Tag Archives: R&D

China’s R&D Gets Ever Bigger Bucks

TARIFF CUTS ON imports of some 200 IT products ranging from touch screens to semiconductors took effect on Thursday. The goal is to eliminate them within seven years.

China is one of 50 countries that signed up to a World Trade Organisation Information Technology Agreement last year to promote trade liberalisation of technology goods. China imports an estimated $325 billion worth a year of the components covered by the agreement. Reducing the duty on them will cost an estimated $2.25 billion a year, rising to a potential $8 billion a year with complete elimination.

However, the benefits of cheaper imports for the IT sector are seeing as outweighing these costs. Beijing is undertaking a drive to promote the development of technology-based industries. To this end, it is also raising research and development spending to 2.5% of GDP by 2020 from 2015’s 2.1%, a change that eventually will fatten China’s R&D pot by $50 billion a year.

Intensification of investment into R&D facilities outside China parallels this. So far this year, Chinese companies have announced nine new overseas R&D centres for a total capital expenditure estimated at $224m, according to fDi Markets, a Financial Times division, with pharma and biotech investments particularly prominent. Only Germany and the United States have spent more.

That will support the transformation of the manufacturing economy from low-end exports to self-sustaining indigenous technological innovation, an essential prop for the rebalancing of the economy overall towards being consumption-led.

Winning domestic market share is the aim for now of Chinese firms’ R&D efforts.  The success some are having is creating an indigenous innovation culture built around rapid, incremental product development that can take advantage of the economies of scale of the domestic market.

However, Chinese firms are closer than ever to competing with developed-economy companies in R&D. Products they are now selling in Africa and Asia, as well as at home, are starting to show the results of that, a harbinger of what will eventually come to developed markets, too.

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China Plans To Recalculate Its GDP Number Upwards

Most developed countries have done it, and now so will China — boost GDP growth through an accounting change. The National Statistics Bureau says wants to use market values for assets such as land and property values when calculating gross domestic product. It also says it wants to bring its calculations more in line with international practice. That most likely means that research and development and other intangible assets will no longer be regarded as a mere expense, but will be transmogrified into an investment.

The instant effect will be a one-off jump in the GDP number. It is hard to know by how much without knowing more of the accounting detail but it is likely to be material. R&D spending in China reached 1 trillion yuan ($64 billion) in 2012, equivalent to 2% of its gross domestic product, according to state media.

It is, though, a change to be welcomed, and one a U.N. working group to set an international standard for GDP accounting agreed in 2008. The U.S., Canada, Australia and U.S have already made or are making the change on intangible assets. Europe will, too, next year.

GDP is a creature of the manufacturing economy, a measure of an economy’s hard output of goods and services. It is less good at capturing the intangible economy that is coming to represent more and more of the value created though innovation and creativity in the economies of the 21st century. Intangibles include not just R&D but also patents, copyrights, trademarks, designs, cultural creations, and business processes.

When the U.S. made the change in the middle of this year, which in its case also included counting creative works such as films and books as long-lived assets, it provided a one-off jump in GDP of 2.7% (in raw data terms, the equivalent to adding an economy the size of Belgium). When new definitions are introduced, past estimates of GDP get re-stated so percentage changes in GDP are only slightly affected. But they do capture something of the changing nature of an economy. Restating the U.S.’s historical GDP numbers using the new definitions raised annual economic growth between 1959 and 2007 to 3.39% from 3.32%. In more recent periods the difference has been higher, an 0.17 percentage points difference in 1995-2001 and an 0.12 percentage points difference from 2002 to 2007.

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The Next Stage Of Innovation In China

The McKinsey Quarterly has a newly published package of pieces on innovation in China. As the authors of the overview, Gordon Orr, a director of McKinsey’s Shanghai office, and his colleague Erik Roth, note:

Considerable innovation is occurring in China in both the business- to-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as communications equipment and alternative energy.

Chinese companies’ increasingly outdated global reputation for being imitative not innovative is because much product innovation in China stays there, and so escapes the notice of those not on the ground. That is as true of advances by local companies in domestically oriented consumer electronics as it is in tech media such as instant messaging and online gaming.

