-value innovative product exports to sustain robust growth.  If they cannot move up the value spectrum and create globally competitive products, the economy will be squeezed between rising labor costs and low-cost, low-tech assembly.

So, is China still growing more competitive, or has the economy hit a ceiling? Can Chinese firms create innovative, globally competitive products to keep moving up the manufacturing value spectrum and outpace growing labor costs?  Measuring China’s ability to innovate and produce globally competitive products presents a mixed picture.  While China’s economy seems to be in the midst of growing its innovation potential, it is unclear that the country has moved far beyond the days of cloning foreign ideas and low-cost assembly.

Chinese Firms’ Share of Global Revenues
Chinese companies do have some successes in competing on the global stage.  According to McKinsey & Company, Chinese appliance firms account for 36% of global revenues, telecom companies about 18%, high speed trains account for roughly 41% of the global market, and Chinese solar panel firms account for over half of all global solar panel revenues.  A single Chinese firm, DJI, accounts for 70% of the global consumer drone market.  But in R&D heavy science-based industries, like branded pharma and semiconductors, Chinese firms account for less than 12% of global revenues, below China’s share of global GDP.  China’s auto firms only account for 8% of total global revenues.

Patent Filings
Many discussions on China’s capacity to make innovative, globally competitive products turn to the recent massive surge in patent filings.  According to the World Intellectual Property Organization, in 2014 China patent filings numbered roughly 928,000, compared to 579,000 in the US, 326,000 in Japan, and 210,000 in South Korea.  That number amounts to one-third of all global patent filings, a huge number for a country still in the middle of an economic transition.  And, 2015 filings in China rose another 18.7% to 1.1 million, making China the first country to file over a million patents in one year.  Sinopec led Chinese patent filings in 2015 with a total of 2,844, followed by telecom equipment national champions ZTE and Huawei.  China’s successful rise in patent dominance has been cited as evidence of its success as an innovation economy.

By the numbers, China has churned out some impressive patent filing statistics over the last few years, but a great deal of China’s patent surge is proving hollow.  Some years ago, Beijing instituted a number of incentives for patent filings, including tax breaks, remuneration, and other benefits.  Those incentives have resulted in an emphasis on quantity rather than quality.  Evidence of that can be found in two numbers described below.  

Only a third of China’s patent filings are for invention patents, the rest are for design and utility model patents whereby a patent can be filed for making minor design adjustments to existing inventions.  The high ratio of non-invention patents highlights the low quality of China’s total patent filings.  Large numbers of patents for minor modifications should not be seen as rapid innovation.

Chinese firms tend to file the vast majority of patents domestically, and not in foreign markets where incentives are not offered and costs are higher.  Fewer patents were filed in the US in comparison to China, but US firms account for 26% of European patent filings and China only 9%.  Only about 6% of China’s innovations are protected and commercialized outside of China.  That all implies that the lion’s share of China’s growing war chest of patents are meant for collecting Beijing’s incentives, and not for the purpose of competing in the global marketplace.

More evidence of China’s lack of patent quality can be found in the Thompson Reuters 2015 Top 100 Global Innovators list published in November last year.  The list looks at the volume of unique inventions owned by firms globally, as well as the quality and usage of inventions by those firms.  Not a single Chinese firm made the 2015 list.  Huawei made the list in 2014, but was dropped last year.  The reason for China’s absence in the top 100 is its lack of innovation outside of its borders, according to Thompson Reuters.

So, while China’s surge in patent filings is impressive, the underlying level of innovation is much lower than the headline numbers imply.

High Tech Exports as a % of China's Total Exports

Source:World Bank

High Tech Exports
Another often cited demonstration of China’s growing innovation and rising competitiveness in high-value products is the country’s exports of high-tech goods.  The Asia Development Bank recently reported that China’s share of Asia’s exports of high-tech goods, like aircraft and telecommunications equipment, rose to 43.7%, overtaking Japan’s dominance in the region.  According to the World Bank, China has increased its export share of high-tech goods significantly over the last decade.

But, again, here is another instance where the headline numbers do not tell the full story.  Asian export statistics do not clearly specify exact component destinations along the global supply chain and mistakenly credit the full values of assembled high-tech goods to China.  MIT’s Yuqing Xing in his paper “China’s High-Tech Exports: The Myth and Reality” published in 2014 contends that China’s real contribution to such a high share of high-tech trade is simply labor and assembly, not technology innovation.  On top of that, 82% of China’s high-tech exports were produced by foreign-owned firms, like Taiwan’s Foxconn.  China’s real value-added technology exports are not only much lower than the stated numbers, but perhaps impossible to estimate precisely.  It is hard to differentiate between assembly of parts and production of competitive, innovative indigenous products.

A Boost to Potential Innovation
While attempting to measure China’s current level of innovation and global competitiveness yields mixed results, there are a number of factors in the works to boost China’s potential for competitive and technological strides.  The first is education.  Back in 1999 fewer than one million students acquired a college degree.  By 2004, China college graduates surpassed the US, and by 2014, college graduates numbered roughly 7 million.  Adding to the rise in secondary education, Chinese universities award nearly a third of their degrees to engineering students, while in the US that number is only 5%.  China’s pool of potential innovators is growing rapidly.

R&D spending is another factor driving China’s innovation potential.  China is the second largest R&D spender in the world, after the US.  In 2014, R&D spending grew almost 10% to over $200 billion USD, more than spending by innovation giants Germany and Japan, but well under half of the $475 billion in the US.  

Over the last few years, Beijing tax breaks and the success of tech firms like Alibaba and Tencent have spawned a wave of new tech start-ups.  Last year China cut nearly $46 billion in taxes associated with entrepreneurs and start-ups.  The numbers are quite staggering.  According to the Wall Street Journal, by the end of 2014 there were 1,600 tech incubators in China with start-up projects employing roughly 1.75 million people.  China Daily reported that last year 10,000 start-up firms were being set up every day.  Venture capitalists poured a record $37 billion USD into start-up firms in 2015, over double the tally in 2014.  That total was 27% of all global venture capital investment in 2015, but trails the US with $68 billion.  Those numbers indicate China’s entrepreneurs have possibly embraced the kind of investment and potential for failure required to build globally competitive innovation.  Although it is important to note that China’s investors have a well-documented history of throwing massive sums of capital into numerous boondoggles.

But, China’s biggest secret weapon in its strive to improve technological competitiveness is its manufacturing ecosystem.  As mentioned above, China assembles much of the rest of the world’s innovative products, and that assembly capacity can be put to work for use by indigenous starts ups.  According to McKinsey & Company, China has five times the Japanese supplier base, 150 million experienced factory workers, massive ports, and the world’s largest hoard of contract manufacturers.  Not only has China developed an unparalleled manufacturing ecosystem, the countries in close proximity to growing and often untapped Asian markets allow for rapid deployment of new products.

So, measuring China’s current ability to create globally competitive products in order to move up the value spectrum presents a mixed picture.  Recent developments indicate that China’s potential for more innovation is on the rise.  But, only time will tell if massive R&D capital investments, more university graduates, a patent hoard, and a surge in start-ups will drive competitiveness, or whether China’s attempts to push for innovation will be as empty as its massive ghost towns.