China must innovate now or lose its economic competitiveness

Xu Qing says profound changes in demography, the environment and market conditions are forcing a transformation on the country, but China has the capacity to shift gear, and upgrade its economy to one driven by innovation

China economy

Xu Qing

Published: 5:10pm, 5 Dec 2017

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China has the ability to scale the mountain of innovation: it has the human capital to propel research and development. Illustration: Craig Stephens

China’s stellar rise to the world’s second-largest economy was underpinned by an abundant supply of cheap labour and capital, huge export markets buying cheap Chinese goods, and a growth-at-all-cost development model at the expense of environmental and social well-being.

Now, the low-hanging fruits have been picked and the old economic engines are spluttering.

First, the demographic dividend is diminishing and society is rapidly ageing. The number of working-age Chinese has been dropping, and the times of a seemingly unlimited supply of young and cheap labour are gone. Meanwhile, the elderly population is set to skyrocket as a result of the low fertility rate and increasing life expectancy. Such demographic pressures signal an urgent need for productivity gains through technological innovation and upgrading.

Second, the high level of credit supply has left China with diminishing returns on capital and a high debt-to-GDP ratio. Regulators have made deleveraging a top priority. Therefore, it is highly unlikely that the liquidity floodgates will be opened again to stimulate growth, and in the remote possibility that credit growth speeds up again, its effectiveness will be much less profound.

Third, China’s competitiveness in low-value-added exports is declining, with rising labour costs and regulatory costs, such as for environmental protection, driving up corporate expenses.

On top of that, China’s large trade surplus and “unfair trade practices” are often criticised by developed countries. As a result, economically and politically, it is hard for China to expect exports to drive growth.

Fundamentally, for China to tackle all the above challenges, avoid the middle-income trap and achieve the goals laid out by President Xi Jinping to become “a moderately prosperous society” by 2020 and “a great modern socialist country” by 2050, transforming itself into an innovation-driven and high-value-added market is no longer an option, but a must.

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Fortunately, China has the ability to scale the mountain of innovation. It has the human capital to propel research and development. Even though the generic labour force has been shrinking, there has been a surge in graduates in the natural sciences and engineering. This follows higher-education reform in 1999 when university admission was expanded.

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In 2017, a record 8 million students graduated from Chinese universities, 10 times more than in 1997 and more than double the number in the United States this year. In particular, China leads the US in awarding natural sciences and engineering degrees, at a ratio of about 6 to 1. It also leads the US in awarding PhD degrees, although the gap is much smaller.

China is making a point to woo overseas talent. It has offered attractive financial rewards, career paths, research facilities and funding under various schemes, such as the central government’s Thousand Talents Plan.

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Public and private R&D funding has also been increasing fast. R&D spending grew by 18 per cent per year from 2006 to 2016, to account for 20 per cent of total R&D expenditure (PPP-adjusted) worldwide. The national target for R&D spending is 2.5 per cent of GDP by 2020. In 2015, it was 2.07 per cent for China, compared with 3.28 per cent for Japan, 2.79 per cent for the US, and 2.05 per cent for the EU.

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Government fiscal policies are supportive of R&D. In China, 150 per cent of R&D expenditure can be tax deductible, and the preferential corporate tax rate is cut to 15 per cent from the prevailing 25 per cent for hi-tech enterprises. Also, governments at different levels directly grant subsidies to select research projects.

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Further, the regulatory environment and market ecosystem are favourable. The government tends to be tolerant and forgiving of disruptive business models. Otherwise, there would probably be no Alipay, Didi Chuxing, or WeChat today.

China’s disadvantages have often turned out to be blessings in disguise. For instance, the inefficient services and logistics infrastructure stimulated the growth of e-commerce, while the low credit card penetration led to the wild success of Alipay and WeChat Wallet. The same logic probably holds for alternative-fuel vehicles too. Underserved Chinese consumers are less demanding than in other countries, and are more willing to embrace new products and business models.

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Last but not least, the size of China’s market is another important factor. There is a huge market for start-ups to quickly ramp up scale. The big user base also produces a large amount of data, which is a critical competitive advantage for technological innovations, particularly artificial intelligence.

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With all the efforts in R&D and innovation, China has been catching up in both the quantity and quality of production of scientific knowledge. Its global share of scientific papers has been growing at a far higher rate than developed countries’, and it has been awarded the largest number of patents since 2015.

In terms of quality, China ranks highly in terms of the number of significant publications and citations. The Nature Index, which provides a near-real-time proxy for high-quality research output, puts China second, after the US.

In the industrial sphere, value-added created by hi-tech manufacturing has been climbing rapidly and approaching the US level. In areas like telecoms equipment, high-speed railway, and alternative-fuel vehicles, China is already in the leading league in the world.

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There are still many challenges. China still lacks fundamental research, which is critical but takes time to produce tangible results. China’s research and development workforce was only 0.19 per cent of total employment in 2013, far behind Japan (1.02 per cent) and the US (0.87 per cent). In addition, the institutional structure of universities and research institutes is not yet ideal for top-notch research work.

However, the imperative to innovate and upgrade has never been stronger and the advancement never more pronounced. China is in the early phase of a transition from low-value-added to high-value-added. Investors who ignore such developments do so at their own risk.

Xu Qing is a senior investment manager at Neo-Criterion Capital Limited, an investment company specialising in pan-China equities

This article appeared in the South China Morning Post print edition as: Shifting gear

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