Orr and Roth acknowledge the importance of government support, clearly already evident in the development of industries, from high-speed rail to pharmaceuticals to green energy technologies, that Beijing considers strategically important. There will be more of that to come. The current five-year plan calls for a large increase in R&D spending. Up to 10 trillion yuan ($1.5 trillion) is a figure being bandied about. 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.

But government support for R&D is far from the only reason for China’s increasing innovation. The quantity and quality of the country’s scientific and technical talent is growing. China’s universities graduate more than 10,000 science PhDs each year. That is enabling a potent blend of technology transfers from multinationals and indigenous R&D.

The formula isn’t infallible. Again, as Orr and Roth note:

Some notable examples [of flops] include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

As we noted yesterday about some Harvard Business School research on the management of Chinese companies, the heavy preponderance of state-owned companies acts as a counterweight to developing the internal corporate cultures of risk taking, learning and collaboration that are necessary to nurture innovation. Chinese companies have traditionally preferred what Orr and Roth call “innovation through commercialization”—putting a new product or service into the market quickly, however rough its initial quality might be, but improving its performance rapidly through subsequent generations.

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, including its intellectual capital, supply chain integrity and infrastructure to reduce cost. As S.D. Shibulal, chief operating officer of Infosys Technologies, noted 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 pick off niches where consumers are prepared to accept a small drop in quality in return for a large cut in price. The real challenge for foreign firms is going to be not so much at the top end of the market in many given industries, but in the middle market. No doubt China will eventually be making breakthrough innovations; Orr and Roth say it will only be a matter of time before China evolves “from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common”. But before that happens, Western multinationals are going to have to learn to compete in the middle market as well as the top-end one, as that is where the next battles for world market share will be fought.

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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.

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China’s New R&D Path

Moving from imitation to innovation is a main pillar of China’s effort to develop its economy. The five-year plan just ended had targeted 2% of GDP to be spent on research and development. It probably fell short of that; 1.5% of GDP in 2008 is the most recent number available. But still that accounts 12% of global R&D spending.

More significantly, says management consultancy McKinsey’s Gordon Orr in a newly published article in the McKinsey Quarterly, China’s R&D spending is shifting from government-controlled research institutes to large and medium-sized enterprises, which now account for 60% of it (though given the dominance of state-owned enterprises in the economy that may represent less of shift than it first appears). However, one-thirteenth of the non-government R&D is accounted for by companies with foreign investors. China is now home to nearly 1,500 R&D centers set up by multinationals.

Orr also says that beyond industrial innovation, “much of the best innovation in China today is built around developing creative business models”.  Examples:

Broad Air Conditioning developed a way to commercialize gas-powered air conditioning systems for large buildings. Alibaba built a new business around an online platform to connect smaller Chinese producers with buyers abroad.

Chinese policy makers have learned some important lessons from earlier innovation failures, Orr says, “the biggest being that it’s hard to impose innovation from the top down”. So Beijing is focusing on identifying opportunities earlier and creating incentives for companies to innovate. Electric vehicles are his case in point, with government underwriting future demand through promises to buy for official fleets and incentives to consumers.

Undoubtedly, China’s innovation record is mixed. It is easy to spot areas such as financial services and consumer electronics where the record is poor, just as there are areas such as pharmaceuticals and telecoms where it is much better. And for many of China’s emerging multinationals, expanding market share through lower-cost rather than innovative new products is still their business model.

For all the shifts in R&D that Orr identifies, China’s policymakers won’t be getting out of the business of picking winners anytime soon, even if they want companies to do more of the donkey work of actual innovation. How good they prove to be at winner-picking, and how deftly they manage to let the market drive more innovation while still encouraging it to go broadly where they want it to for national policy reasons, will shape how fast and successfully China moves to the next phase of its development — two challenges that apply more broadly to the economy as a whole, too.

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China Proposes Changes To Patent Law

The FT reports two potential changes to patent law that will hit foreign companies.

One would require foreign companies making discoveries in the country to file first for patent protection in China or risk losing legal protection for their IP (a provision common in many countries). The other would make it more difficult to get patent protection in China for inventions already in use elsewhere.

The other issue surrounding these draft proposals — a shortage of Chinese-litterate patent lawyers.

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