China’s innovation drive should first target its grossly inefficient state-owned companies

Why has Beijing set innovation as the next growth engine? There may not be many other options left. With the working population now declining, there are no more surplus farmers to be converted to factory workers. Many hidden costs, such as poor safety, are coming into the open and migrant workers expect fairer treatment. Citizens no longer accept the high costs of pollution, and China is suffering from chronic overcapacity.

China got to where it is not just through cheap labour and investment, but also through innovation. Innovation need not come from new technologies or even new business models. As defined by economist Joseph Schumpeter, innovation is the creative destruction of inefficient enterprises by more productive ones.

Since the implementation of economic reforms, many inefficient state-owned enterprises have first been replaced by more nimble township and village enterprises and, later, by private enterprises. In 1978, nearly all urban residents were employed by the state. Now that figure is fewer than 20 per cent. What remain of the state-owned enterprises are giants in protected industries such as resources, heavy industries, banking and telecommunications. But they remain far less productive than private enterprises.

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The service sector, which has surpassed manufacturing to become the largest part of the economy, may represent the biggest opportunity for productivity improvements. Compared to manufacturing, it has lagged behind in productivity growth. One reason may be the continued state dominance in many service industries.

Making China’s state-owned enterprises more efficient will be a better way to improve productivity than mass start-ups – most of which will fail. And reforming the state-controlled telecoms and banking sectors will improve the odds for start-ups to succeed. Inefficiencies in these sectors have widespread ramifications. As the whole economy depends on them, poor, limited or expensive services in banking and telecommunications inhibit overall growth.

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Other than by privatisation or introducing fully fledged direct competition, one important way to promote efficiency is through better regulations to protect consumer welfare. International benchmarking can be used to set tariffs, and hold managers of state-owned enterprises accountable to world-class efficiency standards. Importantly, China needs more independent regulators.