Ordering Up Innovation

If there is one thing that officials and employees of state-owned companies are creative at it it is filing quotas. In a bid to change Made in China in to Designed in China, Beijing has set quotas for patent filings. The target is 2 million a year by the end of the current five-year plan in 2015, backed up in part by the controversial indigenous innovation policy, a large increase in planned R&D spending and a big drive to increase the number of scientists being produced by China’s universities.

China’s innovators have set themselves to the task. At 1.6 million, China last year overtook the U.S. in the number of patents applied for, with two-thirds of China’s being applied for by medium and large state-owned enterprises. But quantity isn’t quality. A new report from the EU Chamber of Commerce says that only a third of those applications were for patents in the top category, new inventions.

The majority of Chinese patents are lower-end design or utility patents covering incremental developments to an existing product but not a technological breakthrough. It is a class of patents that the U.S. doesn’t award, though other developed economies such as Germany do. Innovation through commercialization, as utility development is also known, is arguably appropriate for developing economies where frugal innovation can be as important as step-change advances.

The lower-end skew of China’s patents leads the report to conclude that while China’s innovation potential is “impressive”, its actual innovation is “overhyped”. Creativity has to be nurtured, not mandated, true. Yet any multinational rival that fails to notice how Chinese companies’ innovation is not yet so much leading-edge technological innovation, as process innovation that uses the country’s labor quality, supply chain integrity and infrastructure to reduce costs puts itself in peril.

From Fast Imitation To Frugal Innovation

China, like India for that matter, has set off down a development path to convert its companies from imitators to innovators. President Hu Jintao reaffirmed that at an exhibition in Beijing showcasing the country’s scientific and technological achievements during the just concluded five-year plan, urging scientists to enhance China’s capacity for innovation so as to seize the initiative in global competition.

China has made a purposeful start, but it will be a long journey. The country ranks 21st out of 40 countries on its own global innovation list. Against the oft-used benchmark of patents granted, China generates 2,000 a year, one fortieth as many as the U.S., and half of China’s comes from local affiliates of multinationals. Yet that belies advances China is starting to make in fundamental science and technology. Measured by how much the country spends on research and development as a percentage of its gross domestic product, a measure known as GERD, China now ranks third in the world after the U.S. and Japan, having raised its GERD from 0.57% in 1995 to 1.54% in 2008. That translates into annual R&D spending approaching half a trillion yuan ($75 billion), though China’s critics will jibe that much of that should be called R&C spending, for research and copying.

Beijing’s long-term target is for a 2.5% GERD by 2020. The new five-year plan calls for a large increase in R&D spending. There are straws in the wind that suggest that that will manifest itself as an up to 10 trillion yuan ($1.5 trillion) boost for selected advanced industries over the next five years, both directly through soft loans and government procurement and via incentives for foreign companies to set up more R&D facilities in China. The number being floated may be pie in the sky (it is after all two and a half times the size of the 2008 stimulus package) and it is far from clear how much would go for R&D as opposed to infrastructure development, but it is clear that improving the technological capabilities of China’s manufacturers is a policy priority. The anointed industries are biotech, post-fossil-fuels energy, energy conservation and environmental protection, clean-energy vehicles, new materials, and next-generation information technology and high-end equipment manufacturing. The plan calls for these industries to account for 15% of China’s GDP at the end of the next five-year plan, up from 5% going into it.

It is easy to forget that China’s exports have been moving up the value chain away from low-tech products since the 1990s. Firms like Huawei and Lenovo have prospered by absorbing foreign technology and business expertise, and adapting them to produce products for the Chinese market before taking the same strategy into global markets. Not all foreign suppliers of technology and expertise have been happy with the first part of that strategy. They have had to agree to hand over technology to win access to domestic markets and then found that Chinese enterprises are preferring — or being encourage to prefer — to buy locally developed products, patriotic support of the pursuit of “indigenous innovation’.

What also needs not to be lost sight of is that this is a different stripe of innovation, not so much yet leading-edge technological innovation as process innovation; the use of China’s labor quality, supply chain integrity and infrastructure to reduce cost. As S.D. Shibulal, chief operating officer of Infosys Technologies, notes in an INSEAD article on innovation in emerging markets, Chinese companies “are redesigning products to reduce costs; they are redesigning entire business processes to do things better and faster than their rivals.” He dubs this “frugal innovation”.

This lets Chinese companies pickoff niches where they can refine their products and market entry. Haier, the white-goods manufacturer, was a harbinger of  this approach with wine-cooler refrigerators, turning what was a high-end consumer good into a much cheaper middle-market one, and grabbing 60% of the market in the process, according to Peter Williamson, a former INSEAD professor who has written a book on the topic. Consumers were prepared to accept a small drop in quality in return for a large cut in price.

“The real challenge for foreign firms is not so much the top end of the market in many given industries, but the medium sector, which we call the ‘good enough’ sector,” says Anil K. Gupta, a current INSEAD professor. The lesson is that Western multinationals are going to have to learn to compete in the middle market as well as the top-end one, as this is where “future battles for world market share will be fought.”

Meanwhile the challenge for Chinese firms will be to develop their own brands and innovate their own products, then move from manufacturing them at home to designing them there and manufacturing in lower cost countries.

Update: The Economist Intelligence Unit estimates that China’s R&D spending of 500 billion yuan in 2009 will rise to 1.2 trillion yuan by 2015 and to 2.1 trillion yuan by 2020, which is $320 billion at today’s exchange rates. Much of the support will come via fiscal inducements, it says.